Tumbling rates on Canadian and U.S. government bonds inevitably raise this question: what should you suggest to clients who want yield to go with safety?

The usual response, which is to migrate to corporate bonds, can boost yield. But real diversification is so tough to achieve in investment-grade Canadian corporates that some financial advisors figure it’s enough to buy chartered-bank bonds.

The rush to a safe haven has driven yields down on bonds across all maturities. On July 7, two-year Government of Canada bonds were quoted with indicative yields of 1.44% to maturity — down by 15 basis points from the previous month. Ten-year Canadas were yielding 3.09%, down by 10 bps vs the preceding month; and 30-year Canada yields fell to 3.65%, down by 22 bps in the same period.

So, if your clients want yield, you can suggest moving to a Telus Corp. 5.05% issue due Dec. 4, 2019, recently priced at $102.12 to yield 4.77%, from a 10-year Canada 3.50% issue due June 1, 2020, recently priced at $103.42 to pay 3.09% to maturity. The gain is 168 bps — more than half of the federal bond’s yield to maturity. Telus has a solid investment-grade A (low) rating from DBRS Ltd. on its senior debentures. But the telecommunications business is leveraged on economic activity — and the outlook for that is not quite so rosy right now.

The baseline for any diversification strategy is, of course, a national bond issued in the national currency. The governments of Canada, the U.S., Britain and Japan are able to produce as much cash as they need to honour their bonds. The future buying power of that cash may be questionable, but default in the native currency is given a zero-to-low probability by the market.

Outright default on corporate debt may be feared, but it is seldom realized. Even in 2008, there were only eight companies to which one credit evaluator, DBRS, gave D (for “in default”) ratings. In this group of failed hopes were investment dealer Lehman Brothers Holdings Inc., commercial bank Washington Mutual Bank, forest-products company Tembec Inc., publisher Tribune Co. and printer Quebecor World Inc. There were other flops, of course, but they tended to end with workouts or restructurings.

Many of the failed businesses had, at one time, been senior debt issuers. Quebecor had been rated A (low); Lehman Brothers, AA; and Washington Mutual, A (high). There is a lesson in the graveyard of these and other insolvencies: vigilance is the price of holding corporate debt.

Bonds of a given rating tend to move as a class, says Tom Czitron, managing director and chief investment officer with Morrison Williams Investment Management LP in Toronto. The reasons are embedded in their structure.

“Investment-grade corporates tend to be macro-sensitive,” Czitron says. “What makes them move is not credit questions — that’s eliminated in their high-quality ratings. So, if you take away variation based on interest rate changes, you find a lot of co-variance. Add in the market characteristic that the largest issuers of Canadian corporates are financial services companies, and you really do have a problem of spreading out your risks.”
@page_break@Canadian corporate bond indices reflect the heavy weighting of financial services issues, so diversification — which means getting away from bond index allocations — requires that you seek substantial weightings in other sectors, such as industrial or retail bonds. There are relatively few of those in Canada, and most do not trade actively.

So, what’s the solution? Shop for U.S. corporates. The interest rates of Canada and the U.S. dance to the same tune, so the wider market should spread out risk. Mario De Rose, fixed-income strategist with Edward Jones in St. Louis, suggests breaking down broad categories to reduce bond co-variance.

“You can open up utilities and find bonds issued by electric power companies, nuclear power operators, natural gas suppliers and pipelines,” De Rose explains. “They are almost all regulated and, therefore, guaranteed a return. When you look at industrials, you find railroads that are, as a group, quite sensitive to economic activity. There are health-care companies in the U.S. that are not very macro-sensitive. So, as economic entities, they have widely different prospects of keeping or losing their ratings.”

All of this is true, of course, but U.S. bond plays add currency risk; and the U.S. dollar is going to suffer from that federal government’s massive foreign and domestic debts. Furthermore, for any diversification strategy, risk management is vital because every corporate bond is subject to company or event risk.

Canso Investment Counsel Ltd. , a Richmond Hill, Ont., company that specializes in bond research, suggests a simple formula to limit bond losses. Says vice president Vivek Verma: “If you want to add 1% to your portfolio return and you think that a bond under consideration has a 33% chance of a price decline, limit your exposure to 3% of total portfolio value in that bond. If the bond does drop by a third, it can do no more than cut the value of the position back to the portfolio’s average return.”

The problem with this strategy is that it does not lead far from the clustering of financial issues in the Canadian bond market. The Canso methodology implies that in order to get a 30% weighting in corporates, a portfolio that starts at 100% government bonds will need 10 issues acquired in 10 trades. That would bring the portfolio to about the DEX total market weighting, something that could have been achieved with a broad market Canadian bond index fund.

Meanwhile, Caroline Nalban-toglu, a registered financial planner with PWL Advisors Inc. in Montreal, says: “I don’t think broad diversification within corporate bonds is worth the risk.” She figures it’s enough to move money into bank debt. For yield, she doesn’t mind carrying chartered-bank debt, such as Royal Bank of Canada’s 4.35% issue due June 15, 2015, recently priced to yield 3.75% — 142 bps over a Canada 2.50% issue due June 1, 2015, recently priced to yield 2.33%.

“I would buy actual bonds from the big chartered banks, on the theory that these institutions will survive,” Nalbantoglu says. “They may be leveraged lenders, but Canadian politics ensures that no major bank will be allowed to fail.”

Moreover, buying a managed portfolio of bonds is not enough because a fund manager can get the picks or timing wrong, she adds: “Why add managerial risk to the solid return of actual bonds that revert to cash at term?”

In the end, Nalbantoglu reasons, if there is no way to eliminate co-variance in corporates, you should take the cream of the crop — senior bank debt — and live with the politically limited risk of default.

IE