Bonds that are market darlings today can turn into tomorrow’s orphans, priced at a tiny fraction of their cost at issue and seldom, if ever, traded.

This happened recently to Maple bonds and structured debt built on cash flows, and low-covenant bonds that offer little protection to investors. Prior to that, there were other failures, including pay-in-kind (PIK) junk bonds that paid more junk instead of cash.

Each of these formerly sought-after credits have become financial untouchables in a market that is terrified of risks that can be seen, such as changing interest rates, and invisible risks, such as names of counterparties. The market is frightened and, therefore, penalizing innovation, a troubling development

Maple bonds — issued outside of Canada for the domestic market and priced and paid in loonies — were among the most popular bonds sold in Canada in 2006 and 2007. Issued by supranational agencies such as the European Bank for Reconstruction and
Development and state-backed banks such as Germany’s Kreditanstalt für Wiederaufbau at yield premiums to Canadian bonds of similar terms, they were usually rated “AAA.”

Now, the Maples market has become a land of hot bargains. For example, an American International Group Inc. 4.9% bond due June 2014 and rated “AA-” at issue, traded at a yield of 1,500 basis points over a Government of Canada bond of the same term — about 16.9% to maturity — at the end of January. A Bank of Irelandbond rated “A” due September 2015, traded at 1,498 bps over a Canada bond of the same term for a net return of about 17.1% to maturity at the end of January. These returns are deep into junk territory, the result of the global financial crisis and the realization that some major institutions are close to insolvency.

The worst hit are Iceland’s financial services bonds. For example, the Landsbanki Islands HF 4.40% bond due in January 2010 came to market in December 2006, traded at $99.90 per $100 face value on Dec. 31, 2007, and at $8.58 per $100 a year later. It now has no bids and is not trading.

This is not an isolated case. A sixth of the outstanding issues of Maples lost money last year and 17 of 110 issues in the Maples market index ended 2008 priced at less than 80¢ on the $1. Maples of issuers that were solvent but troubled, such as Royal Bank of Scotland Group PLC and Citigroup Inc., were discounted to 50¢ on the $1.

What hit Maples was a combination of mean reversion — that is, the process of returns on risk-adjusted capital returning to long run averages — and a lapse in belief in the credit quality of issuers, many of whom were never really familiar names in Canada, says Randy LeClair, senior vice president and portfolio manager with AIC Ltd.in Burlington, Ont.

But while Maples are down, they are not dead. “They could revive,” says Vivek Verma, vice president with bond manager Canso Investment Counsel Ltd. in Rich-mond Hill, Ont., “if spreads on domestic equivalents [financial services bonds] begin to narrow. Then, at some point, investors will recognize that Maples are attractive.” His view is that there is nothing wrong with the credit quality of debt from quasi-governmental entities such as KfW and government-backed banks such as Norway’s Kommunalbanken.

A return of confidence could rehabilitate the vast structured products market. These products, which include asset-backed commercial paper, fell out of favour in early 2008, says Edward Jong, senior vice president with MAK Allen & Day Capital Partners Inc. and portfolio manager of frontierAlt Opportunistic Bond Fund.

“Structured products were casualties of the fall of Lehman Brothers Holdings Inc. in 2008,” Jong notes. “They still trade, but they are not liquid. They traded with narrower spreads [over Government of Canada bonds of similar terms] before the financial crisis broke and now they trade with wide spreads.”

For example, a Golden Credit Card Trust that holds Royal Bank Visa accounts receivable due April 2013, issued with a 5.4% coupon and a rating of “AAA,” has recently traded at 260 bps over a Canada bond of a similar term that pays 1.9% to maturity. For a medium-term bond rated “AAA,” that’s a huge yield boost.

Whether a bond is a good trader or an orphan depends on what’s behind it. As Michael McHugh, vice president of fixed-income and bond portfolio manager with Dynamic Funds Ltd. in Toronto, suggests, if the issue is backed by tangible assets or a revenue stream, it can trade. But if it is built on synthetic derivatives or if the assets are opaque and difficult to see, it’s probably frozen. Case in point: Canada’s ABCP market.

@page_break@Behind the rigor mortis that has taken over parts of the bond market is a dearth of capital, McHugh argues: “Investment dealers won’t put their money into inventory. They do not want to get stuck with bonds they can’t sell. In fact, some dealers have taken traders off desks that handle less liquid bonds.”

Some exotic bonds are completely dead. PIK bonds issued in the mid-1980s by Ottawa builder turned retail mogul Robert Campeau were designed to pay not money, but more debt. The concept, akin to a stock that pays no dividend, no longer appeals to a market focused on security.

Avoiding bonds that could be debt-market zombies is the key. “You want issues with a lot of bonds in the market,” McHugh says. “Those are the well-known ones. You want big issues in the hundreds of millions of dollars, not small issues in the tens of millions. A low-coupon billion-dollar issue will trade with a smaller spread than a small, high-coupon issue.”

As well, McHugh suggests that you steer your clients away from exotics, such as catastrophe bonds that trade on specified events such as hurricanes. Also on his list of thin traders are bonds with complex terms or weak covenants. Even fixed-floaters, which pay a specified rate until a given date and then pay a specified formula, have come into doubt since Deutsche Bank AG refused to call one of its bonds in mid-December.

“Fixed-floaters still trade,” he notes, “but their spreads have widened. In this skittish bond market, any bonds with conditions — even calls — can expand spreads over government bonds and reduce liquidity.”

In a market terrified of defaults, bonds with complexities are potential orphans. They may offer excellent returns based on credit rating, but what you gain in potential yield can be lost in a trade. “If you want complex bonds that may be subject to impaired liquidity,” McHugh warns, “let a professional bond manager pick them for you.” IE