Bond investors who want to add to yield can move away from federal and provincial bonds, which present little or no chance of default, and buy corporate debt that boosts yield in proportion to the risk carried.

Alternatively, those clients who want to avoid the problem of inflation reducing their purchasing power can buy real-return bonds that pay a guaranteed base rate plus the annual change in the consumer price index.

Credit-sensitive bonds were in a benign market in 2006. Data from Standard & Poor’s Corp. shows that in the first 11 months of 2006, there were 23 Canadian downgrades. That was more than the 19 downgrades in the same period a year earlier, says Robert Palombi, director of fixed-income research for Standard & Poor’s in Toronto. But there were also more upgrades — 14 vs eight in the same period a year earlier. That works out to 1.64 downgrades per upgrade in 2006, vs 2.38 in 2005, suggesting an improvement in credit quality.

Corporate spreads over federal debt, an important measure of the relative prices of credit-sensitive bonds, have been tight in 2006, adds Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver. As of Dec. 31, 2006, five- to 10-year AA bonds were priced at 4.3%, or 22 basis points more than federal debt, which paid 4.08% to maturity. BBBs, the lowest rung of investment-grade debt, in the same term range yielded 100 bps more than federal debt to maturity. By historical standards, those are tight spreads.

In 2002, at the bottom of the credit cycle, when interest rates were low and defaults were high, five-year AA bonds were priced at 40 bps more than federal debt with the same maturity, and BBB were 175 bps higher than federal bonds.

At current spreads, investment-grade debt is attractive, Bondy says. After all, 22 bps is a nice boost over the underlying rate on government bonds for what amounts to relatively low risk.

However, there are risks in buying corporate debt. Toronto-based Dominion Bond Rating Service Ltd. notes that different industries face risks in different ways.

In a recent report, Peter Beth-lenfalvy, DBRS’s group managing director for global corporate finance, notes the special problems of auto parts companies. Those companies lack power to pass on higher costs because General Motors Corp., Ford Motor Co. and DaimlerChrysler AG have all cut production. And North American auto parts makers now face competition from China.

He also points out that although mining companies have strong balance sheets, they face major cost pressures and the potential to lose sales if there is a global slowdown.

In forestry, declining residential construction could affect companies’ credit quality.

In merchandising, there are cases of companies being bought out by companies that raise debt levels and, as a result, lower the acquired firms’ credit quality.

The other risk is more general — a hard landing in the U.S. and Canadian economies caused by American consumers cutting back on their spending on non-essentials if the U.S. housing slump continues. But even if that happens, high-quality debt should not be too adversely affected and the risk of widening spreads that would reflect lower corporate bond prices is small, says Bondy. His view: buy high-quality corporate bonds for a relatively safe boost over low rates on government debt.

JUNK ANOTHER STORY

High-yield debt is another story. In 2006, high-yield bonds rose in price. The market, almost entirely U.S.-based, showed prices of debt rated CCC (very highly speculative and in danger of default) and lower gained 33% in value in the first 11 months of 2006, compared with a gain of 8.6% for investment-grade bonds.

As a result, high-yield bonds are in robust health compared with their historical standard. According to the Merrill Lynch master II high-yield index, the most widely followed measure of junk bond prices in the U.S., high-yield bonds have been trading at about 300 basis points more than yields for U.S. Treasury bonds. By comparison, yields were 1,100 bps more than U.S. Treasury bonds at the bottom of the tech bust in the summer of 2002.

Buying junk to cash in on higher yields is a matter of getting the timing right. According to Barry Allan, president of Marret Asset Management Inc. in Toronto, high-yield bonds have greater risk of spreads widening and their prices falling relative to government debt.

@page_break@“It is certain that the next 300-bps move will be up, not down,” he adds.

Nevertheless, Allan argues, it is still sensible to buy into the high-yield market. He notes that defaults are running at near historical lows, and recoveries from defaults are 50%-60% of amounts outstanding. If that continues, junk bonds could have returns of 8%-9% this year. His conclusion: 2007 still leaves room for an entry into junk bonds — until the U.S. business cycle experiences a broad turndown, which he thinks will not happen until 2008.

Real-return bonds are a bet on long-term inflation. Typically issued for 30 years, they provide a guaranteed interest rate plus an annual adjustment for inflation. They tend to be volatile, with their price at any point in time determined by demand and market expectations for long-term inflation.

At the end of 2006, federal RRBs, with coupons of 3%-4.5%, were priced to yield 4.13% to maturity. The inflation assumption at that price is 2.37%, leaving a real return of 1.76%.

If inflation is higher than 2.37%, the return will go up; if it is lower, the return will come down and investors would have been better off with a conventional 30-year bond, which was yielding 4.16% at yearend.

BET ON INFLATION

Should a prudent investor make a 30-year bet on inflation by buying in at 2.4% or, for that matter, at any other rate?

“Think of RRBs not as bets but as hedges against inflation,” Bondy advises. “If inflation runs at a higher rate, then the hedge will be profitable. If inflation is lower than 2.4%, then you have bought insurance that you have not needed in hindsight.”

So, how much RRBs should a client have? You have to consider the outlook for inflation, Bondy says, and 2.4% looks to be on the high side. Inflation expectations are 2% for the next three decades, in line with the midpoint in the Bank of Canada’s 1%-3% target range. Furthermore, he points out, global forces now are disinflationary.

Nevertheless, investors may sleep better if they have some RRBs. It depends on their inflation sensitivity and age, Bondy says: “After all, a person of average health at age 75 probably does not need 30 years of inflation protection.

“RRBs are good for protecting one’s nest egg in retirement,” he adds. “But you don’t want to go overboard and suffer the opportunity costs of carrying too much low-yield debt. For those older people with shorter planning horizons, the high volatility of RRBs, which are all long-term bonds with high sensitivity to interest rate changes, is probably inappropriate.”

Genus holds 5% of its clients’ total portfolios in RRBs. “We had 10% as a normal exposure. But we cut it back because yields were too low,” says Bondy. “That’s why we remain underweighted on RRBs. The break-even inflation rate is relatively high; RRBs, therefore, represent poor value to nominal bonds. So, we have them for insurance and for diversification into a unique asset class.” IE