Corporate bonds are the place to be

Case in point: if you choose to lend a sum to the U.S. Treasury for two years — and you are a heavy hitter able to get a good price from your dealer — you will get 0.2% a year to maturity for your troubles.

Another example: two-year Canada bonds will return 1.02%, still a skinflintish payoff for having faith in government.

Yields have crumbled to the point at which interest flows — usually a large part of the reason for buying bonds — no longer offer much cover for declines in bond prices. Eventually, of course, rates will rise. That leaves the market with a split personality.

High-quality government debt now pays zilch, or close to it. Global junk, such as Greek sovereign debt, which was priced to yield 46.5% a year at the beginning of September, clearly reflects the expectation of default — no matter what eurocrats in Brussels and bankers in Berlin say. A gambler can take a ride on this kind of risk, although the odds of making money may be better in Las Vegas.

It helps to understand why the bond market has so little to offer investors who just want a safe flow of income. In the old days, before the euro became the single currency in Europe, the yin and yang of these nations’ currencies absorbed the ebbs and flows of macroeconomic news. Now, with a common currency and no intra-Europe currency adjustments possible, national economic prospects are being reflected in bond prices. Thus, sovereign bonds are taking the heat for the troubled economies — all except the U.S., that is. Although weighed down by massive debt, a Houdini effect allows U.S. debt to escape its shackles and rise again and again as the world’s reserve currency.

That, however, doesn’t mean that U.S. government debt is profitable. The US$245-billion PIMCO Total Return Fund lost 1% in Aug-ust. That was partially the result of the move by Bill Gross, California-based Pacific Investment Management Co. LLC‘s founder, managing director and co-chief investment officer, to boost U.S. T-bonds to 10% of total fund assets in July from 8% in June.@page_break@T-bonds may be a security blanket, but that’s all they offer these days. In order to get a reasonable and dependable yield, investment-grade corporate issues are the place to be. And the idea that corporate bonds can offer more protection for equities portfolios, not to mention reasonable risk/return proportions, is based on the fact that there is just too much pessimism in capital markets.

“It is clear that the bond market is very expensive,” says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax. “The market is pricing in the worst outlook for the economy. It is like getting back to recession.”

That pessimism has kicked down prices and boosted yields on corporate debt, creating both good yields and buying opportunities, he says.

With U.S. government bonds overpriced for anything but a multi-year recession, Canada bonds have gotten a lot of admiring looks from foreign investors. But there is not too much fat in our bonds. Real-return bond prices have tumbled as inflation forecasts have fallen. The RRB market now predicts 2.35% inflation for the next 30 years. Conventional 30-year Canadas offer just 0.7% a year more than that for three decades of nail-biting over government deficits. Corporate debt looks much better.

There are good yields to be had on pretty solid bonds. For example, a Sun Life Financial Inc. 10-year issue due in 2021, recently priced to yield 4.45%, offers 196 basis points more yield than a Canada bond of similar term that pays 2.49% to maturity. Go further out and the returns are fatter: a GE Capital Canada 5.83% issue due Oct. 22, 2037, recently priced to yield 5.3% to maturity and backed by GE Capital in the U.S., offers a 2.2% spread over the 30-year Canada. (The GE Canada bond is rated AA.) And if you go down the quality ladder, you can get a 5.75% Shaw Communications Inc. issue due Nov. 9, 2039, which was recently priced to yield 6.75% — 370 bps over Canada bonds with a similar maturity.

So, what to do? Michael Mc-Hugh, vice president of fixed-income with Dynamic Mutual Funds Ltd. in Toronto, notes that in the present market, liquidity is deteriorating. That means wider spreads on bond trades. It’s getting harder for institutions to trade profitably and almost impossible for individual investors to get their spreads down to acceptable levels.

After all, if the yield on a bond is just 1%, a half-point buy/sell spread eviscerates the return. Pay the spreads both on the way in and on the way out, and there is no return at all. The short-term prospects, he explains, are also worsening for investors.

“There is going to be heavy issuance of corporates this fall,” McHugh says, suggesting that prices will drop a bit and yields will rise. “We are cutting durations and moving to higher-quality issues.”

In this market of government bonds with low yields and the prospect of more shocks from Europe, a financial advisor seeking yield and security for clients has little choice but to buy best-of-breed corporates. IE