As 2006 begins, the yield curve — the line that connects the dots of interest rates from one day to 30 years — is returning to normal. Briefly inverted in the U.S. and Canada in December 2005, when short rates temporarily rose over long rates, the curve is widely expected to regain its normal, upward slope. What is driving the return to normalcy is an expected decline in rates for periods from 30 days to five years, and that may push income-seeking investors to buy risky bonds.

“Normalization” implies that bond investors are going to have to accept fairly modest returns. “In 2006, the return for the SC universe bond total return index is going to be in the range of 4% to 5%,” says Tom Czitron, managing director and head of fixed-income products at Sceptre Investment Counsel Ltd. in Toronto. That’s far less than the 6.9% return the index produced in the 12 months ended Nov. 30, 2005.

U.S. treasury 10-year bonds will pay slightly more, according to Bank of Nova Scotia’s economics department, which forecasts the bellwether 10-year U.S. treasury bond will yield 5.2% from mid-2006 to the first quarter of 2007. That is less than the benchmark produced in any of the past 10 calendar years from 1995 to 2004 — except 1999, when the index produced a 1.1% loss.

In the expected environment of low bond returns, investors and advisors who are desperate for yield may begin to climb the ladder of risk. “People are moving to preferred shares, high-yield common stock and income trusts,” says Dan Stronach, president of Stronach Financial Group Inc. in Toronto. “But each of those alternative assets has a higher level of short-term risk than investment-grade bonds. You have to be very skeptical of what you are buying.”

Debt as junk

As a sign of the times, the Republic of Venezuela, a conspicuous bond defaulter, issued $1.5 billion of U.S. dollar-denominated bonds on Nov. 22, 2005. The bonds were snapped up in the domestic market and quickly swapped for domestic bonds in a flip that produced an instantaneous 7.2% return, according to a report on the Venezuelan news Web site, www.vcrisis.com, on Nov. 27, 2005.

As long as energy prices stay high, Venezuela should be able to service its debt. But for now, the global bond market is treating Venezuelan debt as junk. A federal Venezuelan bond payable in bolivars, the national currency, due in March 2010, was recently priced to yield 8.78% — about double the going rate for five-year U.S. treasuries.

“Risk creep” also shows up in the public’s appetite for income trusts, of which many are virtually certain to have to cut or eliminate their distributions over time. In April 2005, Blackmont Capital Inc. — an investment dealer based in Toronto — issued a report on income trusts that said higher-quality business trusts are just as risky as junk bonds, while lower-quality income trusts are about as sound as dicey stocks.

“We believe the business trust universe has the financial characteristics of equities with a single-B rating, given that 20% have become fallen angels within only 2.4 years, on average, of going public,” the Blackmont report stated. Single-B, it should be noted, is subinvestment-grade, high-yield debt.

The Blackmont study made it clear that there is a pattern of failure in certain income trusts. Successive events make the point. In the past month alone, Connors Bros. Income Fund, a fish processor, reduced payouts on Dec. 19, 2005; Boyd Group Income Fund, a chain of collision-repair shops, suspended payment of dividends on Dec. 15, 2005; and pet-food maker Menu Foods Income Fund cut distributions on Dec. 2, 2005.

The risk of chasing yield in a market that correctly prices income trust default risk should be apparent. The alternative investment plan for the investor eager to hold down his or her losses is to stick with government bonds, accepting that they look to produce a year of modest returns, and then seek to boost those returns with adept market moves.

Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver, figures that part of the strategy is patience. “The yield curve will get steeper by August 2006, although it is hard to be precise,” he says.

@page_break@Middle of the curve

His plan is to move to the middle of the curve with five- to 10-year bonds. The reasoning is simple: “If long-term rates don’t change and short rates fall with, say, a 2% drop in T-bill rates and a 1% drop in mid-term bonds, you’ll get a capital gain on the mid-term bonds, no change in long bonds and no significant price change on the short maturities that revert to cash,” he says. “The implication is you are better off holding all your money in the middle than in the wings. If you barbell and put your money at the short and long ends of the curve, you won’t benefit from the drop in short rates.”

An alternative to betting on a decline in interest rates is to invest in corporate bonds that have higher yields than those on government issues. But that’s not a good plan now, Bondy insists. He’s been moving his own bond portfolios to higher-quality issues. And if the economy weakens, which is consistent with a central bank decision to lower interest rates, spreads will widen and holders of corporate bonds from investment-grade to junk will sustain losses, he says.

In the coming normalization of the yield curve, conservatism will pay by reducing risk. “In an environment of low anticipated returns for bonds, stocks may seem a better value,” Czitron says. “The difference is in the equity premium for stocks — the amount they return over government bonds.”

He says the equity premium, which is 3%-4%, implies a total stock return of 7%-9%. Although the return is higher than that of investment-grade bonds, they also come with equity risk. In the end, Czitron says, if bonds represent portfolio insurance, they are worthwhile even if they impose what amounts to an opportunity cost for not taking equity risk in stocks.

That cost, Czitron adds, is the equity premium. But opportunity cost is just theory.

“What matters is not the cost of not doing something, but how much money you have when the music stops,” he says. “With junk bonds and questionable income trusts, you never know. With investment-grade bonds, you do.” IE