Moving into 2006, the economies of Canada and the U.S. are set for expansion with a touch of inflation. The U.S. Federal Reserve Board and the Bank of Canada are expected to raise interest rates in what the market expects to be tidy, quarter-point steps.

The consensus is that the Fed will raise rates to 4.5% from 4.25% on Jan. 31, coincidently the date on which Ben Bernanke will take over as Fed chairman from Alan Greenspan. In Canada, observers expect the Bank of Canada to raise rates on Jan. 24 to 3.5% from the current 3.25%.

More rate hikes are on the way, market-watchers say. “I would not say the central banks have gone too far at this point,” says Carolyn Kwan, financial markets economist at Bank of Nova Scotia in Toronto. “The banks are poised for more tightening. The banks see inflation as a risk bigger than slower growth at this time.”

Before the rate hikes end, probably by mid-2006, U.S. short-term rates will have hit 5%-5.25% and the Bank of Canada will have raised its rates to 4%-4.25%, predicts Tom Czitron, managing director and head of fixed-income products at Sceptre Investment Counsel Ltd. in Toronto. Robert Marcus, president and chief operating officer of Majorica Asset Management Corp. in Toronto, agrees those hikes are on their way.

Some bond portfolio managers are worried the banks are going too far with rate increases and moving too fast. Says Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver: “The central banks will overshoot their marks. The U.S. economy is facing strong headwinds. U.S. consumers are at the end of their rope. Consumer spending has been sustained by the wealth effects of rising house prices and even if — driven by higher interest rates — housing prices just level off, that will remove the stimulus for higher spending. Where the U.S. goes, Canada will follow. By the end of 2006, the central banks will be lowering short-term rates, and that would tend to eliminate any inversion of the yield curve.”

The rise in short-term rates has not been accompanied by an increase in long rates because inflationary expectations are very moderate. In Canada, the yield curve is almost flat. In early January, Canada bonds paid 3.86% for two years, 3.93% for 10 years and 3.98% for 30 years. A boost of 12 basis points for going from two years to three decades is quite modest, Marcus says.

In the U.S., two-year treasury bonds paid 4.35%; five years, 4.31%; 10 years, 4.36%; and 30 years, 4.53%. .“The U.S. yield curve is very flat, with a technical inversion between two and five years. There is only an 18-bps premium in going from two years to 30 years because the Fed has been aggressively raising short rates while inflationary expectations have not risen much,” Marcus adds.

From the bond investor’s point of view, the flatness of the yield curve reflects the consensus view that the cycle of tightening will end later this year. As Marcus puts it: “In the U.S., central bankers will change their minds and start lowering rates.” The consensus is that, by the end of the year, there should be visible effects of the tightening and the Fed will begin lowering rates. “The Bank of Canada started tightening later and has a way to go before it stops. What’s more, higher energy prices will be a negative for the American consumer but a positive for the Canadian economy.”

Buy in the middle

The question is how to play the expected decline in interest rates when it occurs. Marcus suggests one way is to buy into the middle of the yield curve, around seven years, and package the play in stripped bonds. His reasoning: the middle captures the greatest rate of change in rates. And stripped bonds, which pay all their interest at maturity, do not suffer from falling reinvestment returns produced by conventional bonds, whose semi-annual coupons are reinvested at progressively lower rates.

But strips are also the riskiest way to play the expected decline in rates. If rates move higher, the complete commitment to the lower interest rate scenario that is built into the strip play could backfire, with the strips producing leveraged losses in comparison to conventional bonds.

@page_break@The alternative way to play the expected decline in rates is to buy conventional bonds with semi-annual coupons — called “vanilla” bonds in the industry. “I’d go a little over index duration [the weighted average return of bonds expressed in years] with vanillas,” Bondy says. “If interest rates decline and the whole yield curve drops, it won’t matter where you are on the curve. You will make money everywhere. So a seven- or eight-year bond works fine.”

What’s more, a bond with seven to eight years to go to maturity does not expose the holder to too much risk. Even if interest rates continue to rise — perhaps driven by a spike in energy prices and resulting central bank moves to restrain increases in inflation — the mid-term bond will allow a gracious if not entirely free way out if the holder sells. And if the holder keeps the mid-term bonds, they will allow some positive reinvestment returns from rising yields on reinvested coupons.

Advisors who do not want to put all their clients’ money on one interest rate bet can keep their powder dry and wait for the banks to make the moves expected in 2006. Michael Crofts, fixed-income portfolio manager at Mawer Investment Management Ltd. in Calgary, is holding his portfolio with an average duration of 6.25 years, slightly short of the index duration. “We think the yield curve will rise moderately into the second quarter of 2006, then begin to fall moderately,” he says. “We’ll then move to index duration and then go to longer duration by the middle of 2006. Our strategy is to wait for more upward movement on rates, then make commitments that will generate gains.”

Looking for additional returns from corporate bonds does not offer much benefit right now. For example, a Royal Bank of Canada 6.3% bond due April 12, 2011, priced to yield 4.28% to maturity in early January beats the 6% Government of Canada due June 1, 2011, priced to yield 4.02%. The spread, 26 bps, is relatively small for the additional risk.

No compensation for risk

“The present spreads on credit-sensitive debt don’t compensate for the risk of holding corporate bonds,” Marcus says. “When the economy slows down, the corporate debt will lose value as its spreads widen in relation to federal debt, and the premium the investor got for buying the corporate bonds will not compensate for the capital loss caused by widening spreads.”

Bondy concurs: “The spreads on corporate debt are too narrow. Companies have improving fundamentals, but there is too much money chasing the spreads.” He says he would take a pass for now.

If, as some observers fear, growth falters, corporate spreads would widen significantly, reflecting investors’ insistence on getting paid for carrying more risk. That would mean falling bond prices and losses for holders of the affected corporate debt.

Junk bonds’ enhanced returns over investment-grade bonds is often appealing. But the time is not right to buy into the high-yield market, says Chris Kresic, senior vice president, investments, at Mackenzie Financial Corp. in Toronto. “The spreads on junk over treasury bonds are pretty tight right now at 400 points. But in the last recession, from 2000 to 2002, spreads went to 800 or 900 bps over federal debt.” He worries that if economic fundamentals weaken, junk spreads will widen and expose holders to losses. For now, he is lightening up on junk.

U.S. baseball legend Yogi Berra once quipped: “Predictions are tough to make, especially about the future.” Economic forecasts are no exception. Crofts says sustained oil price spikes, geopolitical worries and the possible separation of Quebec from the rest of Canada could lift the long end of the yield curve and decimate predictions that central banks will have to lower interest rates once they see they have overshot their marks. However, if capital markets experience a sustained period of reduced risk expectations, bond prices would fall.

Nobody ever said that bond investing is easy. IE