Bond buyers earn their keep when times are tough and markets are in despair. The recent dismal performance of formerly high flying stocks and the strong returns of stodgy, but comparatively safe, bonds have made gloom downright profitable.

For the six months ended Jan 31, the DEX long-term bond index (formerly called the SC universe bond total return index) produced a 5% return. In comparison, the S&P/TSX composite index lost 5.1% in the same period.

The bond market has been divided into two parts by troubles in financial services and in the wider economy. Investors and advisors can choose between Government of Canada bonds that pay as little as 3% for five years, or bonds issued by chartered banks that pay up to 5.5% for a similar term.

Investors also want to be paid for the time risk of putting money into bonds. The difference in yield between a two-year bond and a 10-year bond in Canada is 100 basis points.

The rush to refuge from tumbling equity prices has taken investors to bonds that have no credit risk. The safest bonds are issued by governments with the power to tax. Prices of two-year U.S. treasury bonds soared on Mar. 3, causing a massive drop in yield from 2.11% to 1.62% in the space of a week.

For its part, the Bank of Canada dropped interest rates paid by banks for overnight loans from 4% to 3.5% on Mar. 3. If interest rates fall further, there is money to be made, but the central argument for putting money into government debt is not about profit. Rather, it is safety at two levels.

First, governments with the power to tax need not default. Moreover, even if corporate bond yields rise, government bonds, as the referent for other debt, will lose nothing.

The fear on the street is apparent in the cost of insuring debt against default on repayment of interest or principal.

On Feb. 19, the Wall Street Journal reported that the price of insuring a US$10 million basket of top-rated commercial mortgages, called “AAA super senior debt,” had risen to US$214,000 from US$39,000 six months ago. On US$10 million of “BBB” commercial mortgages, the cost of protection has risen from to $1.5 million from US$672,000. Buying protection on the good stuff is no longer cheap; on the bad paper, the cost is equivalent to what a driver with a series of crackups has to pay.

Advisors and investors can go for safety or for yield. The “play safe” strategy focuses on government bonds in the expectation that interest rates will fall and thereby drive up the prices of existing bonds with relatively high-coupon yields.

Chris Kresic, senior vice president for investments at Mackenzie Financial Corp. in Toronto, figures that more rate cuts are inevitable: “Rates could go down to 1.5% in the U.S. and as low as 2% in Canada.”

A one-percentage point drop in interest rates will produce a gain on 10-year government bonds of 6.5% to 7% at current rates of interest.

The conventional method of capturing the most gains out of interest rate moves is to bet on long bonds. But that would not be optimal in this market, says Sunil Shah, vice president and portfolio manager at Sceptre Investment Counsel Ltd. in Toronto.

“Pick the mid-term bond,” Shah says. “The belly of the yield curve — bonds with terms of five to 10 years — usually outperforms when the yield curve is steepening, as it is now. The steepening is happening because the Bank of Canada has been dropping short-term rates. The same explanation applies to the U.S. as its yield curve steepens.”

The second strategy is to go for yield, but with the risk that spreads will widen and today’s corporate bond prices will be undercut by more business news. “Financial services bonds are coming out with increasing incentives,” says Craig Allardyce, vice president and associate portfolio manager at Mavrix Fund Management Inc. in Toronto.

In this market, corporate debt is under a cloud of suspicion and bank debt, in particular, is being treated like junk. Currently, the average yield for A-rated bonds issued by chartered banks and due in 10 years, is 5.63%, compared to an average yield of 3.63% for 10-year Government of Canada bonds. That’s a spread of 200 bps. A year ago, the spread on comparable bank bonds was just 55 bps.

@page_break@That leaves open the question of whether to buy conventional junk bonds. Barry Allan, president of Marrett Asset Management Inc. in Toronto, is a respected high-yield bond manager. A subadvisor to the Dynamic High Yield Bond Fund, he urges patience.

“In high-yield bonds, the time to buy has yet to arrive,” he says. “The Merrill Lynch master II high yield index — the most widely used measure of the high-yield market — is at 775. The index will peak at 1,100 to 1,200 and then probably turn. So, the time to start looking is when the index hits 1,000.”

Allan figures it will be time to go shopping in late 2008 or early 2009.

Advisors and investors have to make a fundamental decision: go for safety in governments or for return in corporates. For Ed Jong, vice president at MAK Allan & Day Capital Partners Inc. in Toronto and portfolio manager of the frontierAlt Opportunistic Bond Fund, the choice is a managed blend.

“We are seeing a lot of frightened retail investors fleeing into money market funds. But they are going to get almost nothing and they are taking a lot of reinvestment risk. After all, the average term is 90 days in those funds. Take off the management fee and they return just 1%,” he says.

“The better place to be is in a bond fund that spreads out terms and adds in some corporate debt,” Jong suggests. “If the Bank of Canada drops overnight rates to 2%, 10-year government bond prices could rise 5%. A bond fund can capture that gain, though a retail investor paying a wide spread on trades can’t.” IE