Given the pessimism surrounding the global economy, bonds are obvious bets. That’s why risky issues that would be shunned in normal market conditions are being snapped up as run-of-the-mill investments.

The dilemma right now, though, is whether to buy into conventional risk with low yields, to accept some risk in bonds a little below investment-grade or to take on duration and credit risks that would be considered long shots. The last of these three choices is actually gaining ground — in the hunt for something that pays a decent yield, dubious global sovereign issues and North American long shots are getting respect.

For the record, there is good reason to look for something that pays better than the current 2.52% on a U.S. 10-year treasury bond or the 2.82% on a 10-year Canada. Bank of America Merrill Lynch Canada reports that the yield to maturity on a diversified portfolio of investment-grade Canadian corporate bonds fell to 3.63% at the end of August, down from 6.18% during the worst of the gloom in the 2008-09 credit crisis and the lowest yield since 1992, when the company began compiling data on historical yields.

Investors’ pursuit of yield is pushing up term limits. In the U.S., a recent issue from railway company Norfolk Southern Corp. with a 100-year term and a 6% coupon has sold well. Rated as BBB+ by Standard & Poor’s Corp. and Fitch Ratings Ltd. , the Norfolk bond carries a 75-basis-point spread over similar corporate issues with 30-year terms. The yield is attractive compared with the 30-year U.S. treasury bond, which pays just 3.62%; however, the interest rate sensitivity of the so-called “century bond” implies that investors will have to accept immense price declines when rates rise.

Credit quality is also under review, and junk is getting more respect. The Merrill Lynch II high-yield index shows average junk, with a yield of 8.37%, trading at 696 bps over a five-year treasury bond that recently yielded 1.41%. That makes junk an attractive place to be, says Barry Allan, president of high-yield bond specialist Marret Asset Management Inc. in Toronto.

There are also what some may think of as good deals in emerging-markets bonds. Yields in emerging-markets sovereign debt are 289 bps higher than 10-year U.S. treasuries, for a net return of 5.41%.

The next essential question — Is the return worth the risk? — gets a thumbs-up answer, Allan says: “The credit quality of companies in the sector is relatively high. As for sovereign risk, given that the economies of [Brazil, Russia, India and China] are very strong and that commodities prices are strong, the national capacity to pay bonds is good. When you realize that Russia, which defaulted in 1998, now has more foreign exchange reserves than the U.S., the risk is reasonable.”

In the new world of sovereign risk, emerging-markets corporates with implied or actual state guarantees are being given a warmer reception and charged lower risk premiums than the bonds of many European Union members.

For example, on Aug. 26, Mexico-based state-owned oil company Pemex sold a 6.625% 10-year bond rated BBB+ by S&P at a premium to yield 5.975% to maturity. The bond, with a 346-bps spread over the U.S. 10-year bond, was a hot seller.
@page_break@Meanwhile, on the same day, S&P downgraded Ireland’s sovereign debt to AA- from AA. Ireland’s state finances are suffering from the government’s decision to buy bad loans from its ailing banks. Case in point: Anglo Irish Bank Corp., a mortgage lender that admitted it would have to write off half of its loans. That would cost Ireland’s government 25 billion euros — or 11.3% of the country’s gross domestic product. Thus, it is a sovereign risk indeed.

So, how far afield should you go in search for yield? Going too far can be dangerous to a client’s financial health. For example, the Republic of Angola — which has a B+ credit rating from S&P and Fitch, and the equivalent from Moody’s Investors Service Inc. — struggled to sell a US$4 billion issue earlier this year. Market reception was cool, but the issue, with a 10% coupon and a 10-year maturity, appears to have been privately placed. The yield is attractive, but it should be noted that Angola has been in default for 21 of the 35 years since declaring its independence from Portugal in November 1975. Says Allan: “People have to be delusional to buy this one.”

With bond yields falling to new lows, it is precarious to take on too much time or credit risk. Bond yields will eventually rise and produce substantial capital losses for bondholders, especially for issues with terms of 10 years and longer. If the 10-year Canada were to rise by just 30 bps, it would produce a capital loss equal to the first year’s yield.

In a market dominated by pessimism, dubious trades are flourishing. The bond market is awarding premium returns for taking on unconventional risks, says Mario de Rose, a fixed-income strategist with Edward Jones & Co. in St. Louis. Yet, the writing is on the wall that losses will come, he says: “You know that at some time, rates will rise and holders of very low-yield bonds will have to book losses.”

If opportunism is driving inves-tors to snap up dodgy bonds, wisdom suggests doing the exact opposite. Marc Stern, vice president and portfolio manager and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal, says that it is better to have no losses on a GIC or have a savings account that pays paltry interest than hold an edgy bond with an 8% coupon that winds up producing a 15% loss: “I would not sleep at night if I put people into junk.”

But there is a middle course of moderate risk, suggests Mark Carpani, senior vice president at Ridgewood Capital Asset Management Inc. in Toronto. In his view, domestic bonds at the low end of the investment-grade range offer acceptable security and pay decent returns.

“You can go for yield on foreign credits and take on currency risk,” he says, “or buy a Canadian BBB corporate bond, such as Shaw [Communications Inc.]’s 6.5% issue due Nov. 9, 2039, recently priced at $103.50 to yield 6.47% — 365 bps over a Canada issue of similar term — or a similarly rated Yellow Media Inc. 7.75% issue due March 2, 2020, recently priced at $109.60 to yield 6.45% to maturity — 363 bps over a Canada bond of the same term. They’re good [issues] with good yields.”

In the end, Stern suggests, compounding risk is likely to lead to unhappiness.

The wiser course is to stick close to home, says David Rosenberg, chief economist and strategist with money manager Gluskin Sheff & Associates Inc. in Toronto: “We could see the 30-year Canada bond yield go to 2% from the present level of 3.48%. So, there is potential value in that bond. And there is potential in BB-rated bonds a little below investment-grade. What we do know is that Canadian corporate balance sheets are in good shape. Most of that — 70% of corporate debt — is long-term.”

Rosenberg’s choice is non-cyclical utilities with strong balance sheets. As he sees it, a trip on a roller-coaster of risk is unnecessary. By implication, prudence will pay off. IE