It appears that global bond returns are likely to beat Canadian bonds in 2007. But playing the global bond market will require a discriminating sense of credit quality, suggests Standard & Poor’s Corp. in its 2007 Global Credit Strategy Asset Class Outlook.

The S&P study, which was published on Dec. 8, 2006, notes that “credit quality metrics show downside risks.” This means that this year’s expected global slowdown will result in a deterioration of corporate credit quality. It follows that the money to be made will be in global government bonds — especially G-7 government issues — as inverted yield curves around the world normalize and markets provide declining interest rates. This process will raise the prices of existing government bonds.

Anticipation of a global slowdown is widespread. If that slowdown is mild, stocks and bonds should continue to fare well. But if the slowdown turns into a global crash and stocks plummet, bondholders will be the winners. The implication: get ready to buy global bonds for insurance and return.

The chances of a hard landing justify a move to higher-quality bonds because moves by central banks to cut their short-term rates as the global economy softens will be the fundamental driver of global bond markets, says Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver.

Foreign currencies are due to appreciate against the U.S. dollar, and that means there will be additional gains to be had on the currency side of foreign bonds, says Randy LeClair, vice president and portfolio manager at AIC Investment Services Inc. in Burlington, Ont.

The US$, though, could move up as well, Bondy says: “U.S. yields are higher than those in Canada, Europe and Japan. And that makes investing in U.S. Treasuries attractive. But there is the financial and political problem of the U.S. trade deficit, which is currently US$900 billion per year. That pile of purchasing power resides in U.S. T-bonds held by foreign central banks that have been watching their stash lose value.”

China and other creditor countries will not move to cut their holdings of U.S. bonds or revalue enough to fix the trade imbalance because “that would inflict too much damage on their own economies,” Bondy adds. If these countries were to revalue, it would cause a substantial reduction in their growth rates. And if there were massive selling of U.S. Treasuries, bond prices would fall and interest rates would rise. That would lead to a slow U.S. economy as well, he explains, and that would feed back to China in the form of reduced U.S. demand for Chinese industrial products.

It’s a critical balance for global bond investors: a slowing global economy implies falling interest rates and profits to be made in any quality bond, especially long-term issues. But any rejection of U.S. debt by foreign central banks implies rising interest rates and rewards for anyone who either shorts bonds or uses a bear strategy, he says.

A Chinese rejection of U.S. bonds would amount to China saying that it doesn’t want to sell to the U.S. anymore. Bondy says this is highly unlikely, adding, “The moves against the US$ are probably going to be orderly.”

The two drivers of an orderly global bond market should be falling interest rates and currency moves, he adds. Falling rates follow from the weakening world economy that will result from lower economic growth in China and the U.S. And, in spite of widespread predictions that the US$ is due for further declines, it could actually move upward against the Canadian dollar. That unexpected result would come as the oversold greenback rises against a C$ weakened by declining world commodity prices, Bondy suggests.

“Relative to other bonds, the U.S. represents good value because both nominal and real yields are higher on U.S. debt,” he says, pointing out that Britain’s yield curve is inverted and would steepen with drops in short rates. That implies that the greatest relative gains are to be made on bonds with terms of five years or shorter. The European Central Bank, which is still tightening, will eventually loosen by the end of 2007, when it will be useful to stay long with maturities of 10 years or longer, Bondy adds.

Currently, the Bank of Japan maintains a 40-basis-point overnight rate, the lowest in the G-7, as that nation continues to reflate. The Bank of Japan is unlikely to raise short rates for fear of triggering a slowdown. A major appreciation of the yen is also unlikely, Bondy says.

@page_break@The consensus among economic forecasters and global bond managers holds that the U.S. and, by implication, Canada will have a soft landing. That means profits for a strategy of lengthening terms.

Although one cannot predict the outcome of U.S. foreign policy in the Middle East, there is a modest chance that the U.S. will move toward protectionist policies, either by increasing tariffs or by imposing higher non-tariff barriers to trade in the form of security measures, Bondy says. That would tend to push up inflation and would change the whole story of the bond market, he adds. Inflation going up would imply higher interest rates, and that would be bad for bond returns.

But these risks can translate into portfolio profits. Bondy suggests that global bonds should return 6.5%-7%, before fees, on managed portfolios. Canadian bonds, which should return 4.5%-5.0% in 2007, will be less desirable, he suggests, adding that Canadian institutional managers have already moved to lengthen their average maturities to take advantage of the anticipated higher returns of existing bonds and their superior coupons in the coming falling interest rate environment.

However, not all global bond markets and bond funds will fare equally. Emerging-markets bonds — the last to be bought and first to be sold when there are global credit worries — may lose value. Eastern European debt has been played out on the theory that the former East Bloc would converge interest rates with the senior states of the European Union. But “a lot of people who rushed to this theory got burned,” LeClair says, because “it didn’t turn out that way.”

So, as 2007 unfolds, advisors and investors should look for diversified global bond funds that are not currency-hedged. “After all, the currency play is part of the appeal of not holding Canadian bonds,” says LeClair. Meanwhile, Bondy recommends staying away from corporate debt that could suffer widening spreads against government debt.

It appears that some of the best bets in government bonds in 2007 will be across the border and overseas. It will take a discriminating buyer: with declining credit quality, there is likely to be a rush to safety in top-rated sovereigns. IE