North American debt markets remain in turmoil as the astonishingly high rate of defaults on U.S. subprime mortgages and the paralysis of Canada’s market for asset-backed commercial paper have spooked investors.

The subprime mess and the collateralized debt problem are cases of structured financing run amok. In the wake of these events, fear has left bargains on the table.

These are venerable crises, for the ABCP issue stems from long-term loans financed with short-term debt — a classic case of mismatching —that has brought down banks and markets in the past. The U.S. subprime mortgage problem is a classic, as well — lending a lot of money on so-called “Ninja” (no income, job or assets) loans.

Optimists may be sad that it all happened, realists figure it had to happen and opportunists will be moving to buy perfectly good bonds that others now shun.

Chartered banks’ bonds and short-term IOUs called “bankers’ acceptances” are trading with yield boosts at almost record lows. In late September, $1 million of 30-day CIBC BAs traded at 4.91%, vs a treasury bill that paid 3.60%. That’s a spread of 131 basis points on a name that no one expects to default in the next month or two.

There are also huge spreads in prices of longer-term bonds. For example, a Bank of Montreal bond with a 5.04% coupon due Feb. 20, 2012, currently yields 5.20% to maturity, compared with a five-year Government of Canada issue that yields 4.31% to maturity. The pickup, 89 bps for a AA credit, is compelling. At 10 years, the yield spreads are at 114 bps, up from 50 bps in the summer, before the debt crisis broke open.

What has been happening in the money market has added to the spreads on non-government short-term paper, says Michael McHugh, a portfolio manager at Dynamic Funds Management Ltd. in Toronto who looks after $2.5 billion of bonds for the company: “BAs right now offer good value to investors.”

The market has been myopic in assessing risk. According to the Merrill Lynch master II high-yield index, the spreads for junk bonds have widened from almost record lows in May and June of 220 bps over U.S. treasury bonds; nevertheless, the current spreads of about 450 bps over U.S. T-bonds are still modest compared with the record 1,100 bps at the deepest moments of the dot-com meltdown in 2001. There is no great fear of defaults evident in the high-yield market.

Ironically, it’s in the top levels of investment-grade debt that fear of default has created bargains. Spreads on such bonds have expanded dramatically. For example, a 5.05% Kreditanstalt für Wiederaufbau bond due Feb. 4, 2025, that was issued in Canadian dollars with a yield premium of 47 bps over Government of Canada bonds, has recently traded at 65 bps over an 18-year Canada that yields 4.40% to maturity. And although KFW is a relatively unfamiliar name in Canada, the German government guarantee on the debt of this bank should ease doubts.

For now, corporate bonds — especially bank bonds — are being priced like fur coats in June. What’s more, the bargains look like they are here to stay for at least a few months. “There are no quick fixes for the crisis,” says Peter Kotsopoulos, executive vice president of McLean Budden Ltd. , a major institutional portfolio manager in Toronto.

So, how will the present crisis play out? A good model for the present debacle is what happened in 1998. Back then, there were three key problems — the Thai currency collapse, the failure of Long-Term Capital Management LP and Russia’s default on much of its debt — that caused havoc in both debt and equity markets. But the markets recovered and moved on to the next disaster — the dot-com meltdown at the beginning of this decade.

The question posed by the present debt crisis is whether the prices in the market are compelling values. After all, if asset prices continue to fall, today’s bargains may be tomorrow’s regrets. Answer: we can’t be sure, but much of the grief has already been priced into the market.

According to Robert Marcus, president and chief operating officer of specialist bond manager Majorica Investment Management Corp. in Toronto, it will take a return of confidence in structured products — such as ABCP — that investment bankers devised in the last decade to regain liquidity in this part of the market. Many of these are deeply subordinated debt issues that can be treated like bonds by issuers and deducted as expenses from income. Others are synthetic issues cooked up by investment banks to change the income and capital characteristics of cash flows.

@page_break@The healing process will require clearing out the overhang of dubious debt, Marcus says. That means vulture funds buying the debt others shun, paying perhaps a few dimes on the dollar and accepting some defaults along the way.

Central banks will drop their rates; short rates are expected to drop more than long rates, which are supported by inflationary expectations, he adds. That implies a steepening of the yield curve, a healthy process after the inversion that has been part of the bond market for as long as two years.

Some of the fundamental problems of the bond market are not going to be fixed by governments. The lack of long government bonds that pension funds and life insurance companies need to match their liabilities has created a void that structured products were meant to fill. But governments are probably not going to start issuing long-term debt just to chase out iffy bonds, Marcus says: “It would make no sense for governments to borrow long at high rates when they can borrow short at lower rates.”

So, what is the lesson? “Investors have to understand the risks they are assuming,” McHugh says. “If you can’t understand it, don’t buy it.”

Philosopher George Santayana once said that those who cannot remember the past are condemned to repeat it. Astute bond investors can go one better — learn the lessons themselves and buy cheap from those who need to learn. IE