Bond investing has seasons good and bad. The S&P/TSX total return index and the megacap Dow Jones industrial average may not repeat 2006’s sparkling performances in 2007, but bond returns should be robust as falling interest rates make bonds with fixed coupons more desirable.

The yield curve, which is the sum of all expectations, hopes and fears in the Canadian debt market, is currently inverted, which means markets believe the economy is slowing sufficiently to make lower rates probable. “There is consensus — really, an overwhelming agreement — that both short and long rates will come down, that the yield curve will normalize and get steeper and thereby add some consistency to the rewards of fixed-income investing,” says Tom Czitron, managing director and head of income and structured products at Sceptre Investment Counsel Ltd. in Toronto.

The tracks of the slowing economy can be seen in data from the Bank of Canada. In mid-summer, the bank forecast an annualized rise of 3% in gross domestic product in the fourth quarter of 2006. By October, after economic growth in Canada and the U.S. backed off in the third quarter — coming in at annualized rates of 1.7% and 2.2%, respectively — the number was reduced to 2.8%. As the quarter was ending, the consensus was that GDP will be up just 2%. For 2007, the central bank originally projected a 2.8% rise in GDP. By October, it had cut its forecast to 2%.

Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver, manages $400 million in Canadian and global debt. With three-month Government of Canada treasuries at 4.16% as of Dec. 29, 2006, and the bellwether 10-year Canada bond yielding 4.08% to maturity, Bondy expects a period of slowing growth that will extend well into 2007. “We are going to see short rates moving lower,” he says.

Although that scenario is consistent with a recession, capital markets in the U.S. and Canada expect only a gentle slowdown, Bondy says. Lower interest rates will tend to support and even raise corporate profits.

As a result, the consensus is that by the third quarter of 2007, the Bank of Canada rate will drop to 3.75% from the recent 4.25%, and the U.S. Federal Reserve Board will cut its discount rate to 4.25% from 5.25%.

Returns on investment-grade bonds have been rising since mid-2006, based on predictions of falling interest rates. If the Bank of Canada lowers interest rates, as is widely expected, the yield curve will tend to normalize and the inversion will subside.

Steve Locke, senior portfolio manager of fixed income at Howson Tattersall Investment Counsel Ltd. in Toronto, figures the process of normalization will be at work at both ends of the curve — lower administered rates at the short end and stable inflation expectations at the long end.

“We will have a steepening yield curve this year,” he says, “based on central bank rates coming down and markets becoming comfortable with stable long-term inflation expectations.”

A steeper yield curve implies a normalized return for time risk. That, Locke says, means a laddered structure of maturities will pay well and spread risk.

Michael McHugh, a bond manager at Dynamic Mutual Funds Ltd. in Toronto, agrees: “Long conventional bonds will outperform shorter terms. I would be buying long-term bonds over the next six to 12 months and would recommend that investors shift their bonds to longer durations.”

This is by-the-book bond investing: choose long-duration bonds that give the biggest gains for interest rate declines — but don’t bet the farm on the most extreme time strategy, which would be buying nothing but long strips.

Bond index duration was around seven years as this year began, which means that for every 1% drop in interest rates, a bond or portfolio of bonds will gain about 7%. Duration of a strip is equal to its term. So, a 25-year strip could produce a 25% gain for a 100-basis-point drop in interest rates. That sounds great — but it could also produce a loss of 25% if rates go up by 100 bps.

Long strips are highly volatile because they are long bets on events and trends that are unknown and unforeseeable. The safer course is the ladder or the barbell, either of which puts some money on short rates and some money on long rates. It’s finding the right balance that is key to subsequent returns.

@page_break@McHugh’s approach favours less weight at the short end and more on the long end of the curve, thereby extending the average duration. “I would buy longer-term bonds over the next six to 12 months,” he says. McHugh, true to his word, has been stocking up on 30-year bonds, to get the biggest kick when rates do decline.

A benefit of extending duration is that there is a shortage of long bonds. The implication: long bonds will not only rise in value as inflationary expectations decline but supply and demand mechanics will also tend to increase prices.

But there are no sure things. The consensus that interest rates will drop this year could pose a risk for investors, says Chris Kresic, vice president of investments and portfolio manager of $4 billion of debt at Mackenzie Financial Corp. in Toronto.

In Kresic’s view, the troubled U.S. dollar could result in rate hikes. If the greenback were to drop precipitously, the Fed might have to raise interest rates. “Right now, fundamentals are stacked against the US$,” Kresic says. “The Fed and other central banks will go with economic reality and accept an orderly retreat. But if there is panic selling of the US$, the Fed could raise rates.”

Another risk is that many investors have already moved to longer terms and high durations, says Czitron. Are there enough inves-tors who haven’t moved to make the process continue? “It’s like a stock that everyone has loaded up on so that there is no one left to buy,” he says.

“When that happens, there is a reallocation process that gets investors taking the opposite view,” he adds. “In this case, putting their money into bets on when rates are expected to rise, perhaps in a few years.” IE