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Andrew Allentuck

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A security blanket

Andrew Allentuck

The financial crisis that began in mid-August, 2007 has driven a cleaver into bond yields. Government bond prices have soared and yields, which move opposite to prices, have collapsed as investors have fled to safety. Corporate bonds, on the other hand, have tumbled in price, with the result that their yields are at near record levels, in some cases exceeding the dividend yields on the same companies' common shares.

Which way to turn is the question. Government bonds are riding high because investors mainly institutional buyers are fearful of holding any corporate bonds that could turn into bombs overnight or over a weekend. The fear is so great that on March 20, the day before Good Friday, yields on U.S. Treasury Inflation Protected bonds, often called TIPs, briefly turned negative. People buying these long bonds were actually paying the Treasury to hold their money. On the same day, yields on Canada t-bills fell to 1.6 per cent from 1.9 per cent. On March 20, U.S. 3 month bills' yields fell just below 1 per cent, then dropped to 61 basis points on Easter Monday. There has been recovery since then. U.S. 90 days T-bills have recently yielded 1.16 per cent, which is still very low.

Today, there are really two bond markets. The government bond market

offers rock bottom yields. For example, a two year Government of Canada bond pays 2.70 per cent to maturity. A five year Canada yields 3.02 per cent and a 10 year Canada pays 3.55 per cent to maturity. If you have the bonds in a registered plan, then there is no immediate tax issue. The bonds will pace inflation but not much more.

Shift to the corporate bond market and the returns begin to look a lot better.

A Highway 407 10 year bond with a single A rating, which is quite a respectable investment grade, yields 4.89 per cent to maturity. A financial services bond like a Bank of Montreal 10 year single A yields 5.97 per cent. That's about the same as BMO's current stock dividend, 6 per cent, but with a difference. The bond interest has to be paid., The dividend is paid at the discretion of the board of directors. BMO could cut its dividend, as some large American banks have done, though there seems no immediate risk that it will do so. .

"The bonds are cheap and the yields are high because of the credit crisis," says Tom Czitron, managing director for income and structured products at Sceptre Investment Counsel Ltd. in Toronto. "Instead of irrational exuberance, there is irrational trepidation "That is why bank bonds have gone on sale. But the odds of default are very slim. The bank bonds have yields we have not seen for a couple of decades. It is a good time for the long-term investor to go shopping for bank bonds."

"If you are comfortable with the credit risk, corporates offer a lot of value," says Craig Allardyce, vice president and associate portfolio manager for Mavrix Fund Management Inc. That goes for financial services bonds too, he adds. "Bank capital to asset ratios are regulated by the Office of the Superintendent of Financial Institutions. That offers some protection. Even if there were a forced marriage, the bank that takes over a weaker rival would be likely to honour its debts."

Institutional bond managers who are active traders are in a different situation. They have to ensure that any corporate bonds that they hold do at least as well as their government bonds. If interest rates drop further, which is likely, then governments will rise in price and tend to beat corporates, which are more influenced by credit conditions. Moreover, if a company or even a sector is known to have a lot of bonds coming to market, relevant bond prices are likely to weaken. That would make the debt of the company or the sector under perform governments bonds. A lot of bank bonds are known to be coming to market another reason for the low prices of even senior bank issues.

"For an institutional trading portfolio or one that is marked to market [priced daily], weakening bank bond prices are a strong negative," says Edward Jong, vice president for investments at Mak Allan & Day Capital Partners Inc. in Toronto and portfolio manager of the $22-million FrontierAlt Opportunistic Bond Fund. "But if you buy and hold bank bonds to maturity, changes in value relative to government bonds won't be important. It is like buying a house and not worrying about daily fluctuations in the price."

For those who can handle even more risk, high-yield bonds are nearing the highest spreads on records. The bible of the junk business, the Merrill Lynch Master II High Yield Index, currently yields 10.56 per cent, which is a spread of 7.70 per cent over a 2.86 per cent yield on a seven year U.S. Treasury.

Barry Allan, president of Marret Asset Management Inc. in Toronto, is one of Canada's top high-yield bond managers. "The higher quality bonds rated BB or BBB offer a lot of value," he explains. "But in the single B and CCC bonds, prices may weaken further."

It's not unduly risky to buy a single A rated bank bond, especially if its senior debt, but buying a single high-yield issue is, as Mr. Allan says, "unduly risky." His advice -- either have the money to buy five dozen high-yield issues over 20 to 25 industries and several countries or hire a manager to do it for you." The evidence, he says, is in surviving today's tough market.

When business conditions improve, corporates' credit ratings could rise, driving up their prices. Moreover, as repayment looms, corporates will swiftly rise in price. For buy and hold investors, investment grade corporates offer value, Mr. Jong concludes.

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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