Equity and bond markets have been behaving lately like a couple headed for divorce. Since March 9, when the S&P/TSX composite index hit an intraday low of 7515, Canadian and U.S. equities markets, as well as most global markets, have soared.

Yet, corporate bonds are slumping as more bad news hits. Worries about default on the one hand and inflation on the other have given very different signals.

Take the case of Bank of America Corp. With the largest consumer banking business in the U.S., it has seen its shares fall to US$2.53 on Feb. 20 from US$40 in April 2008. They have since risen as high as US$11.90.

However, Bank of America’s bonds have not done so well. Take its 5.15% issue due Feb. 15, 2017. It traded at US99¢ in January, fell to US63¢ in early March and is now at US75¢, which puts it in the company of what amounts to senior junk.

For equities and bond prices to head in different directions is a paradox. When spreads between corporate bond yields and those of government bonds widen, there is evident apprehension of default. Yet stocks, which capture only the residual earnings after bondholders and other creditors are paid, have been decidedly bullish.

So, is bond investors’ pessimism justified? Speaking as a shrewd bond manager, Chris Kresic, senior vice president for investments and fixed-income portfolio manager with Mackenzie Financial Corp. in Toronto, says: “We have seen credit spreads narrowing in Canada but widening in the U.S. South of the border, there is fear of nationalization. If that happens, the bondholder will have to pay, along with the equity holder.”

Consider General Electric Co. As this century began, GE shares were trading in the US$60-a-share range and GE bonds were rated AAA. Today, GE Capital, the former money-spinner for its parent, is a candidate for default; its credit-default swaps indicate that it is more likely to default than Russia.

On March 12, Standard & Poor’s Corp. dumped GE out of the coveted “AAA” ranking and down the scale one full grade. GE’s stock is in the US$10-a-share range and the company has cut its dividend. GE’s 5.53% bond due Aug. 17, 2017, recently priced at US$90 to yield 7.135% to maturity, has roller-coastered from 450 basis points more than U.S. Treasuries in January to as much as 650 bps more than T-bonds; it has since settled down to 440 bps on GE’s promise to support GE Capital. The markets remember that General Motors Corp., which is now restructuring its debt, said as much for General Motors Acceptance Corp. So much for nice sentiments.

The risk of default on low-quality debt has divided the bond market into high-grade debt of major institutions that are still welcome in credit markets and low-grade debt that appeals only to vulture funds.

Moody’s Investors Service Inc.’ s default report reveals that the annualized global speculative bond default rate climbed to 5.2% in February from 4.8% in January. A year ago, the rate was only 1.2%.

Not only have defaults risen, but the nation with the highest defaults is the U.S., accounting for 76% of failures to pay interest or to refund principal. Moody’s is forecasting that the default rate on speculative debt — which is where senior debt winds up just before payments lapse — will rise to 15.3% in the fourth quarter of 2009. Regionally, defaults will hit 13.8% of outstanding speculative-grade debt in the U.S. and a breathtaking 22.5% in Europe by yearend.

There are islands of safety in the debt markets. Utilities can appeal to their regulators for more money if inflation drives up their costs or if credit markets raise the cost of rolling over debt. “The risk of default is more on the side of industrial and retail bonds than it is on utilities,” says Vitek Verma, vice president of Can-so Investment Counsel Ltd. in Rich-mond Hill, Ont. Canso, a specialist bond manager, downplays the risk of inflation. “It is a worry in one or two years, but it is not immediate.”

Inflation/default angst has nevertheless depressed the prices of good debt issues, Verma notes. For example, a TransCanada Corp.8.05% bond due Feb. 17, 2039, has recently been priced at $105.30 to yield 7.6%. That’s 400 bps more than the comparable Canada bond that pays 3.6% for the same term. It’s a big premium, yet the issuer has never defaulted and has customarily had to pay no more than 1% over federal bonds. Moreover, if inflation were to raise the cost of rolling over debt, regulators would be likely to compensate the company with higher prices for the energy it transports.

@page_break@There is a way to play default fears and still put money on beaten-down bank shares. “If you think that weaker U.S. banks will be nationalized and existing shareholders wiped out, then you would go long senior debt and short the stock,” Kresic says. “If shareholders are wiped out, the stock will make a handsome return and the bonds will be paid. If a bank is not taken over by regulators or government but still fails, then the stock short will gain while the bonds lose some value. But if the bank recovers, then the shorts lose and the bonds gain. The risk is that the bond gain will not offset the loss on the short. Right now, the trade could work, but it is a risky proposition. It is easier to go long on senior bonds and take advantage of spreads.”

Is this kind of white-knuckle investing worth the potential gains? Holders of senior debt can unclench their fists, Kresic says: “But buying U.S. subordinated corporate debt, such as the Citigroup 8.3% bond due Dec. 21, 2057, recently priced at $48 to yield 17.5% to maturity, amounts to taking a flyer on terrific spreads that go with risk of failure or nationalization. These bonds have CC ratings from S&P, which speak to a high probability of default. So, buying them for their theoretical return takes courage.” IE