Long bonds are making a comeback. As a sign of more relaxed credit conditions, institutional investors such as pension funds and insurance companies are back to buying debt with terms to maturity of 10 years to 30 years.

Yet, there is a paradox in this niche of the bond market. That’s because, although long government bonds are paying less than their historical average returns, long corporate bonds with investment-grade ratings are offering returns that are so high they beat the historical average returns of equities.

And fear of default has cleaved the long-bond market into two.

In government bonds, a U.S. 30-year bond yields 3.5% to maturity, while a Government of Canada bond of the same term yields 3.7% to maturity.

“We are carving out a secular bottom in long government yields after a decline of almost 30 years,” says Michael McHugh, vice president of fixed-income and a bond portfolio manager with Dynamic Funds Ltd. in Toronto.

In this two-faced market, long-term government debt issued or purchased at today’s rates will be vulnerable to substantial price declines when interest rates rise and existing bond coupons become less desirable. In the most extreme situation, a stripped federal bond with 30 years to maturity will drop in price by 30% for each 1% rise in interest rates, according to the standard equation that links time risk with returns.

Meanwhile, long corporate bonds offer a degree of protection. After all, when the business cycle returns to expansion, corporate issuers will have better interest coverage. Today’s wide spreads will shrink, but bonds bought with the current generous yields will be very desirable. Spreads will tend to trump duration, which is really how long it takes your clients to get their money back.

Corporate bonds with an “A” rating have recently traded at an average of 225 basis points over 30-year government bonds, for a net return of 5.78% to maturity. This also means that a client who buys long corporate bonds can count on beating average stock returns.

For instance, in the two decades ended Jan. 31, the MSCI world index reported an average annual compound return of 4.7% in U.S.-dollar terms, or 4.9% in Canadian dollars. Similarly, the S&P/TSX composite index returned 4.5% compounded annually in the same period. Moreover, returns on investment-grade bonds are fairly certain, while returns on stocks are not.

This means that it clearly pays to go with long bonds. Using BCE Inc. bonds as an example, the five-year 6% issue due June 15, 2014, has recently been priced at $95.76 to yield 6.97% to maturity. The 23-year 7.30% issue due Feb. 23, 2032, has recently been priced at $87.84 to yield 8.51% to maturity. And the 44-year 9.25% issue due May, 15, 2053, has recently been priced at $91 to yield 10.17% to maturity. BCE is an A-rated issuer and the time spread quite properly shows the rewards of taking on long-term interest rate and credit risk.

Bond returns vary by sector. The sector hardest hit in the downturn has been financial services. As a result, discounts on bank debt have been extensive and deep. Yet, Canadian bank bonds have been oversold, argues Chris Kresic, senior vice president for investments and fixed-income portfolio manager with Mackenzie Financial Corp. in Toronto.

“Canadian banks have been put into the same category of financial basket cases as many U.S. banks, but are in far healthier condition,” Kresic says. “When the markets see that Canadian banks are in better shape than foreign banks, Canadian bank bond prices will rise.”

Indeed, reports of the Big Five’s performance in their first quarter ended Jan. 31 showed that, as a group, they remain in the black, reporting positive though lower earnings than for the same period a year earlier. None appears ready to fail.

Moreover, Canadian bank bonds with the richest yields, Tier 1 debt, are still priced to yield as much as 10% a year to their call date, McHugh says. Tier 1 bonds are perpetual bonds — and issues with low coupons may not be called. But, he adds, recent issues with double-digit coupons that were needed to entice nervous investors are almost certain to be called.

Other desirable bonds include those of regulated utilities and pipelines that have rate review processes that assure levels of cash flow are adequate to pay bond interest, suggests Sunil Shah, vice president and portfolio manager for fixed-income products with Sceptre Investment Counsel Ltd. in Toronto.

@page_break@For example, Terasen Inc.’s 5.55% bond due Sept. 25, 2036, has recently been priced at $85 to yield 6.7% to maturity. As well, TransCanada Corp.’s 8.05% issue due Feb. 17, 2039, was recently priced at $103.75 to yield 7.73% to maturity. And, says Shah, BCE’s 5% bond due Feb. 15, 2017, recently priced at $90.40 to yield 6.57% to maturity, is also a fair value on a credit-quality basis.

However, shopping for long bonds is complicated by the shortage of high-quality bonds, Shah adds: “There has been a persistent shortage of credit-sensitive bonds, so that market factor has driven up their prices. Moreover, a lot of companies don’t want to lock in 30-year debt at historically wide credit spreads.

“The fact that there is not a lot of issuance means that the demand side of the market will sustain prices of bonds that mature between 2030 and 2039,” Shah says. “If there were a flood of new issues, the paper would be well received. It depends on name, but there are, after all, mostly good names at the long end of the curve. After all, it’s tough to be there unless you have a good name.”

Still, going for long bonds means giving up the theoretically unlimited gains that come with investing in common stocks in exchange for the certainty intrinsic in high-quality bonds.

Kresic says that it all comes down to what your clients want: “Common shares with an upside, or bonds with a return superior to stocks’ long-term return and a promise to return your money?

“If you are tax-ambivalent or in a sheltered account, you can get about 10% on Tier 1 bank debt or 6.5% on the common shares’ dividend,” Kresic points out. “After taxes, the bonds and stocks come out above even, so the decision is safety vs growth.” IE