Once a quiet club for conservative clients, fixed-income investing has become a jungle in which low yields on government bonds have forced those who crave yield to take on the substantial default risk of corporate bonds.

Government bonds have been priced up to levels at which they yield little in the short run, offer not much in the middle and expose holders on the long end to massive losses when inflation comes back and interest rates rise.

Corporates, on the other hand, have become outcasts that inves-tors will take only with massive interest rate boosts.

That said, the frothy payouts on corporates should protect their holders when economic conditions improve and interest rates rise. As a result, there are remarkable bargains for those willing to take on the risk of buying investment-grade debt that is lying on the sidewalk waiting to be picked up.

The returns on government bonds — 2.4% on U.S. 10-year treasuries, 2.7% on 10-year Government of Canada bonds — are at long-term lows. “I don’t see a lot of value in government bonds,” says Chris Kresic, senior vice president for investments and fixed-income portfolio manager with Mackenzie Financial Corp. in Toronto. “But government bonds, in the short term, are a way to play deflation risk.”

If deflation, now more of a threat than a force, spreads from the capital markets — in 2008, the S&P 500 composite index was down by 38.5% and the S&P/TSX composite index was down by 35% — to the broader economy, then low-yield government issues will pay handsomely. The seeds of that deflation already exist in falling real estate prices and contracting retail margins.

At the other end of the investment-grade risk spectrum, A-rated debt such as Bank of Montreal Tier 1 perpetuals were priced at issue on Dec. 12, 2008, to yield 10.22% to their 10-year call date in December 2018. If the issue isn’t called, the bond resets to yield the five-year Government of Canada bond rate, which was recently 1.6% plus 10.5%. “That’s about a 12% yield,” Kresic says, “and the issuer would be likely to extend [the term] and keep the premium on the bond.”

Other bonds pay comparably attractive returns — so long as you assume that the issuers won’t go bust. “Corporate bond spreads are at all-time highs, with wider spreads than we had in the 1930s,” says John Carswell, president of Canso Investment Counsel Ltd. in Richmond Hill, Ont.

A case in point is the recent Toronto-Dominion Bank 100-year bond, issued Jan. 15, with a 9.523% coupon to reset in 2019. The high rate of interest will moderate the risk in these bonds, making their duration comparable to that of a much shorter bond.

These Canadian bond yields are still reasonable compared with what U.S. banks and some European banks have been yielding. This past December, Germany-based Deutsche Bank AG failed to call a fixed floater. The issue began to trade as a floater trading at the European Union interbank lending rate, which is comparable with the London interbank offered rate. That was cheap funding for the issuer.

Although Deutsche Bank got a good deal by skipping the call, the entire callable bond market began to trade as though all callable corporates were floaters. With interest rates declining, cash yields were seen as being at risk of sinking to the Euribor rate, recently 2.86%. Bond prices would have to fall so that the bond would pay a yield comparable with that of similar floating rate and perpetual securities. A bond with a 6% coupon formerly priced at $100 would have to fall to about $50, depending on time to maturity, to be competitive, says Carswell.

Angst over bonds not being called has spread to Canada, Carswell adds. A TransCanada Pipelines Ltd. U.S.-dollar junior subordinated bond with a 6.35% coupon fixed to call in 2017, which then floats at LIBOR plus 2.21%, was priced at issue at the 10-year bond rate plus 1.6% but has tumbled by half to about $50 and trades as a long bond due in 2067. This is a yield to maturity of 9.9%, comparable with a perpetual preferred share. The fear that the issuer will not call the bond has pushed the yield to the call date to 18%.

@page_break@Clients have to take this anxiety seriously. Carswell, an experienced bond strategist, expresses the consensus of the bond community: “Our view is that the economic cycle is worsening and the credit losses for banks will increase. Banks have huge government support but remain short of capital. They have to build capital in advance of loan losses. A year ago, subordinated Tier 1 debt was 0.8% over government bonds and nobody thought it would widen. Now, the spread is 6%.”

You can get a sense of the seriousness of the disbelief in the market by looking back to the 1930s. Then, the spread on top-grade, long corporates over U.S. Treasury bonds was 67 basis points. Now, it averages 400 bps or more, Carswell notes. In sum, getting high yields on deeply discounted corporate debt, especially bank debt, may not be a free ride.

Still, he suggests, the fear may exceed the reality: “We think that investment-grade corporates are attractive at all terms, especially longs. If they were bargains during the Great Depression, they should be good deals now.”

So, should you pick the long-hanging fruit for your clients — that is, high-yield corporates with default risk — or should you stick with riskless short government issues or mid-curve governments with limited risk of loss if interest rates rise?

Says Edward Jong, senior vice president with MAK Allen & Day Capital Partners Inc. in Toronto and portfolio manager of frontierAlt Opportunistic Bond Fund: “Canadian banks won’t default, but their bonds are being realigned with global levels of risk.” In other words, there is global risk priced into domestic bonds. This makes for terrific yields if defaults don’t occur.

Still, the global credit crisis has not yet ended, and its manifestations — including expected calls that don’t occur, unexpected losses and insolvencies — are on the minds of bond investors. IE