One Good Idea: Buy iShares Canadian corporate bond ETF

Prices have been beaten down, while the risk of default is low

Dianne Maley
Globe Investor Magazine Online, November 6, 2008

Source: Michael Herring, managing director and fixed income strategist, BMO Nesbitt Burns.

The Idea: Buy iShares Cdn Corporate Bond Index Fund, an ETF that trades on the Toronto Stock Exchange.

The global credit crisis beat corporate bond prices down as investors fled to the safety of government securities, leading to an unusually large difference in yields between the two types of issuers. Although corporate bond prices have recovered slightly, the lingering nervousness over possible defaults spells opportunity for investors willing to venture back into the bond market, Mr. Herring says. Already, big investors have been snapping up bonds of Canada's major financial institutions.

The best way for individual investors to get a diversified portfolio of bank bonds is through the iShares Cdn Corporate Bond Index Fund, in which nine of the top 10 holdings are financials, Mr. Herring said in an interview.

"Diversifying your holdings is the way to go," he said. Although it's unlikely a major Canadian financial institution would run into serious trouble, "you never know what might happen to one name."

The fund's top holdings include securities issued by Royal Bank of Canada, Bank of Nova Scotia, Greater Toronto Airports Authority, GE Capital Canada Funding Co., Bank of Montreal, Toronto Dominion Bank, CIBC World Markets Inc., and Sun Life of Canada (US) Capital. The fund aims to track the performance of the Scotia Capital All Corporate Bond Index.

On average, the bonds tend to be medium term, with a weighted average duration of 4.65 years and an average term to maturity of six or seven years. (The duration measure allows bonds of different maturities and coupon rates to be compared.) The fund has a management expense ratio of 0.40 per cent. Its shares, which rose as high as $19.88 in March, slipped below $18.10 a share in intraday trading last month and had crept back to around $18.39 Thursday.

Key to Mr. Herring's recommendation is his belief that financial markets hit a bottom on Oct. 10. He thinks the worst of the credit crisis is over, although there may still be some frightening days ahead. He also believes credit markets must sort themselves out before the stock market can recover, which is why he prefers bonds over stocks.

When a company goes broke, bond holders are among the first in line for their share of the spoils, shareholders among the last.

The Payoff: A much higher yield than is available on government bonds - 5.5 per cent compared with 2.8 per cent for five-year Government of Canada bonds - an important consideration for people living on a fixed income.

The Big Risk: "The credit crisis reasserts itself in an even more malignant form," Mr. Herring says. If that happens, corporate bond prices will tumble again and investors who sell before the market recovers stand to lose money.

Why listen to Michael Herring? Last November, he advised BMO Nesbitt Burns clients to move out of Canadian dollar investments into U.S. dollar ones. Since then, the Canadian dollar has lost substantial ground against the greenback. Last June, Mr. Herring advised clients to expunge high-yield debt securities from their portfolios. "That has worked out pretty well," he observes. Prices of riskier bonds plunged in the ensuing flight to safety.

Special to The Globe and Mail