Smart strategies for bond investors in 2008

By Andrew Allentuck
Globe Investor Magazine Online, February 22, 2008

Bond investing is all about anticipation. In the present bear market in equities, the safe stuff - short-term treasury bills, government bonds, supranational bonds issued by the likes of the World Bank, and global issues backed by governments - have been bought up by frightened investors.

There is not a lot of profit or yield left in this safest of all sectors of the market. Now the game is looking ahead to the recovery which, in the cyclical nature of the market, will come one day.

"Canada will show an increase in the rate of growth of GDP in the third quarter this year," says Paul Ferley, assistant chief economist of Royal Bank in Toronto. "Once the Fed and the Bank of Canada accept the idea that a return to growth can be sustained, they will begin to raise interest rates. The Royal Bank predicts a return to rising interest rates early in 2009." In turn, the bond market will anticipate a return to higher interest rates by the second half of this year, he suggests.

In the coming months, bond investors will be jockeying to position themselves for rising interest rates. As rates rise, government bonds will tend to fall in price as new bonds with higher coupons come onto the market.

"You want to cut your exposure to rising interest rates in government bonds in the late spring, say in April or early May, to take advantage of rising interest rates," says Tom Czitron, managing director and head of income and structured products for Sceptre Investment Counsel Ltd. in Toronto.

As interest rates rise, investors will sell government bonds and buy the kinds of bonds that can be winners in a rising rate environment.

Here is a list of bonds that should benefit.

Floating rate bonds

The problem of declining yields in a bear market does not affect floating rate bonds because they reset what they pay monthly or quarterly, rising in yield as various administered rates set by central banks rise.

"They are sensitive to the economy and, as central banks raise interest rates, the floaters pay more," said Edward Jong, senior vice-president for fixed income at Mak Allen & Day Capital Partners Inc. in Toronto.

Corporate bonds

In a bear market, investors flee corporate bonds because they're nervous of bankruptcies and take haven in government bonds. But when economic fears pass, corporate bonds will rise in price.

Even fixed-rate corporate bonds could do well, Mr. Jong adds. "Corporate bonds with good yields should hold their prices even as government bond prices fall," he says. In the recovery, government bond yields will rise to the place where corporates already are, he explains.

Convertible bonds

These bonds, which can be turned into common shares of the issuer, are linked both to interest rates and to the price of the common shares of the issuer. So if the common stock of the company goes up, the bond price rises too. Therefore, when the recovery comes and common stocks tend to head upward, the convertibles will go up too, says Michael McHugh, vice-president and head of fixed income at Dynamic Funds in Toronto.

Bond funds

When interest rates begin to rise, conventional bond funds will suffer. But one exchange traded fund, the HBP Canadian Bond Fear Plus Fund, should prosper. Through derivatives-based financial engineering, it provides returns that increase as rates rise.

"The fund can produce profits if bond prices fall," said Howard Atkinson, President of BetaPro Management Inc. in Toronto. The fund, which holds relatively long Canada bonds, is engineered to produce a 13-per-cent gain for every 1-per-cent rise in interest rates. But there is corresponding risk. The fund will produce a 13-per-cent loss for every 1-per-cent decline in rates.

In other words, if the recovery does not work out and the Bank of Canada lowers rates aggressively, the fund would increase the investor's losses rapidly.

Deposit notes

These are a special class of corporate credit that already have yields that rival those that will be available when a recovery takes place.

John Carswell, president of Canso Investment Counsel Ltd. in Richmond Hill, Ont., is an adviser to pension funds and other institutional bond investors. He suggests investors look at deposit notes, which are the same thing as term deposits, but sold in the corporate market and eligible for resale through investment dealers. They are senior obligations of chartered banks and are traded like bonds.

"In the current credit crisis, bank bonds have been hard to sell," Mr. Carswell said. "In their place, the banks have been issuing deposit notes at as much as 150 basis points (there are 100 basis points in one percentage point) over the interest paid on government bonds." The premium on deposit notes has widened drastically from as little as 40 points early in 2007, he added.

Moreover, deposit notes are more secure than normal bonds. "In a bankruptcy scenario, deposits rank superior to bonds," Mr. Carswell said. "[The] government may protect depositors but not the bondholders or other investors."

Special to The Globe and Mail