Bond markets are getting used to mayhem. As the Middle East burns, bond investors, it would seem, have collectively yawned and turned back to watching inflation and interest rate trends. Unexpectedly, government and in-vestment-grade corporate bonds aren’t thriving in today’s chaos.

Even though hostilities in Lebanon flared on July 12, U.S., Canadian and other G-7 bond markets showed little or no response. On July 20, a 10-year Canada bond yielded 4.4% to maturity, exactly the same as it yielded on July 20, 2005. Add in worries about North Korean missiles, terrorist bombings in London, Madrid and Mumbai, as well as the growing probability that Iran will develop its own nuclear bomb, and investors should be fleeing to bonds as a safe haven. But, curiously, judging by bond market activity, they are not. Case in point: Barclays Global Investors Services Canada Ltd. ’s broad bond index exchange-traded fund (symbol: XBB), which mirrors movement in the SC universe bond total return index, lost 3¢ on July 12.

Wars and terrorist attacks used to make stock markets stumble. The OPEC oil embargo in the fourth quarter of 1973 took the Dow Jones industrial average down 18.5%. And the destruction of the World Trade Center in 2001 caused the Dow to drop 14.3%.

However, stock markets have been bullish since hostilities erupted in July. On July 24, the Dow rose 182.67 points, and the S&P/TSX composite index rose 206.83 points — spectacular gains after the mid-summer correction. Bond markets also appear to be taking the war in stride and, as a result, are reacting only to genuine economic fundamentals. Data from Barclays show that although capital inflows to the U.S. fell drastically after 9/11, they showed little or no change as Israel and its terrorist foes fought it out in Lebanon. If investors are nervous about war — or anything else — they are certainly not showing it in trading.

The steadiness of bond and stock markets in the face of global mayhem is a new phenomenon. It may also be perilously wrong for investors and advisors to stick it out in stocks when there is a prospect of even more warfare to come. The good news that inflation has been restrained has also outweighed concerns that terrorism will wreck stocks.

“Madrid, London, Mumbai, Israel — it is endless,” says Tom Czitron, head of income and structured products at Sceptre Investment Counsel Ltd. in Toronto. “We have become anaesthetized to terrorist activity. The bond market cannot rally every time there is an attack. Only a significant slowdown in the economy or a recession will push up bond prices.”

Around the world, investors have become used to terrorism. Even the Tel Aviv stock market, which dropped on July 12, rebounded on July 13, notes Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver. “The market has assumed that war in the Middle East will not impact oil flows,” he says. And without changes in fundamentals, bomb blasts and regional wars no longer move markets, Bondy argues.

For the time being, complacency has overtaken caution in as-set allocation. Many investors take the view of Richard Howson, chief investment officer of Howson Tattersall Investment Counsel Ltd. in Toronto, that the best policy is non-reactive. “Portfolios should be structured according to long-term, personal objectives and not respond to short-term phenomena,” he says.

The market appears to believe there will be business as usual, regardless of disaster in faraway places.

Acceptance of terrorism as the status quo is based on the assumption that war is regional and disaster is someplace else. Were that to change, if terrorists did more than kill by the hundreds — as they have done in train bombings in Madrid and Mumbai, nightclub attacks in Bali, and in somewhat smaller numbers in London — outside of regional hot spots, the market could react quite strongly.

More specifically, terrorist attacks of a higher than usual severity would cause spreads in bond markets to widen as investors rushed to the most secure government bonds, says Tristan Sones, vice president and portfolio manager of AGF Funds Inc. ’s AGF Global Government Bond Fund in Toronto.

“There is a general consensus that war in the Middle East is not going to spread,” says Sones. “If more countries got involved, there would be a spike in volatility in capital markets and bond yields would come down.”

@page_break@As a result of the conflict and prospects that the U.S. Federal Reserve Board and the Bank of Canada may ease up on rates, Sones says now is the appropriate time to increase bond allocations: “With interest rates up quite a bit since their lows in 2004 and inflation contained, it would be prudent to be a little overweighted in bonds.”

Moreover, “markets are trading on optimism that world events will work out in a peaceful way,” Sones adds. “They are not pricing in worst cases. And if there is no peaceful resolution [of conflicts], there would be a flight to quality.”

The better investment-grade bonds would produce the strongest gains, he suggests. After all, when buying insurance, you want a policy with a solid issuer.

If the bond market appears blasé about conflicts around the world, it could be time for prudent investors to buy. So far, investors are watching fundamentals such as oil prices, which have a risk premium built in for energy disruptions. But if events in places such as India and North Korea take centre stage, if there is a disaster in a major financial market akin to 9/11, or if the any of the other G-7 countries other than the U.S. becomes involved in some military way in the conflicts, the bond market would react, says Randy LeClair, vice president and global bond portfolio manager at AIC Investment Services Inc. in Burlington, Ont.

That reaction has been postponed, LeClair maintains, by the summer torpor. “We are in the holiday months and a lot of portfolio managers are away on vacation or interested in things other than world tensions,” he says.

For now, bond markets are in a state of suspension, held up by the probability of worse geopolitical events to come and the possibility that nothing more than a cooling world economy will cause interest rates to drop.

Either way, there’s a case to be made for raising bond allocations now. IE