With interest rates moving upward to cover the massive and unknown risks posed by the subprime scandal in the U.S. — and now spreading throughout the world — and bond returns in the red, you can fairly ask: why have bonds at all?

For the past six months, the SC universe bond total return index has been negative. “Most bond funds are losing money relative to the coupon,” says Tom Czitron, managing director of income and structured products at Sceptre Investment Counsel Ltd. in Toronto.

Translation: losses on bonds priced for yield to maturity have dropped more than current interest yield. Bonds will rise again, but, for now, the fundamental question is: what good are they?

Plenty good — just not for near-term price gains. First, in the interest of full disclosure, let’s lay out the trouble with the bond market. It’s Canada’s inverted yield curve.

Recently, two-year Canadas have traded to yield 4.71% to maturity, and 30-year Canadas have yielded 4.52% to maturity. Canadian interest rates appear to be headed upward, given strong retail prices backed by robust consumer demand. No wonder Robert Marcus, president and chief investment officer of bond specialist Majorica Asset Management Corp. in Toronto, says: “Cash is a good place to be right now.”

Cash can earn 4.5% in 90-day Canada T-bills with virtually no price risk. The case for going longer rests, as Marcus notes, on the chance that the Bank of Canada will eventually drop interest rates and leave T-bill holders with declining yields.

So, taking the risk on terms of a few years — or even going out to 30 years — amounts to paying an insurance charge in the form of the risk intrinsic in long bonds and the slightly lower yields for long bonds in comparison to shorts.

There is a sea change underway in the bond market. After five years of shrinking spreads over Canada bonds, corporate bond yields are beginning to widen, driven by the realization that the optimism that drove capital markets until mid-July was misplaced.

The situation reflects the crisis in the U.S. debt markets, in which yield boosts on subprime loans made a few years ago are coming home to roost in the form of shocking default rates, which are now as much as one-fifth of all U.S. subprime residential mortgages outstanding.

In Canada, institutional bond buyers who have been financing leveraged buyouts by loading up on relatively low-interest bonds with loose covenants have been walking away from recent offerings. Banks that have acted as short-term intermediaries in the deals are stuck with loans that they will have to sell with enhanced yields. The implication for all this is that spreads will continue to widen as bond buyers demand more return for what they perceive as more risk.

None of this bodes well for bond shoppers who hope to score bargains in the near term. What is cheap today may well be cheaper tomorrow, after all.

But the case for bonds cannot be viewed in isolation. Stocks are in their own time of troubles. Witness the 400-point plunge in the S&P/TSX composite index on July 24, along with the 226-point drop in the Dow Jones industrial average on the same day. Bellwether stocks such as Research in Motion Ltd. lost 4.6% and nuclear power company Cameo Corp. saw its shares drop by 7%.

Bonds’ redeeming value is likely to be as a safe haven. Nobody is going to get rich at T-bill interest rates, but nobody will get poor, either. Canada T-bills, bankers’ acceptances, short-term provincial bonds and some of the premium savings accounts that pay 4% or more being offered by several chartered banks all provide safety of capital, liquidity for buying into stocks when downward momentum ends and the potential for making some shrewd bond buys in what may be the not so distant future.

In Canada, there is a shortage of long bonds. Debt reduction by the federal government has turned long bonds into an endangered asset. Life insurance companies and pension funds have been buying long bonds to match their own liabilities, pushing up prices and bringing down yields.

The debt-reduction trend does not appear to be over, so you can expect lift in long-bond prices, Marcus explains. U.S. Treasury bonds have their own troubles, he adds: “Foreigners, who own 44% of U.S. debt, have been backing out of the market. China has been a net seller of treasuries.”

@page_break@Falling U.S. long-bond prices will be pushing up yields, steepening the U.S. yield curve and adding to the case for holding long U.S. bonds.

Bond and stock markets operate like a teeter-totter, as long as interest rates are not too high.

We are far from the double-digit interest rate days of the late 1970s, when bonds were in what was probably the worst debt market in Canada’s history and stocks were locked into the winless vice of stagflation. Today, inflation is a manageable 2.2%, unemployment is at a 33-year low and consumers rule.

Cash and cash equivalents make sense as stock markets have roiled in August, yet the prospects for Canadian long bonds are good.

But don’t rush to buy just yet. The Bank of Canada may raise rates later this year, pushing down returns on outstanding, investment-grade bonds.

Unlike stocks, whose upper prices are unbounded, bond returns are finite. More than with stocks, bond trading takes good timing.

Until the time is right, staying in cash equivalents such as T-bills is a pretty good strategy. IE