The auguries are ominous. Investors, fearing recession and expecting interest rate cuts, have been plunging into government bonds, forsaking yield for security.

With one-month Canada treasury bills priced to yield 3.44% to maturity and five-year Canada bonds priced to yield 3.40% to maturity in late-January trading, investors have given a clear sign that they are willing to give up current income for yield insurance.

For now, though, the question is how far out in term length should your clients go in pursuit of a safe haven? The problem is in balancing the likelihood of a recession with the probability of an eventual recovery. And this is no easy task, because going too long on bonds to capture falling interest rates will set a bond portfolio up for losses when central banks eventually begin to worry more about inflation than recession and start pushing up rates. Then these rising rates will deliver losses to holders of existing bonds, which become less attractive as new bonds emerge with higher coupons.

For now, there are warning signs of a recession and of the inability of American consumers to rescue the U.S. economy, as they did after the dot-com meltdown at the beginning of the century. Americans are shopping less because they feel less wealthy. House prices in the U.S. were down 5.6% in the third quarter of 2007 from the same time a year earlier — and could go much lower, suggests Robert Shiller, the Yale University economist who helped create the S&P/Case-Shiller home price index.

Add in the rising price of oil and it becomes all the clearer that the U.S. and one of its key energy suppliers, Canada, could be headed into a period of slow or no economic growth combined with rising unemployment. The only issue is how serious and prolonged this slowdown will be.

“We are looking at a marked slowdown in the U.S. It will be prolonged,” saysBank of Nova Scotia economist Karen Cordes in Toronto. “The U.S. Federal Reserve Board cut overnight rates by 75 basis points in late January. We think that the Fed will continue to cut. In Canada, we see the [Bank of Canada] continuing to cut rates this year.”

Tom Czitron, managing director for income and structured products at Sceptre Investment Counsel Ltd. in Toronto, agrees: “We agree that the Bank of Canada, the Fed and eventually the European Central Bank will drop rates. I see growth of GDP slowing, and there is a 30% chance of recession in Canada and a 50% chance of recession in the U.S.

“The U.S. situation is serious,” he adds. “Houses were like an ATM machine for homeowners, but that machine is now broken.”

As a result, there is a mild recession in the offing, Czitron insists, and the expected drop in interest rates and the resulting steepening of the yield curve will reward bondholders who go long on their bond picks.

Czitron has pushed his average duration (the price to value relationship of bond income flows) to equal the 6.7-year average duration of the DEX universe bond index, formerly the SC universe bond total return index. “The recession will be relatively short and it is not wise to go very long,” he says. “The biggest gains will be in the middle of the curve, at about 10 years, where we have positioned ourselves.”

The signs of hard times are hard to miss, says Chris Kresic, Mackenzie Financial Corp. ’s senior vice president for investments: “Not only is there a housing market contraction, but also there is less lending going on. We are going to see more rate-cutting around the world, with central banks reducing rates to resist appreciation of their currencies. The result, if they all do it, will be inflationary.”

Kresic’s view is that interest rates will drop at the short end of the yield curve while inflation concerns continue to hold up the long end of the curve. “Oil is a sideshow; if it goes up, it is a tax on consumers. If it goes down, it gives consumers more spending ability,” he says. “The Fed is lowering rates as oil prices rise. That is an unusual combination, but what it means is that the Fed is trading stimulus now for inflation later. That means that the yield curve will steepen as the short end drops and the long end holds or rises.”

@page_break@Kresic is playing his terms and duration conservatively: “There is less risk on the short end. The market already prices in recession. But long bonds are a bet on a real recession and an assumption that the Fed is behind the curve and not doing enough. In fact, the Fed is ahead of the curve.

“And in Canada, where we never tighten as much, rates will drop, too, but not as much. As long as the Canadian dollar stays close to par with the U.S. dollar, then the Bank of Canada will trail the Fed’s easing. So, in Canada, I would be short on terms of five years and under. That is where you’ll get the most increase in value for the central bank moves that I anticipate.”

There is also value in deeply discounted corporate bonds that have been reduced to bargains by the flight to safety. Says Kresic: “Where I see value is in high-quality corporate bonds and asset-backed bonds rated A to AAA. Use today’s pessimism to buy short corporates of five years and less. These are bank bonds, commercial mortgage-backed securities and any financial services company bonds that have been marked down in the current credit crisis.”

Bond markets now accept the high probability of a recession. The only question, says Edward Jong, senior vice president for fixed-income at MAK Allen & Day Capital Partners Inc. in Toronto, is how severe it will be. His strategy is to go to a year longer on duration than the index and avoid corporates because of the global economic slowdown.

“Everyone is tripping over the ‘R’ word, and now the expectation is that the Bank of Canada will match moves by the Fed,” Jong says. “Rates are headed downward. The Fed could go down below 3% and the Bank of Canada could go toward 3.25%. We know that the central banks will do whatever it takes.”

As a result, the theme for 2008 is: dig in, invest for safety and survive. Corporate spreads will widen, says Jong. The only issue: will it be worth taking on credit risk as business conditions get tougher? IE