The crisis in global credit markets has pummelled prices of top-quality bonds, those of a subinvestment-grade nature and even real-return bonds, the last of which are almost entirely Government of Canada issues. Now worried more about insolvency than inflation, investors have reduced their exposure to the bond market in general.

In Canada, the lack of confidence in the bond market is a direct result of the non-bank asset-backed commercial paper problem. Buyers are scarce, as no one wants to wind up with assets that cannot be resold. The problem may be resolved by restructuring the structured notes; but the issue remains one of confidence.

The Bank of Canada tried to reassure investors by cutting interest rates by 25 basis points to 4.25% on Dec. 4. With five-year Canada bonds paying only 3.75% in early January, the yield curve, which connects what bonds pay with their terms to maturity, is now negative.

The rationale for getting less yield for a longer period of time comes down to expectations. In this case, investors think short-term interest rates are likely to drop both in the U.S. and in Canada, says Ed Jong, senior vice president for fixed-income at Toronto-based MAK Allen & Day Capital Partners Inc.

“There is a lot of fear,” Jong explains, “and the spread on investment-grade debt is as wide as I have seen it in my career.”

This has pushed down bond prices, including senior debt of the chartered banks, which was the most solid part of the Canadian bond market until this past August. Five-year Royal Bank of Canada deposit notes, which are senior obligations of the bank, have recently been priced to yield 120 bps over Canada bonds, at 4.95%. Before the crisis broke, senior chartered bank debt yielded just 30 to 50 bps over Canada bonds.

STRONG PRESSURE TO SELL

The problem is that pressure to sell Canadian banks’ bonds is stronger than support for buying them, according to Jong: “If you own Canadian bank bonds and you are overweighted on corporates, you cannot load up anymore.”

In other words, there is a market imbalance with few buyers and many sellers of corporate bonds, leading Jong to predict that corporate bond prices will fall further.

Barry Allan, president of high-yield bond specialist firm Marrett Asset Management Inc. in Toronto, also believes spreads on Canadian bank bonds will widen further before they rally. The reason is that banks will have to add to their debt to increase their Tier 2 capital. “The cheapest way for banks to do this is to add to their subordinated debentures,” Allan says. “That will put pressure on spreads. But, this way, they will not have to dilute their stock. Banks would rather not offend shareholders.”

Just how far bond prices may fall is uncertain. There is US$300 billion of leveraged mortgage loans that have to be unwound in the U.S., says Fred Lazar, a member of the faculty of the Schulich School of Business at York University in Toronto. Selling off these loans will depress banks’ bond prices and affect the tightly linked global bond market.

However, this doesn’t mean investors should sell their corporate and bank bond holdings. Prices will recover once the ABCP mess is resolved and investors regain their confidence. And in the meantime, there will be bargains to be had while the prices of bank and corporate bonds languish. (See page B22.)

As a result, analysts recommend focusing on mid-term bonds. Says Allan: “The belly of the curve at five years is the best place to be.”

INCREASED LIQUIDITY

The short end will drop as central banks cut rates to stimulate economic activity and increase liquidity. The long end is expected to hold fairly steady. So, the midsection of the curve provides the most potential for positive moves.

This appears to be the consensus view among veteran bond strategists.

“The middle of the curve, about five years’ [in] term, is a good compromise between the safety of short terms and getting some insurance on interest rates at the long term,” says Tom Czitron, managing director and head of income and structured products at Toronto-based Sceptre Investment Counsel Ltd.

This strategy is a matter of setting up the portfolio to capture profits as the yield curve steepens, says Brad Bondy, vice president of fixed-income at Genus Capital Management Inc. in Vancouver.

@page_break@And investors should pick underpriced bank bonds for the inevitable recognition that the big chartered banks are not going to fail. “If any chartered bank really did get into trouble, which is not even likely in spite of the write-offs they are taking,” Allan suggests, “then the government would allow bank mergers.”

With the potential bargains in investment-grade bonds, this isn’t a time to be focused on junk bonds, even though there hasn’t been a dramatic increase in these spreads. High-yield bond yields are priced as spreads over U.S. treasury yields. The definitive benchmark for high-yield bonds is the Merrill Lynch master II high-yield index, which has shown junk bond yield spreads at 563 bps over treasuries.

“This has moved up from 250 bps since June, but the average of the past 30 years has been about 450 bps,” Allan says. “Compared with the historic high of 1,000 points in 2002, this is not serious.”

