Bond yields are rising around the world, setting the stage for a tumble in bond prices in North America, Europe and major emerging markets. Specific reasons apply to each territory, but, collectively, they form a global surge in the cost of money and a profound change in the bond market that neither you nor your clients can ignore.

“I think that rates are rising around the world mainly because of economic growth,” says Tom Czitron, managing director and chief investment officer with Morrison Williams Investment Management LP in Toronto. “But that is not the only reason. There is default risk in the ‘PIIGS’ [Portugal, Ireland, Italy Greece and Spain]. The sovereign debt crisis will
come to a head later this year.”

In Europe, rates are up because of fears of sovereign default. Driven by Fitch Ratings Ltd. ’s mid-January downgrade of Greece’s government debt to junk status “with a negative outlook” (making Fitch the last of the three big credit-rating agencies to take away Greece’s investment-grade rating), credit-default swaps show the gravity of investors’ apprehensions.

In Jan. 17 trading, according to Bloomberg LP data, Greece’s sovereign swaps, which are really insurance premiums against default, were trading at 926 basis points. Irish sovereign swaps were at 636 bps and Portuguese sovereign swaps were at 489 bps.

In the U.S. — tantalized by prospects of economic recovery in the industrial economy — interest rates are rising in the middle of the yield curve. U.S. Treasury 10-year bonds that now yield 3.35% a year to maturity will show rising yields to 3.75% by the end of 2011 and then to 4.25% by the end of 2012. This is all being driven by higher expectations of inflation, increased demand for loanable funds and higher risk premiums, especially in the troubled housing market, according to Scotia Capital Inc. forecasts.

Emerging markets are doing so well that their interest rates are soaring. The “BRIC” nations of Brazil, Russia, India and China have high interest rates reflecting their boom conditions, inflation outlooks and prospects for rates to climb further this year. In mid-January trading, Brazil’s government bonds were priced to yield 26.5% to maturity. Take off Brazil’s 12% inflation rate and the bonds offer a real return of 14.5%, with prospects of further rises. Russian rates of 7.7%-8.0% to maturity for 10-year bonds and Indian 10-year bonds priced to yield 8.24% to maturity show the effects of rapid economic growth.@page_break@Bond investors are caught in a vise of what are, paradoxically, opposite expectations. One jaw of the vise is based on the belief that there will be sufficient growth in the U.S. economy to revive inflation and drive up interest rates.

In mid-January, prices of 20-year U.S. T-bonds fell, supported by investor purchases of T-bonds that pumped another US$600 billion into the economy. That drove up 30-year T-bond yields by five bps to 4.53% and pushed the gap between two-year and 30-year yields to an exceptionally large 395 bps.

The implication is that inves-tors are insisting on a big reward for taking on long U.S. T-bonds to cover inflation risk that could grow as the money issued to reflate the U.S. economy drives up prices.

In contrast, here in Canada, the premium for going from 10-year to 30-year federal bonds is just 45 bps, reflecting a relatively moderate view of inflation worries.

The other jaw of the aforementioned vise is the apprehensiveness about the weakness of the U.S. and European recoveries, leading to the argument that default risk will force up rates.

Europe’s recovery remains uncertain as the European Central Bank, whose only mandate is to control inflation, shepherds ad hoc stimulus programs. National debts in the region continue to climb, rioting workers insist they won’t pay to bail out banks and the recovery remains on shaky ground, says Chris Kresic, partner and co-head of fixed-income with Montreal-based Jarislowsky Fraser Ltd. in Toronto.

“The European problem is that growth of real [gross domestic product] is down while real interest rates are up,” Kresic says. “That implies more debt and no cure. Governments will have to issue more debt to stay afloat.”

In his view, fundamentals will weaken currencies, the chances of an extended recession will make investors more concerned about corporate earnings and balance sheets, and interest rates will remain high or even climb further.

So, what should a bond investor do in this market? It depends on your client’s goals. If it’s nothing but safety at any cost, buy Canadian federal bonds with maturities of up to five years and accept returns that Czitron suggests will be flat to slightly negative. But going out to 30 years could pay as well, with a 192-bps pickup to 3.70% at 30 years from 1.78% at two years. “That’s an attractive gain,” Kresic says, “because the market is discounting more inflation and more credit problems than I think will happen.”

Canadian junk bonds are still a good play, adds Adrian Prenc, vice president with Toronto-based Marret Asset Management Inc. He predicts junk should have another good year in 2011, rising by 6%-7% on average as issuers’ balance sheets improve — twice the gain he expects on investment-grade corporate bonds.

As for investing in foreign debt, says Czitron, that’s not a good idea: “You could get a good return in U.S. or other foreign bonds, but you would have to accept so much volatility that it wouldn’t be worth it.” IE