For a bond investor, life looks a little better south of the border — at least, for now. In the U.S., a 10-year treasury bond recently was priced to yield 4.37% a year, whereas in Canada, a federal 10-year bond was yielding 3.98%.

The U.S. T-bond offers a better nominal return. So, should the fixed-income investor in pursuit of security opt for the U.S. bond? That depends on the outlook for rates in each country and, of course, on the trend of exchange rates, which in mid-January valued the Canadian dollar at US85.38¢.

How to play what the market calls a “negative spread” — because interest rates are customarily higher in Canada than in the U.S. — depends on the client’s risk tolerance.

The simplest move is to ride the yield curve (the line that connects interest rates with terms to maturity) as the Bank of Canada raises rates. Until the peak is in sight — the consensus says that will happen late this year, when the expected series of Bank of Canada tightening moves should end — the bondholder has to accept relatively low yields: about 3.27% on a 30-day T-bill or 3.60% on a 6-month T-bill, giving up the 3.98% yield to maturity on the 10-year bond for a few months.

Presently, the yield curve is quite flat, so the sacrifice is modest. But the investor then has to extend term and duration. When the tightening ends, bond prices should soar.

The strategy of staying in Canadian bonds heavily weighted with government issues, which is how the SC universe bond total return index is structured, will produce a 6%-7% return for 2006, says Randy LeClair, vice president and portfolio manager for AIC Investment Services Inc. in Burlington, Ont.

In contrast, a more aggressive investor can buy U.S. bonds and trust that the greenback will rise against the loonie and boost total return on the U.S. bond position.

Higher returns on U.S. bonds

LeClair expects the U.S. dollar, which has risen from its 2004 low, to gain value both on fundamentals and by virtue of the principle of “regression to the mean,” which maintains that, over time, averages do assert themselves. Putting money into the U.S. 10-year T-bond should produce a 12%-15% total return, he says.

All these trades will also work with low-fee bond exchange-traded funds. A client can stay short in either Barclays Global Investors Canada Ltd. ’s Canadian iUnits Short Bond Index ETF or in Barclays iShares Lehman One- to Three-Year Treasury Bond Fund. The client can then move to longer bonds in Barclays iShares Broad Market Index Fund, which replicates the SC universe bond total return index, or the Barclays iShares Lehman Seven- to 10-Year Treasury Bond Fund, which replicates the Lehman mid- to long-term U.S. treasury bond index. Both of the longer-term ETFs capture the middle of the yield curve, the part that tends to be most responsive to interest rate changes.

Moving into a mid-term bond or bond fund will generate enhanced returns if interest rates should decline more than is generally expected. That would happen if a recession should develop.

The possibility of a recession grew on Dec. 27, 2005 — a slow day in the holiday season — when the yield on U.S. 10-year bonds briefly fell below the yield on two-year U.S. T-notes. For those who believe that the yield curve inversions augur recessions, the phenomenon of short bonds paying better than long bonds was ominous. If the yield-curve soothsayers are right, then lower interest rates are ahead, and any bond position will produce not just interest income but also disproportionate capital gains.

The link between the yield curve and economic activity has several explanations, the best of which is the “theory of expectations,” which is just an average. If the five-year rate on bonds is 5% and rates are expected to climb to 10% in five years, then the investor will demand 7.5% today on the 10-year bond; if rates are 5% today and are expected to fall to 3% in five years, then the investor will want to be paid 4% today to take the five-year bet. The first play is a discount on the future; the second is insurance. Either way, the investor is just averaging future interest rates.

@page_break@If there is a recession ahead and if the investor is going to average down, he or she is implicitly accepting the idea of reduced inflation expectations. This close relationship was recently refined by a research paper published on Oct. 20, 2005, by economist Arturo Estrella for the Federal Reserve Bank of New York entitled The yield curve as a leading indicator.

Yield curve and recession

“Since 1960, a yield curve inversion has preceded every recession on record,” Estrella wrote. However, not every inversion precedes a recession. Estrella’s calculations indicate that the probability of a recession following a brief inversion of a few basis points on a small part of the yield curve is only 10%. Therefore, we can conclude that the likelihood of a recession has increased — but not by much.

Bank of Nova Scotia’s economics department forecasts that in 2006, year-over-year inflation in the U.S. will run at 3.2%, vs Canada’s 2.8% forecasted rate of inflation. Inflation expectations alone suggest that U.S. interest rates are going to stay higher than Canadian rates for at least several months, only coming down if the Bank of Canada keeps on tightening, as is expected, for a few quarters after the U.S. Federal Reserve Board has quit tightening its monetary policy.

So, is it time to buy U.S. bonds or U.S. bond funds? Not really, says Tom Czitron, managing director and head of fixed-income and structured products at Sceptre Investment Counsel Ltd. in Toronto.

“There is a good chance that the loonie will move higher because of rising commodity prices and because Canadian interest rates will continue to rise after the Fed stops its raises,” says Czitron, noting that an upward move by the loonie could easily cancel out the yield gain of U.S. bonds. “If your life is in Canada, you should not take foreign currency risk.”

Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver, suggests a balanced approach instead: “For a portion of a fixed-income portfolio, it makes sense to hold some U.S. bonds. We like treasury inflation-protected securities (TIPS), the American version of real-return bonds that raise their yields as the consumer price index rises.

“TIPS have higher yields than RRBs right now and offer a wider choice of terms. There is foreign exchange risk, but, over a long term, it pays to have issuer and currency diversification. You can’t write off the US$ or U.S. bonds,” Bondy concludes. IE