Yields on Canadian and U.S. government bonds are poised to rise as confidence returns to European debt markets and North American interest rates start to recover from historical lows. In turn, this process will slash the value of existing Canadas and U.S. treasury bonds. So, now is the time for a decisive change in the duration of your clients’ bond portfolios.

The tragedy in Greece is moving into its last act — for now. The resolution, after the daily riots and firebombings of government buildings, is likely to bring the curtain down on uncertainty — temporarily, at least. With this decline in apprehension, signalled in a statement by Wolfgang Schaeuble, Germany’s finance minister, on Feb. 12 that “Greece will be saved one way or another,” money in North America that is earning next to nothing could head back to Europe to snap up the 6%-7% yields on Italy’s and Spain’s bonds. That would drop the prices of U.S. T-bonds and Canadas and raise their running yields.

Modest signs of economic improvement in the U.S. suggest a recovery is in place, priming the market for higher rates. In early February, notes Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto, both U.S. and Canadian 10-year government-bond yields rose by 10 to 15 basis points.

The first flickers of life returning to depressed European debt markets are evident in the yields of eurodebt outside of Greece’s. Portugal’s 10-year sovereign now yields “just” 12.89% to maturity, down from the 16.58% it yielded on Jan. 30. Portugal’s sovereign bonds are trading at 53% of face value, up from 42% in January, on the basis of a promise by Portugal’s government to stabilize its deficit at 112% of the country’s 2012 gross domestic product.

In the context of global debt markets, owing 112% of GDP is actually good news. Greece’s debt is estimated to be 153% of its 2011 GDP; Japan, 131%; Italy, 100%; and Britain, a “mere” 73% of its 2011 GDP. In contrast, Canada’s 2011 debt/GDP ratio is a lowly 35% — less than half the U.S.’s 73% but far greater than top-ranking Australia’s 8% debt/GDP ratio last year.

In this climate, in which investors know that interest rates will rise and that any rise will hurt bond portfolios, every uptick in rates is being read as a reason to move out of low-yield U.S. and Canadian debt issues. After a year of stunning gains in bond portfolios, global portfolio managers are headed for the door.

“The likelihood that the 10-year U.S. treasury bond, which currently yields 1.8%, can register a repeat of last year’s performance is nil,” says Jack Ablin, executive vice president and chief investment officer with Harris Private Bank in Chicago.

By how much will interest rates rise? It is a given that the short end of the yield curve — anchored by the U.S. Federal Reserve Board’s announced commitment to keep overnight rates between 0%-0.25% for two years — will hold. So, the yield curve can only swivel upward from its near-zero base.

You can take the view that yields in Europe will remain high for several years as the 17-nation group that uses the euro for currency works out its problems.

The eurozone is likely to get bailed out by common action, says Chris Kresic, partner and co-lead for fixed-income with Jarislowsky Fraser Ltd. in Toronto. That supports investors’ move back to European sovereign debt. Moreover, Europe, in which interest rates have probably peaked, looks safer than North America, where interest rates are likely to rise.

The question, Kresic says, is which scenario to bet on: “There is an outlying chance for a 2% [consumer price index] deflation that would turn a 2% bond yield to a 4% real return. On the other hand, there is the huge risk in staying with low-yield bonds.”

If 30-year yields on Canadas and U.S. T-bonds rise to the 4.5% level they were at before the angst of the European sovereign-debt crisis, investors would lose 22% on their high-duration bonds. To wipe out a 2% yield on a 10-year Canada, Kresic notes, interest rates would have to rise by just 25 bps. Betting on deflation could be a very costly mistake.

So, what should you do for your clients? Markets are expecting modest GDP growth in both Canada and the U.S. of 2.2% in 2012, up from about 2% a year earlier, according to Scotia Capital Inc. That slight growth spurt will support a rise in 10-year Canada bond interest rates to 2.95% by the end of 2013 from 1.95% in the first quarter of 2012. In the U.S., the 10-year T-bond is expected to pay 3% by the end of 2013, up from 1.85% in Q1 2012.

The rise in 30-year rates will be even more dramatic, Scotia Capital predicts: in Canada, to 3.6% by the end of 2013 from 2.5% in Q1 2012; in the U.S., to 4.1% by the end of 2013 from 2.95% in Q1 2012.

Unless your clients accept the deflationary scenario, in which interest rates fall even further and rising bond prices boost real returns on bonds, it’s time to shorten maturities or lighten up on bonds. Says Jong: “I think there is room for rates to move up.”

The next question is: where to be in on the yield curve? In Jong’s view, the big interest moves are in the future: “We need to wait to the end of 2012 to see the curve steepen. Park money in the belly of the yield curve — at five to seven years — to get a good balance of yield to risk.” IE