The financial world has been turned topsy-turvy by the prospect of deflation. As a result, you and your clients now have to shed the idea — long embedded in financial forecasts — that corporate earnings rise, dividends get paid and stock prices go up. If deflation is the mood of the market, none of those things are any longer true.

A low, single-digit percentage return on a bond can look rich in a bear market in which interest rates are falling, inflationary expectations are shrivelling and consumer prices are flatlining or declining.

Here is how a long bond will play out as deflation takes over the economy: a Government of Canada $1,000 stripped coupon, a.k.a. as a residual, with a 4% nominal interest rate due to be paid in 20 years on, say, Dec. 15, 2028, has a time-weighted sensitivity to interest rate changes of 20. In bond-speak, the duration of the strip is equal to its term. If we assume a 1% drop in long interest rates, the strip’s market price will rise by 20% to $1,200.

Now, assume that prices of consumer goods drop by 10%; such prices can and do soften in major recessions. Already, car prices are down by 10%-20%, depending on what car you want and where you shop. The price of gasoline has fallen drastically in the past few months. The cost of leasing a ship is down by 80%, according to the Baltic dry index. So, let’s add 10% to our bond’s price. It now has real purchasing power of $1,320.

A person holding this strip now has a 32% gain, in addition to that 4% annual coupon. If the price appreciation has happened in one year, the total return is 36%. That’s not bad for a sedate bond. In fact, an investor holding this bond can feel wise and certainly prosperous. This is the value in buying government bonds, which tend to rise in price even when equities and even credit-sensitive corporate bonds are tumbling in value.

Corporate bond returns have lagged government bond gains in the past few months. That is why corporate bond spreads are so high these days. For example, a Bank of Montreal 6.17% bond due in 2018 has a yield to maturity of 5.85%, 240 basis points more than the 3.45% yield to maturity of a Canada bond of the same term.

Huge discounts on corporate bonds reflect investors’ credit concerns and their apprehension about getting caught with long bonds if the markets seize up, as they have done several times since March.

Thus, in early November, U.S. long corporate bonds tracked by the Bloomberg corporate average bond index had a 9.5% yield, with an average BBB credit quality and 30-year average terms. At the same time, similar 30-year Canadian corporate bonds with an average credit rating of BBB in the Bloomberg index yielded 8.97%. These are all investment-grade bonds.

Investment-grade debt is now paying about the same as junk did in better times. This means there are bargains to be had in long bonds and credit-sensitive debt for those who are willing to accept some risk of default.

Edward Jong, senior vice president of Toronto-based MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund, says there is value in long government bonds: “If the supply of long bonds [produced to finance bailouts] is not as large as has been expected, long bond prices will tend to be higher than if supply were very large. Moreover, the short end of the yield curve has little room to fall. The U.S. Federal Reserve Board only has 100 bps to cut before the U.S. overnight rate hits zero, while the Bank of Canada has 225 bps to go before it gets to that point.”

So, in Jong’s view, the back end of the yield curve will drop to encourage economic growth. “That’s why an investor who expects deflation from the economy,” he says, “can put money on long bonds and make a good profit.”

Jong is sticking with government issues rather than corporates. “There will be a lot of volatility in corporates, and we are not through seeing the widening of corporate spreads,” he says. “I would not take any more risk than buying provincial bonds or federally guaranteed Canada Mortgage Bonds.”

@page_break@It is a question of relative value. Chris Kresic, senior vice president for investments with Mackenzie Financial Corp. in Toronto, sees opportunities in discounted corporate debt. His Mackenzie Sentinel Bond Fund is weighted 44% in government bonds, 51% in corporates and 5% in cash equivalents. “We have added corporates during the year because they represent better value,” he explains. “The market has priced in a recessionary outcome for corporates, meaning eventual improvement in credit quality.”

If adept bond managers differ on whether to hold corporates or not, what are you or your clients to do? You can bet on mutual fund managers’ track records, which is the equivalent of putting money on the jockey rather than the horse. Or, you can buy low-fee exchange-traded funds to get what amounts to guaranteed style diversification.

For instance, the Claymore One to Five Year Laddered Government Bond ETF, with a 0.15% management expense ratio, has about as low an MER as ETFs get; it is also an efficient play in its sector.

Barclays iShares Canadian Corporate Bond Index Fund ETF, with an MER of 0.40%, is another choice.

Additionally, Barclays iShares Long-Bond Index Fund ETF, with its 0.35% MER, is also a good alternative.

And for the safest of all bets, you can buy Barclays iShares Canadian Short-Bond Index Fund, which has an MER of 0.25%; it is the recent performance winner, up 6.26% for the 12 months ended Oct. 31.

Every addition of time or credit sensitivity to a bond portfolio adds risk and potential return. Yet, the bottom line on all bond investments is cash reversion. “When my clients need bonds, I put them into Government of Canada bonds, not funds or ETFs,” says Caroline Nalbantoglu, a registered financial planner with PWL Capital Inc. in Montreal. “In a pinch, if all else failed, government bonds would still revert to cash at maturity.”

And that, after all, is the bottom line on safe bond investing. IE