Corporate bonds have been discounted to deep bargain levels as a consequence of the ongoing credit crisis. And, in turn, fixed-income investors can now find bargains that have not existed for a decade.

The problem, however, is not in finding deals — they are abundant in investment-grade bonds from banks and other financials — but in understanding why these deals exist in the first place.

“You can buy a senior TD Bank Financial Group five-year deposit note for 125 basis points over a Canada bond of the same term that pays 3.8%,” says Chris Kresic, senior vice president for investments at Mackenzie Financial Corp. in Toronto. “Compare that to the state of the market in 1998, when Long-Term Capital Management LP failed. At that time, senior bank notes were paying 75 bps over comparable government bonds.”

What’s behind this potential bond sale of the decade is negative sentiment. As Bill Gross, chief investment officer of Newport Beach, Calif.-based Pacific Investment Management Co. LLP, the largest bond management firm in the world, says, “We haven’t faced a downturn like this since the Great Depression.”

Bond investors have priced in a wretched outcome for the debt crisis, Kresic says: “We are not at the edge of the abyss; we are already halfway down the slope.”

The mood that things are going to get even nastier than they are now could hardly be more striking or, indeed, more widely held. And it could be right. There is an awful lot of leverage on bad debt that has yet to be resolved, says Tom Czitron, managing director of Sceptre Investment Counsel Ltd. He is in charge of fixed-income assets at the Toronto-based firm.

“LIQUIDITY IS A COWARD”

This is why so many credit markets around the world, including Canada’s own asset-backed commercial paper market, have seized up. Nobody wants to put in a bid on anything that appears certain to drop further in price. As Kresic says, “Liquidity is a coward. It runs away at the first sign of trouble.”

The case for the worse-is-yet-to-come view is embedded in the global credit market. As Satyajit Das, author of the four-volume, 5,000-page door-stopper, Swaps/Financial Derivatives, explains: “A diet of cheap and excessive debt created a bloated financial system.”

Das points to the credit market’s 30:1 capital to debt leverage ratio. The structure of credit is mostly based on derivatives that now account for 80 times the money supply that central banks control. In this view, credit markets are due to melt down even further.

Stock investors are not nearly as pessimistic. Michael Smedley, chief portfolio manager of Toronto-based Morgan Meighen & Associates Ltd. , is keeping his $900-million Canadian General Investment Fund fully invested and almost entirely in Canadian stocks — heavy on oil and gas, light on banks and diversified through industrials, metals and mining.

Smedley’s view is sanguine: “I am fully invested. That is always our policy.” He is hanging on, sure that things will eventually right themselves. “I am confident that conditions will improve in the near term,” he says.

For the moment, however, there is a lack of what Kresic calls “animal spirits” — a phrase for willingness to take on risk. The U.S. subprime mess and Canada’s ABCP crisis have made investors leery of buying into any more risk.

This perception of risk has made a lot of bond investors leery of trading. That has dried up liquidity and made the crisis all the harder to fix. But the central banks are trying. The Bank of Canada cut interest rates by 25 bps on Dec. 4. Then the U.S. Federal Reserve Board — which had already cut interest rates by 75 bps since September — cut interest rates by another 25 bps on Dec. 11.

The case for cuts is clear: inflation is low and there is a desperate need to prod the markets by cutting the cost of lending. Bond markets on either side of the border are pricing in more cuts, says Craig Allardyce, a bond portfolio manager with Mavrix Fund Management Inc. in Toronto.

So what should an investor do? The bond market has already anticipated a worst-case scenario, while the stock market has, perhaps, not yet priced in seriously tough times, Kresic says.

PROFITING ON LONG BONDS

The rush to safety in bonds that began in mid-summer has enabled investors holding long bonds to book profits. “If you were up 10% in stocks in June and then switched to bonds, you would be up 17% year-to-date. It pays to be balanced,” Kresic says.

@page_break@Stock and bond markets have become negatively correlated in the last few years, Kresic notes. That means there should be benefits in asset diversification. His suggestion: realize that even though the bond market has already seen the worst of all possible worlds, the stock market has a way to go before it prices in a truly terrible outcome of the credit crisis.

The implication is that good corporate bonds should be ready for a comeback; in addition, a rally in the prices of government bonds will continue to rise with further rate cuts.

As a result of all this, bond investors can now be in a position to capture value. Here is some advice from the experts as to how this can be done:

> Pick The Survivors. In corporate bonds, these are issuers with manageable debt and strong earnings in both good times and bad, Kresic says, such as banks and life insurance companies.

> Obtain Value In Corporate Bonds. You can get paid for taking on risk with a hefty premium over government bonds of the same term, Kresic suggests.

> Stay At Two Years Or Less in government bonds to cover the risk that central banks won’t deliver on expected interest rate cuts. In that case, bond prices would fall, Allardyce says.

> Use A Professional. This market is tough for someone on the sideline. As such, it’s worth paying a professional bond manager to dodge bullets, Czitron recommends.

> Weigh Your Pessimism. If you believe that the credit crisis will bring on more chaos, which in turn will lead to lower interest rates, go long on your bonds. However, appreciate the risk of excessive pessimism, Kresic says. IE