For bond investors, 2006 was a year of frustration. Despite widespread predictions that interest rates — which rose during the year to 4.25% in Canada and to 5.25% in the U.S. — would fall as an anticipated recession got underway, that consensus view was dead wrong. As a result, broad market bond indices did just about nothing.

For example, Toronto-based Barclays Global Investors Canada Ltd.’ s iShares Canadian Bond Universe exchange-traded fund units, which reflect the tenor of the entire Canadian investment-grade market, started — and finished — 2006 at $29.10. In the U.S., Barclays’ iShares iBOXX Corporate Bond ETF started at US$107.10 on Jan. 2, 2006, and ended at $107.08 on Dec. 29.

The result is that 2006 was a year of missed expectations in which most investors got their coupons and not much more, says Tom Czitron, managing director for income and structured products at Sceptre Investment Counsel Ltd. in Toronto. “In the past, when you had a flat to inverted yield curve, you got a slowdown greater than what happened,” he says. “The stock market was more robust than bond forecasts had anticipated.”

However, despite a listless domestic bond market, some portfolios did thrive. The winning strategies that drove these portfolios varied from average risk levels and average quality. Only one sector flopped — real-return bonds. RRBs lost a stunning 6.5% of their value in the year ended Dec. 31, a return to earth after four calendar years of dramatically outperforming the broad Canadian bond market. When inflation expectations subsided to as little as 2% for as far ahead as anyone could see, RRB nominal interest rates of 1.6% were too low relative to plain Canada bonds that paid 4.2%. As a result, RRBs were sold off.

In investment-grade credits, the winning strategies focused on duration, the responsiveness of bonds to interest rate changes. Portfolios of long bonds turned in above-average returns for 2006 as inflationary expectations declined. Toronto-based McLean Budden Ltd. ’s $654-million MB Long-Term Fixed-Income Fund produced a 4.26% return for calendar 2006. That boosted the return to high in the first quartile relative to the 2.6% average return of Canadian bond funds during the same period. As well, for the five years ended Dec. 31, the fund produced a 9.49% average annual gain, putting it near the top of all 195 Canadian bond funds active in the period.

“Duration was the primary driver of our outperformance,” says Peter Kotsopoulos, vice president for fixed-income at McLean Budden, noting the fund has duration of 13.5 years — more than double the average duration of 6.5 years for the SC universe bond total return index. For 2007, Kotsopoulos figures inflationary expectations will decline, as they did in 2006.

But there were ways to boost performance other than by extending duration. Toronto-based Caldwell Investment Management Ltd. ’s $10-million Caldwell Income Fund produced a high first-quartile return of 6.34% for calendar 2006. The key to its success was adding bond proxies, says portfolio manager Dennis Freeman.

Freeman used the fund’s mandate, which allows the portfolio to hold “corporate securities,” to put a fifth of total assets into stocks of dividend-paying companies such as chartered banks. Realized gains on those stocks added to good bond bets, including a Canada Mortgage and Housing Corp. 4.10% issue that went into the portfolio at $95 and was sold within months at par. For 2007, Freeman will increase duration to enhance gains on the expectation that rates will decline.

High-yield investing is a world apart from the ivory tower of investment-grade bond analysis. It focuses on credit analysis, and on the sense of what bonds will survive and what won’t. One of the most respected high-yield specialists in Canada is Barry Allan, portfolio manager of Toronto-based Dynamic Mutual Funds Ltd.’s $252-million Dynamic High-Yield Bond Fund and president of Marret Asset Management Inc. in Toronto. He boosted the fund’s returns to a first-quartile standing in the years following his 2001 assignment to head the fund.

With the portfolio rejigged, the fund came out in the top 10% of all high-yield bond funds in 2003 with a 30.1% return — almost three times the 11.3% median return — and then produced a string of above-average annual gains. It ended 2006 with a one-year return of 8.1% compared with the 4.9% return of the median high-yield fund and almost twice the 4.1% return of the SC universe bond total return index of investment-grade bonds.

@page_break@What’s the near-term future of high-yield bonds? Spreads on high-yield bonds are close to the historical low of 250 basis points over U.S. treasuries of the same term, Allan says: “That doesn’t mean it’s time to leave the market. When you put the current spreads of 272 bps over the relatively low default rate of 1.7% of all outstanding high-yield credits, the risk-adjusted return isn’t bad.”

Global bonds are among the most sophisticated and difficult categories of debt to buy and manage. Among the first-quartile winners in the foreign bond sector in 2006 was Burlington, Ont.-based AIC Ltd. ’s AIC Global Bond Fund, which produced a 6.4% return — far ahead of the 4% median return of its peers. Randy LeClair, senior vice president and portfolio manager of the $32-million fund, says it was a combination of betting on the right currencies and the right countries that drove performance.

Predicting currency exchange rates, interest rate shifts and macroeconomic trends is akin to winning a trifecta at the races, but LeClair did just that from 2001-2006, making the fund an above-average performer each year. For the five years ended Dec. 31, it was high in the first quartile among almost 50 foreign funds.

AIC’s foreign bond portfolio, which is unhedged, got most of its return from currencies that denominate its foreign bonds, LeClair says. In 2006, it booked gains on the British pound, which advanced 14.1% against the Canadian dollar, and a 10% gain in the Australian dollar.

LeClair predicts the mover for his fund’s value in 2007 will be a rise in the U.S. dollar as Canadian commodity prices continue to fall. The US$ should rise by 10%-15%, he says, and sterling bonds should show a return of almost 13%.

But don’t expect big changes in the bond world, says Czitron, who expects bonds to offer coupon returns and not much more for the next few years. “For 2007,” he says, “the interest rate outlook has not changed much.” IE