Investment-grade corporate bonds are trading as though they are in distress. This means corporate bond prices are generally lower than they should be for issuers that have good credit ratings and strong financial statements.

This paradox exists because many investors in corporate debt remain skittish or scared. But veteran bond traders say this means that there’s money to be made in many sound, investment-grade bonds.

The opportunities in corporate debt show up in the bonds of financial services companies. An A-rated Bank of Montreal 10.2% issue due Dec. 31, 2017, is a case in point. The bond’s payout resets every five years at a breathtaking 1,050 basis points over the current five-year Government of Canada bond.

The BMO issue has recently traded at $133.50 to yield 5.6%. The bond has produced hefty gains since it was issued in December 2008; however, it’s still attractive for a bond with a first call date in October 2018. By comparison, a nine-year Canada issue with a 4.3% coupon due June 1, 2018, has recently traded at $107.87 to yield 3.2% to maturity. The return spread on the two bonds is 234 bps — a dramatic yield boost for a bank bond with an A rating.

“We think that investment-grade corporates are the best value now,” says Vivek Verma, vice president with Richmond Hill, Ont.-based Canso Investment Counsel Ltd. Corporates’ returns are now as much as two standard deviations above their historical mean. Investors have an aversion to holding long corporates, and that has kept their prices down and provided an opportunity to lock in yields of as much as 7% on BBB-rated high credits such as a Bell Canada Inc. 7.9% bond due April 2, 2031, which has recently been priced to yield 6.9% to maturity.

“That’s 300 bps over the Government of Canada 5.75% due June 1, 2033, which has recently offered a yield to maturity of 3.9% on the same term,” Verma adds. “These yield premiums won’t last forever. When investor anxieties subside, the spreads will close.”

Chris Kresic, senior vice president and head of fixed-income with Mackenzie Financial Corp. in Toronto agrees: “In the investment-grade corporate bond space, there are a lot of opportunities. [But] you have to pick your risks.”

He notes that a Canadian Imperial Bank of Commerce deposit note with an AA rating due in four years has recently yielded 2.9% to maturity, compared with a Canada 5.25% issue due June 1, 2013, that has recently yielded 2.2% to maturity. The yield pickup is 72 bps; that’s not bad for the bank’s most senior credit, he says.

However, corporates need to be shopped for with care. On Sept. 4, Royal Bank of Scotland failed to redeem four outstanding bond issues; U.S. bank failures also continue.

“Defaults will peak at 10%-12% on global bonds, and those are mainly North American issues,” says Christine Horoyski, senior vice president and fixed-income portfolio manager with Aurion Capital Management Inc. in Toronto. A cautious investor, she likes utilities and infrastructure bonds that have revenue guaranteed by regulators.

In that space, a typical offering is an EnCana Corp. 5.8% issue due Jan. 18, 2018, priced at $107.85 to yield 4.7% to maturity. Its rating is A-; the price is no bargain, Kresic notes, but the bond’s a solid bet.

The challenge for bond investors is to find value, defined as a measured quality return for the price. Government bonds pay little these days; and high-yield debt, which still pays 835 bps over comparable government bonds, according to the Merrill Lynch master II high-yield index, carry equity risk. In the event that the economic recovery stalls, high-yield bond default rates will soar and prices will sink.

“High-yield [bonds are] a macro bet,” Kresic explains, “and high-yield prices are still closely tied to the stock market.”

And Verma adds: “The current prices of high-yield debt do not reflect their full risk of default.”

The best opportunities are in bond-market sectors that continue to live under a cloud of doubt in spite of strong financial data. Although Canada’s home-grown asset-backed commercial paper fiasco left a bad taste in the mouths of many investors, Kresic notes, there is value in credit card trusts such as four-year, AAA-rated tranches from Broadway Credit Card Trust that pay 250 bps over Canada bonds of similar term.

@page_break@Broadway Credit is an off-balance-sheet entity created by Citigroup Canada. But even if Citi were to go bankrupt, the underlying assets of the Broadway Credit entity would remain the credit card users who pay their bills. Investors who hold the top-rated tranches are at the head of the queue to receive payouts.

Other opportunities, including real estate firms such as RioCan Real Estate Investment Trust, are seen as being vulnerable to hard times in the commercial property market. Thus, a RioCan five-year issue with a BBB- rating, which is at the low end of investment-grade issues, pays 350 bps over a Canada bond of similar term. But RioCan is well capitalized. Thus, the perceived risk is related more to the sector rather than to the company.

Instead of taking single-company risk and buying bonds that are subordinate to first mortgages, Kresic suggests, investors can buy senior mortgagee participation in a pool of first mortgages in commercial mortgage-backed security market.

For example, a 4.9% commercial mortgage-backed security issue from Real Estate Asset Liquidity Trust due March 12, 2015, has recently paid 350 bps over a Canada bond of similar terms. The CMBS issue has an AAA rating and, as a result, Kresic says, “It is the better deal, because you get a AAA rating rather than the BBB rating on the RioCan issue.”

That said, you should take nothing for granted, Kresic warns: “In this market, you have to look at the assets and the business behind debt issues. You want to know the deals and the properties in anything that is securitized, and you want to know the balance sheet and the business of every bond issuer. With financials, which may be less transparent than some structured credits, you have to go on the leverage you are buying, the credit standing of the issue and the ability of management to make money without excessive risk.” IE