To sum it up, caution is the order of the day and careful timing is the key to profits. The biggest risks in timing and return remain with corporates; the lowest risks are with government bonds.

The largest rewards will go to those willing to carry some credit risk.

What has changed in the present market is the size of the credit risk and the potential rewards — and losses — for those who are willing to carry those risks.

The question is: when will it be time to step into investment-grade bonds — especially those of the chartered banks?

One thing to keep in mind is that there are two trends that will be bullish for bonds, says Chris Kresic, senior vice president of investments at Mackenzie Financial Corp. in Toronto, who is in charge of $4 billion of fixed-income assets.

One trend is the move to lower interest rates around the world as central banks take action to boost liquidity. The other is an end to the U.S. housing crisis.

Monetary authorities around the world are working to end the liquidity crisis by cutting interest rates at the short end of the yield curve. On Nov. 12, the Bank of Canada, the U.S. Federal Reserve Board, the Bank of England, the European Central Bank and the Swiss National Bank made a joint announcement that they were taking measures “designed to address elevated pressures in short-term funding markets.”

For the Bank of Canada, that means buying bonds and other assets from chartered banks. The Bank of Canada has said it would buy back superior ABCP issues from non-bank issuers that are clogged in the Canadian market. Buying up bonds and structured products will tend to raise prices and lower yields. But this support is limited and, to date, it has not ameliorated the crisis.

The housing crisis in the U.S., which is probably more severe than the liquidity problem in Canadian credit markets, will end on its own eventually, according to Kresic: “There are more mortgage resets to come. But there are housing cycles, and this is one of them.”

Just how long it will take to undo the damage that the subprime mortgage mess has done is uncertain. Mortgage resets are expected to peak in June, but there will still be resets and foreclosures for a number of years.

Political moves to end the crisis — specifically, U.S. President George W. Bush’s proposal to maintain low introductory rates on certain subprime mortgages not already in default — appear to be of limited value.

In terms of long bond rates, many analysts expect them to be stable this year. Thirty-year Canada bonds were recently yielding 4.2% and 30-year U.S. treasuries were yielding 4.6%. These rates will become more attractive as short-term interest rates drop, thereby steepening the yield curve.

Long interest rates reflect inflationary expectations, which, Czitron says, have ebbed — at least, for the time being.

“Inflation concerns could come back into the market in 2008,” cautions Adrienne Warren, a senior economist with Bank of Nova Scotia in Toronto.

When there is a perception of rising prices, the long end of the curve will tend to rise, notes Craig Allardyce, vice president and associate portfolio manager with Mavrix Fund Management Inc. in Toronto.

INFLATION NOT AN ISSUE

But for now, inflation is not the issue in credit markets; this is reflected in the market for Canada’s RRBs, whose prices fell an average of 3.7% for the 12 months ended Nov. 30. The Canada RRB 5.75% issue due June 1, 2033, had a break-even interest rate of 2.08%, vs 2.40% a year earlier.

“The break-even rate shows premium investors are paying for inflation protection in RRBs,” Allardyce says. “This clearly shows that inflation expectations have dropped in the past year.”

And because the credit crunch is of a global nature, interest rates are also coming down elsewhere. In the U.S., the Fed cut its overnight rate to 4.25% from 4.5% on Dec. 11. Most economists expect further cuts of 75 to 125 bps at the Jan. 30, March 18 and June 25 Fed meetings.

The Bank of England has begun what is expected to be a series of cuts. The European Central Bank, which is still holding firm, may eventually have to join the cutting party, Warren suggests.

A decline in rates would ordinarily be a reason for bond prices to rise as they reset in value to match lower returns on new bonds. But currency moves of a few percentage points can outweigh a few 25-bps cuts in rates.

Global bond returns came down in Cana-dian-dollar terms by an average 2.1% in the 12 months ended Nov. 30, driven by the rise of the loonie.

“The strength of the loonie overcame reasonably strong global bond returns,” Allardyce notes. “The value of global bonds is not in current yield, but in diversification of currency and interest rate cycle. The fact that returns of this diverse pool of many currencies and of many bonds have been modest does not affect the value of investing in this class. After all, when you diversify, it’s more about portfolio safety than about yield.”

Currency movements can also move up foreign bond prices if the C$ falls, as some analysts expect. Randy LeClair, who runs global bond portfolios for AIC Ltd. in Burlington, Ont., believes this is certainly a possibility to keep in mind. IE