With equity markets having swooned off their early October highs, leery investors are regaining interest in the bond market, a natural haven when stocks show signs of trouble.

After the S&P/TSX composite index approached 11,100 early last month, the benchmark index has given up about three months’ worth of performance in a few short weeks. And with income trusts being treated like lepers and central banks in the U.S. and Canada continuing to raise interest rates to control rising inflation, investors have reason to be scared, says Robert Marcus, president and chief investment officer of Majorica Asset Management Corp. in Toronto.

The veteran bond manager notes that equity markets can sense that consumers — who kept the U.S. economy churning during the tech meltdown and sustained its subsequent recovery — feel they are heading into a gloomy period. “The consumer is dealing with higher energy prices, higher short-term interest rates, higher indebtedness and real wage decreases,” he explains. “The stock market is picking up that the consumer [as a market force] is becoming dead.”

The most crippling effects will come from rising interest rates. U.S. Federal Reserve Board chairman Alan Greenspan has already suggested he’ll raise rates before he retires on Jan. 31, 2006, and Bank of Canada governor David Dodge has signalled he’ll do the same, after raising that central bank’s overnight lending rate to 3.0% on Oct. 18.

“Real estate prices have risen by 10% a year for the past few years,” says Marcus, “and people have used those price rises to borrow against their houses. At some point, rising interest rates will bite into income. We are close to that. When the consumer can no longer borrow, he will stop buying. Companies will not be able to pass along price increases, so they will take smaller margins [and] corporate profits will fall. The bond market will anticipate this.”

The main issue is the effect that this could have on credit risk, since debt costs paid by borrowers will surely become more costly. This is already visible in the high-yield market. In Canada, more companies are having their credit ratings reduced to junk status, according to Standard and Poor’s Corp. The rating agency also reports that the risk of defaults has risen as energy prices have headed upward and materials prices have escalated. The problem is one of perception, however. The Canadian default rate, which was 1.6% in 2003, fell to 0.4% in 2004 as just one rated company, Stelco Inc., defaulted on its debt. That low failure level is going to be difficult to maintain.

As a result, bond managers are divided on which way to turn in a credit market that’s fated to have higher interest rates and upward-trending defaults. In terms of taking on corporate debt, there’s not much to be gained in a market in which yield spreads over federal debt are not going to rise, says Tom Czitron, head of income and structured products at Sceptre Investment Counsel Ltd. in Toronto.

“A five-year [Government of] Canada bond pays 3.75% and a Bell Canada [corporate bond] due in 2009 pays about 27 basis points more,” he says. “That’s a very tight spread. You’re not being compensated adequately for the risks of the corporate bond. So I would stay with government bonds for now.”

Marcus agrees: “I think one should stay with high-quality bonds because of [the] possible deterioration of the economy. There is no incentive for buying corporate bonds. And that goes for income trusts, too.”

Adds Chris Kresic, senior vice president of investments at Mackenzie Financial Corp. in Toronto: “You [also] have to be cautious on interest rate exposure. You want to go short, even if the economy performs better than expectations.”

For bond investors who don’t want to have their returns penalized for sticking with “sure things,” the high-yield market offers abundant opportunities.

“The outlook for high-yield debt is good,” says Doug Knight, a portfolio manager with Deans Knight Capital Management Ltd. in Vancouver, one of Canada’s leading junk bond analysts. His own fund, Northwest Specialty High Yield Bond, was up 14.4% for the year ended Sept. 30.

The junk bond sector’s overall performance is far less impressive, however. The 46 high-yield funds with performance trackable for at least one year produced a mean return of 4.5%, exactly half the 9% return of the SC universe bond total return index for the same period. For the high-yield sector as a whole, it is clear that higher risk did not lead to higher returns for the year.

@page_break@And for the next year at least, it is evident that U.S. interest rates — 3.75% at press time and widely expected to head to 4.25%-4.5% — will crush some consumers and businesses who borrowed money when the U.S. Federal Reserve Board dropped short-term interest rates as low as 1% to encourage recovery from the tech bust.

So, what’s next? Majorica’s Marcus suggests there is no expected news that’s going to change the gloomy outlook for capital markets any time soon. There is also little to rejoice in as overextended (in terms of debt) consumers face rising interest rates and suffer negative effects to their wealth resulting from falling house prices. Add to that the effect of higher energy costs and it is certain that there will be less residual income for discretionary spending.

As a result, businesses will have their profit margins compressed, which implies declining corporate earnings. In this market, only the brave, the expert and, perhaps, the foolish will chase yield. Once the interest-raising cycle is done — and Greenspan has hinted that it may end by the time he leaves the helm of the U.S. Federal Reserve Board — bonds could be ready for a resurgence.

So the strategy should be either go short and hold cash or cash equivalents — ready to buy in 2006 — or go long and be in a position for the time when there is recognition that inflation fears were overblown and rates and inflation expectations subside, which could also happen next year.

In Canada, a return to lower rates may take longer, however; as Marcus notes, the U.S. Federal Reserve Board has raised rates 11 times in the past two years to the Bank of Canada’s two times. The U.S. economy has shown many signs of weakening, whereas Canada’s economy remains robust.

The play will be the same, Czitron says, but the Bank of Canada is just getting into a match the U.S. is close to finishing. IE