As the economy recov-ers further, central banks will tend to push interest rates upward. This will undoubtedly have an impact on bond prices.

And while government bond prices will fall, corporate bonds, supported by improving balance sheets, will firm up or, at least, hold their value, suggests Paul Taylor, chief investment officer with Bank of Montreal’s BMO Harris Private Banking in Toronto.

Taylor, who recommends “government bonds as ballast to keep your ship upright in a storm and corporate bonds for wind in your sails,” favours investment-grade corporate bonds.

These fixed-income products yield 145 basis points over government bonds of the same term; this compares with an average gap of 70 bps for the four years ended Dec. 31, 2007.

Within the Canadian corporate market, the best place to be is in bank debt, Taylor says: “[Banks] have strengthened their balance sheets, shown positive earnings surprises and reduced their default risk, especially on subordinated debt. By what turns out to be performance above expectations, they have maintained their ability to get capital on relatively good terms.”

In addition, Taylor says, there are opportunities in senior retailers such as Canadian Tire Corp. and Shoppers Drug Mart Corp., both of which have strong balance sheets. As well, he suggests, utilities and pipelines, both of which are capital-intensive and backed by regulatory protection of their cash flow, have value. Taylor recommends Enbridge Inc., TransCanada Corp., Fortis Inc., Emera Inc. and Canadian Utilities Ltd. for potential buys.

“We don’t expect spreads to contract to the level at which they were three years ago,” Taylor says, “but these ‘name’ bonds will appreciate relative to government bonds of a similar term.”

That said, there will be some contraction of corporate bond spreads. The question is: by how much? Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax, says spreads are still wide: “Mid-term corporate investment-grade yields to maturity average 4.35%, while Government of Canada yields to maturity are 2.86%. That’s 150 bps in the spread. In the next year, spreads should compress to 100 bps-120 bps. Riding the spreads until they compress to normalized values of 60 bps-70 bps over federal debt of similar term is the investment opportunity.”

But moving back to normalized spreads may not be without a few bumps, says Chris Kresic, senior vice president for fixed-income at Mackenzie Financial Corp. in Toronto. He suggests that as governments take back stimulus money lent to the banks, the banks’ own balance sheets will be a little weaker. That would automatically raise the default risk of the banks and — because banks are such a large part of the bond market — of the Canadian corporate bond market in general. That would, in turn, force bond prices down and push yields up marginally.

In high-yield corporate bonds, says Barry Allan, president of high-yield bond specialist firm Marrett Asset Management Inc. in Toronto: “Spreads should normalize by mid-2010 to 500 bps over Canadas.”

Default risk is concentrated in the high-yield corporate bond sector, whose prices collapsed during the 2008-09 liquidity crisis. These bonds provided 2,182 bps of yield over U.S. Treasury bonds in late 2008. As of late December 2009, spreads had recovered to 720 bps over 10-year U.S. T-bonds.

Allan contends that there is still money to be made in recovering high-yield corporate debt. Moreover, he notes, high-yield debt, which is priced far more on company specifics than on interest rate trends, is actually defensive in a rising interest-rate environment.

However, market myopia remains from the collapse of the U.S. mortgage market in 2008. And many investors still avoid issues that contain the word “mortgage.”

This distaste for mortgage debt has created a unique opportunity, Kresic suggests. Commercial mortgage-backed securities trade at 300 bps over Government of Canada bonds of a similar term and have top investment-grade ratings. Says Kresic: “You can buy an unsecured bond issued by RioCan Real Estate Investment Trust [the largest REIT in Canada] with a BBB rating at 250 bps over Canadas; or the CMBS, with broad diversification and a much higher rating, at 300 bps-plus. So, I put my money on the CMBS.”

It should be noted, however, that the CMBS market had collapsed in the wake of the 2008 mortgage crisis. As such, its extra yield comes with a measure of liquidity risk.

@page_break@For any level of credit or liquidity risk, the question is: at which level on the yield curve to shop? Steve Locke, vice president and senior portfolio manager with Howson Tattersall Investment Counsel Ltd. in Toronto, notes that the short end of the bond market has already been plundered for good values: “The market has good values in corporate debt in the five- to 30-year range. The corporate yield curve is still steep, and corporate bond investors will be rewarded by spread compression that reflects rising prices.”

Locke’s shopping list includes the Greater Toronto Airport Authority and regulated utilities such as Enbridge, Hydro One Inc. and Emera. He also likes life insurance companies, such as Manulife Financial Corp., which has been building up its capital base — much to the consternation of its common shareholders, who have seen their stock diluted and their dividend halved.

So, how much government debt and corporate debt should your clients hold in early 2010?

“I’d be 50% corporate, 25% federal and 25% provincial,” Kresic says. “Of the federal allocation, 20% would be real-return bonds. Holding this kind of a mix gives you the intestinal fortitude to withstand the fluctuations in financial markets that inevitably occur. Who is to say that, with no bonds at all, you might not have sold everything at the bottom of the market in early March 2009? But if you had a comfortable level of fixed-income, you would have been less likely to panic.”

IE