If one compares the difference between short- and long-term bond rates, there seems to be little incentive for the income-seeking investor to take on risk for a prolonged period of time. In a nutshell, the premium for taking a long-term risk just isn’t there.

For instance, on bellwether Government of Canada bonds, two-year yields rose to 4% in early April — the highest rate since June 2002. The yield on five-year Canada bonds has risen almost a full percentage point since September 2005 to about 4.2% — the highest it has been since June 2004. But at the same time, the yield on a 30-year Canada bond is only 4.3%.

Even though there is little incentive for an investor to take on three decades of risk, long bonds are much in demand. What appears to be happening is that income-seeking investors and bond speculators are going in opposite directions.

Addressing income investors, David Christianson, a fee-for-service registered financial planner with Wellington West Total Wealth Management Inc. in Winnipeg, says: “You are not being paid for the risk in the long bond right now. While long bonds would make a lot of money if interest rates fall, predicting the direction of interest rates is a risky proposition. Buying and holding a 30-year bond is a lot like buying an annuity. You have to be confident that rates have peaked and will be declining for many years. I don’t have that confidence.”

However, long bonds are attracting speculators waiting for a downturn in interest rates. But they may have to wait even longer for that to happen, says Tom Czitron, managing director for income products at Sceptre Investment Counsel Ltd. in Toronto. “By now, we are supposed to have had a rally in bond prices, but we have not,” he says.

The income-seeking investor has to ask what purpose there is in buying bonds for income when pretty good income trusts easily pay 5%-10% and quite a few very sturdy stocks pay dividends of 2%-3%. A bond of any term that pays just 4%, give or take, with full exposure to taxation outside of registered accounts, looks like an also-ran.

What’s more, the long bond is very sensitive to interest rate changes. If the Bank of Canada were to raise rates in order to combat inflation, then the 30-year bond would get whacked hard. The duration — technically, the weighted average of the bond’s cash flows, including coupons and return of principal — is about 14 years for the 5.75% Canada due June 1, 2033. That’s how long it will take for the bond buyer to get back the investment. It also means that the buyer will lose about $14 per $100 value for every 1% rise in interest rates.

Clearly, long-bond shoppers who are content to buy and hold are betting that interest rates aren’t headed upward or that, even if they do go up, it’s still OK to lock in 4.3% for the next three decades.

From a speculative point of view, the long bond is appealing. Even if rates rise a little before they fall, the long bond’s risk/return trade-off is a decent deal, says Michael McHugh, bond specialist and portfolio manager at Dynamic Mutual Funds Ltd. in Toronto.

“Our view is that North American central banks are close to the end of their rate hikes and that the debt markets are pricing in another hike of 25 basis points by central banks in Canada and the U.S.,” McHugh says.

He adds that he expects the yield curve to shift downward and get steeper. That will happen by the end of the year, he says. The curve’s shifts will improve the premium for holding long debt and handsomely reward its owners.

The income-seeking investor has a considerable choice of long bonds to buy. In Canada, one can take a single long bond such as the 5.75% Canada due June 1, 2033, which currently yields 4.3%, or buy the same yield with the 5% Canada due June 1, 2014.

Going to 2033 is buying insurance against rate increases. To add some safety, the investor could combine it with a short bond, such as a 4.25% Canada due Sept. 1, 2008, which currently yields 4.06% to maturity. A pure long-bond play — a “bullet” bond, in bondspeak — has the better return if rates do fall, McHugh notes.

@page_break@Chris Kresic, senior vice president for investments at Mackenzie Financial Corp. in Toronto, agrees: “The market is looking at the U.S. Federal Reserve Board ending its rate rise at 5.25%, which is 50 bps more than the present rate of 4.75%, with the Bank of Canada adding as many 250 bps to the current 3.75% rate. Once the rate rises end, long bonds should rise dramatically in price.”

For pure insurance, however, nothing beats a real-return bond — a bond in which the return rises or falls in direct proportion to inflation. Currently, a 3% Canada RRB due Dec. 1, 2036, yields 1.56%, which is trifling unless inflation runs at an average rate in excess of 2.74% for the next three decades. RRBs are among the longest bonds on the market, and there is a strong global demand for them, McHugh notes.

“Demand for RRBs from portfolios that are mandated to hold RRBs exceeds issuance, and that is driving real yields lower,” he says.

In other words, even if inflation is not high enough to justify buying very long RRBs, the strength of demand from investors who insist on having inflation protection is keeping prices up.

So, are long bonds a good buy? “Sure, if you are an insurance company and you have to match liabilities, then you buy what you gotta buy,” says Derek Moran, a fee-only financial planner who heads the Kelowna, B.C., office of Macdonald Shymko & Co. “Ditto if you are a pension fund. But, if you are a real person with a pulse, then you may not even have a 30-year time frame. Mortality means you should think about what you really need for income and not just ponder duration.”

Still, if an advisor or investor is sure that rates are about to plummet, the long bond is an ideal buy.

Explains Moran: “You can lock in a good return and carry a paper profit.” IE