Bond investors are in a quandary, for safety now comes at a higher price. Government of Canada bonds, which are the trend-setters for the entire domestic market, have been compressed into a yield curve that’s about as flat as a Prairie landscape.

As a result, an investor interested in nothing more than current yield gets almost nothing extra for taking on the added risk of going from a couple of years to 30 years. In late August, the Canada two-year bond paid 4.13% to maturity. Five years takes the Canada bond to 4.17%. Wait 10 years for your money and you get 4.31%. Hold one out to 2036 and it pays 4.36%.

However, the trivial incentive for holding long bonds is not the whole story. For an investor who wants to maximize total return — which is yield plus capital appreciation — the very flatness of the yield curve is a reason to consider going out as long as 30 years. Flatness implies low inflation and that, in turn, implies lack of economic growth and a stock market wallowing in low returns and defeated expectations.

What hurts stocks often helps bonds. And that is the key to taking the risk of going long when the yield curve augurs lower rates to come.

“Falling bond yields are welcome news to the stock market,” says Brad Bondy, director of research for Genus Capital Management Inc. in Vancouver. “If there is a slowdown, longer-term yields will fall as corporate earnings decline.”

For those who subscribe to this pessimistic view, taking on time risk actually makes some sense. “We are expecting inflation to peak and then to slow down because of lower growth,” says Robert Marcus, a bond manager who heads Toronto’s Majorica Asset Management Corp. Slowing growth implies that central banks may reduce interest rates, he adds, and long bonds that lock in interest rates provide an assurance that reinvestment will not be at lower interest rates.

“This is the time in the interest rate cycle when bonds have their worst returns,” says Randy LeClair, vice president and portfolio manager at AIC Investment Services Inc. in Burlington, Ont. “But it is also the point of time at which long-term yields reach their peak for the cycle. So, it is now an opportunity to take short-term funds and lock them in for longer periods of time.”

Long bond investment strategies have to be looked at in comparison to the amount an investor could earn using certain alternative strategies:

> Bank Stocks. Bank shares tend to pay lower dividends than bank bonds, but dividend increases can make up for it. National Bank of Canada’s 4.7% bond due Nov. 2, 2020, has a 5.0% yield to maturity. In comparison, a National Bank common share pays a dividend of 3.4% and has grown its dividend at an average annual compound rate of 18.5% for the past five years.

> Income Trusts. Yields for income trusts can go as high as double-digit levels. But trusts invested in resources are dependent on uncertain energy and materials prices for income and distribution. Also, many trusts have cut their distributions and none guarantee return of capital. They are not a substitute for bonds.

> High-Yield Bonds. When the business cycle slows, junk bonds tend to get into trouble. This means the time to buy into junk is not at the peak of the business cycle, but at the trough that is yet to come.

> Emerging-Markets Bonds. Emerging-markets bonds thrive late in interest rate cycles, then weaken rapidly when world trade declines. Default rates on sovereign junk are high and recoveries are low.

> Gics And Money Market Funds. Even though capital is secure with these investments, the returns they provide will fall when the Bank of Canada begins to lower interest rates.

> Bond Derivatives. A recently launched bond fund that will produce strong returns, if interest rates decline, falls directly into this type of investment. Horizons BetaPro Canadian Bond Bull Plus Fund, which opened for business on Aug. 11, provides twice the total daily return of the Government of Canada 10-year bond. If interest rates were to fall by just 25 basis points over the next six months, the expected total return of the Horizons BetaPro fund would be 4.5% in the period.

@page_break@It costs $5,000 to get into the fund; there is a 1.5% annual management fee. There are no minimum hold periods nor penalties to cash out early.

For now, interest rates appear to be on hold. Bond markets are betting a decline in rates is coming. If that bet is right, long bonds will pay handsomely. If the bet is wrong, holders of long bond will suffer in proportion to the gains they expect to make. IE