Corporate bonds are making a comeback after they were trashed by institutions terrified of being caught with anything but government bonds.

At end the end of May, subordinated bank debt was yielding 5.4%, 180 basis points more than 10-year Government of Canada bonds yielding 3.6% to maturity. That net return is down, however, from the panic over corporate bonds in March, when subordinated debt paid a net return of 5.9% — 250 bps more than Government of Canada bonds at the time.

The current payoff for corporate bonds is less than it was at the end of the first quarter, but it is significantly better than it was in August 2007, as the U.S. subprime mortgage fiasco began to make its mark, when spreads on AA-rated debt were just 50 to 80 bps more than Canadas.

There is money on the table, but, looking ahead, the question lingers: will fear continue to drive government debt prices up or will improving economic conditions and strengthening corporate balance sheets push central banks to raise interest rates?

The question is critical for advisors and their clients because if interest rates drop by another 50 to 100 bps, government bonds will tend to beat credit-sensitive bonds. But if business conditions improve and interest rates rise, government bonds will suffer and corporate bonds are likely to thrive.

Market-watchers agree that a strong economic recovery is not in the offing for now. Sunil Shah, vice president and portfolio manager with Sceptre Investment Counsel Ltd. in Toronto, sees the weakness in the U.S. economy continuing.

And, in order to preserve some ammunition in case the economy gets weaker, he says: “The U.S. Federal Reserve Board, at the moment, is reluctant to make further rate cuts.”

The direction of interest rates — and the way bond investors will play the market — hangs in a balance between inflation and recession. Bank of Nova Scotia’s economics department shows Canada’s consumer price index rising by 1.4% in March, compared with a 3.9% rise in the U.S.’s CPI during the same month. And when you combine slowing economic growth with rising inflation, you get stagflation.

At this point, of course, neither the U.S. nor the Canadian economies have had two successive quarters of negative growth in gross domestic product. Avoiding a recession remains the target, says Aron Gampel, Scotiabank’s deputy chief economist.

“We see the Bank of Canada dropping rates by 50 bps by the end of the first quarter of 2009,” he says, “and the Fed dropping rates by 75 bps by then.”

In this policy tug of war, recession fears appear to trump inflation angst.

For bond buyers, the problem is that a lot of the bad news is already priced into the market. It is good news that has the capacity to move bond prices upward — when that good news arrives.

In balancing pessimism and optimism, Hanif Mamdani, head of corporate credit at Phillips Hager & North Investment Management Ltd. in Vancouver, suggests that high-quality corporate bonds — especially those issued by financial services firms — are likely to outperform government bonds in the next 12 to 18 months.

Mamdani figures that spreads on five-year chartered bank senior bonds will remain at three times their long-term average and not very far from their 30-year maximum spreads over government bonds.

“There is an ample reward,” he says, “for the modest risks involved.”

Moreover, there is a feeling on the Street that Canadian financial services bonds have survived the most dangerous part of the credit crisis, Mamdani says, and that future writedowns of loans will be manageable.

As well, if Canadian banks go to international credit markets, they will add to the supply and help bring down prices, thus tightening bond spreads.

Finally, if the yield curve continues to steepen, as it has since March, it will reward risk-taking and add to the market’s willingness to take on some credit bets.

Chris Kresic, who manages $4-billion of bond funds for Mackenzie Financial Corp. in Toronto, says, “There is plenty of compensation [for risk] in high-quality corporate bonds.”

He points to some examples, such as a Bank of Montreal 6.17% bond, due March 29, 2023. Priced at $105.60 to yield 5.43% to maturity, it pays 183 bps more than a Canada of the same term. A TD Bank Financial Group bond with a 5.48% coupon due April 2, 2020, offers 4.91% to maturity, which puts it at 155 bps more than a Canada of the same term.

@page_break@Life is returning to corporate bonds, and whether you shop for single issues or buy a mutual fund for clients, the price outlook for credit-sensitive bonds is widely seen to be bullish. But that could change if the fortunes of financial services companies worsen.

Major European banks such as UBS AG in Zurich continue to report wretched losses. To strengthen its balance sheet, the giant Swiss bank went to market on May 22 with US$15.6 billion worth of new shares offered to existing UBS shareholders at a discount of 31% off the market price.

Meanwhile, New York-based American International Group Inc., the largest insurer in the U.S., has taken US$20 billion in writedowns, mainly in credit-default swaps in which it took fees for guaranteeing that bonds and other debt instruments would not default. One can hardly blame investors for thinking that financial institutions don’t have their risk management right.

More writedowns, more red ink and more bad news could widen corporate spreads again. And that, says Ed Jong, senior vice president with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund, could wipe out a lot of profits on credit-sensitive bonds. Instead of buying corporates, he has taken the middle ground, buying provincial and municipal bonds. He has been picking up Saskatchewan provincial issues and 10-year Municipal Finance Authority of British Columbia issues at yield premiums of 60 bps and 100 bps, respectively, over 10-year Canadas.

“The market has seen these Canadian municipals as having similar risks to U.S. municipals, but, in fact, they remain AAA-rated and untouched by U.S.-type housing issues,” Jong says, adding that “Canadian bank debt will be ripe for purchase in the third quarter.”

In a market in which timing is critical, Jong figures that patience will pay — for advisors and their clients. IE