A targeted bond strategy

The way to do that, he suggests, is to develop a “barbell” fixed-income portfolio using safe infrastructure issues, such as the Ontario Highway 407 International Inc. 6.47% bond due July 27, 2029, recently priced at $128.43 to yield 4.17% to maturity at the long end; and a TransCanada Corp. 4.65% issue due Oct. 3, 2016, recently priced at $110.85 to yield 2.24% to maturity for the mid-term portion. In a 50/50 split, the average duration would be 7.7 years, the average yield would be 3.21% and the average term would be 10.5 years. That compares favourably with the 3.25% Canada due June 1, 2021, recently priced at $118.88 to yield 1.87% to maturity.

To get even higher yield, you would normally look to high-yield bonds. However, some bond experts don’t think now is the time to move into or add to that asset class. For now, it’s better to wait because, says Barry Allan, president and CEO of Marret Asset Management Inc. in Toronto: “Spreads are going to get wider before they narrow.”

The Merrill Lynch master II high-yield index’s spread on high-yield debt for blended periods is currently 750 bps over U.S. Treasury bonds, Allan explains: “That’s in the middle of the range. If you exclude 2007-08, the long-term range is 220 bps to 1,200 bps over Treasuries. But when the recovery starts, it will be tough to pick the exact bottom of the high-yield market. The place to look will be in BBB-rated utilities, telecommunications, cable and pipelines.”

BBB-rated bonds are on the bottom rung among investment-grade bonds. But because BBBs offer considerably more yield than higher-rated bonds, they are often included in high-yield portfolios.

High yield presents the problem of default risk. As bond quality declines, the risk of default rises. To control risk, you have to diversify, and every bond under consideration requires substantial due diligence, which is impractical. Your best bet: watch the spreads, then consider a bond fund specializing in the high-yield space when you sense that business conditions are about to improve.

In the higher-rated, investment-grade bond world, financial services bonds are making many investors nervous. The discount is wide on bank and insurance company subordinated debt, not only because of contagion worries but because Basel III compliance will force banks to distance themselves from some of the subordinated debt they had issued at the bottom of the 2008-09 market meltdown.

Says Chris Kresic, co-lead manager for fixed-income and partner with Jarislowsky Fraser Ltd. in Toronto: “2012 will be the year to buy assets at risk, such as insurance company fixed floaters that offer a typical 300 bps over federal debt of a similar term.”

Insurance companies and some large financial services institutions are widely thought of as being “too big to fail.” For example, a 10-year Capital Desjardins fixed-floater bond that pays 290 bps over a Government of Canada bond of the same term is a solid issue that has the implicit backing of Quebec’s provincial government. The issue pays 4.954% to call on Dec. 15, 2021. Capital Desjardins, a wholly owned subsidiary of the Fédération des caisses Desjardins du Québec, offers securities in the financial markets and invests the proceeds in securities issued by Desjardins’ caisses.

Municipal bonds also offer good opportunities, as many municipalities have strong tax bases. The market is dominated by issuing municipalities in Quebec, Ontario and British Columbia. Vancouver, for example, has an AA rating from DBRS Ltd. Issues from Calgary are rated AA (high) and those from Edmonton and Toronto are rated AA.

A City of Montreal 5% issue due Dec.1, 2018, has recently been priced at $113.59 to yield 2.94% to maturity. DBRS rates all City of Montreal issues as A (high), says Travis Shaw, DBRS’s vice president for public finance. A comparable Quebec six-year bond, the 4.50% issue due Dec. 1, 2018, has recently been priced at $113.28 to yield 2.42% to maturity; so, the yield boost for the municipal bond over the provincial issue is 52 bps — and 151 bps over a six-year Canada that yields 1.43% to maturity.

Montreal does not have the tax base of its province and cannot print money, but its bond issue is a moderate risk with a good rating for a fairly short period. Moreover, Montreal is far away from whatever happens in Europe, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

Normally, European bonds also would be a way to diversify. But buying these in the midst of a credit crisis that could get worse before it gets better is speculative at best. Just one default by a major bank would be devastating for the entire sector’s outstanding bonds.

But there are foreign bonds far from the crisis that are potentially rewarding. In particular, the “BRIC” countries of Brazil, Russia, India and China offer investment-grade debt, and each nation has a different story for investors. IE