Into the gap

For a long time, it made sense to stick with the safety of government bonds. But now is the time to think differently

Rob McConnachie, CFA
is the chief investment officer of Dixon Mitchell Investment Counsel, a Vancouver-based wealth management firm.
Globe Investor Magazine online, February 19, 2009

Over the long haul, stocks have always earned you more than bonds. But after the rout that was 2008, this truism may be ringing empty for most people. Corporate bonds look like an attractive alternative.

Not long ago, Canadian corporate bonds didn't throw off much more interest than their government counterparts. Government bonds are the ultimate safe haven, so it was nearly pointless to own company issues. But that's all changed.

We recently purchased some 2011 bonds issued by Suncor Energy with a yield to maturity of more than 6%. Less than two years ago, the yield on such a bond was under 4.5%. But that's only half the story.

Over the same period, the yield from a federal government bond of similar duration has gone in the opposite direction, dropping from 4% to about 2.3%. This has driven the spread between the two to 3.7%, from a paltry 0.5% previously.

What happened? Over the past 10 years, the spread between Canadian investmentgrade corporate bonds and government bonds has averaged about 1.2%. From 2003 to late 2006, spreads fell below 1%, giving investors little incentive to take on extra risk. But as the credit crisis began to unfold in mid-2007, the balance swung the other way. Deprived of easy access to capital, companies had to start issuing bonds that paid tempting premiums.

This is a gift that keeps on giving. The yield on many corporate bonds is now more than double that of five-year Canada bonds. But aren't you taking a chance when you buy these debt securities? Not really. For the past four decades, the average default rate on investment-grade corporate bonds has been less than 1%.

Today, the Canadian credit market is rife with bonds from financial-services and commodity firms offering generous yields. For example, five-year Canadian bank bonds typically have yields to maturity of close to 6%. Or take the March, 2014, George Weston Ltd. bond, which in January had a 5.05% coupon and traded in the $91 range. Patient investors will earn roughly 7% at maturity.

Choosing a great corporate bond is a different exercise than picking a winning stock. But the same rules apply. As the tech meltdown showed, relying solely on ratings to pick a bond is like purchasing a stock just because it has a "buy" recommendation. I look at fundamentals such as assets and cash flow-so I feel comfortable that the company behind the bond won't stiff me.

But even for the savviest retail investor, buying corporate bonds directly is a headache. These bonds tend to be much less liquid than equities, meaning they are harder to trade. And because they aren't sold in small quantities, it's tough to build a diversified portfolio.

With those drawbacks in mind, a good option is the iShares CDN DEX All Corporate Bond Index Fund. Its units are highly liquid and offer a diversified basket of more than 200 investmentgrade corporate bonds. As of year-end, the fund's yield to maturity was 5.8%.

We're probably going to need interestrate hikes if the economy starts to recover. But just as spreads have widened during the slowdown, so should they narrow in a recovery. Simply put, if interest rates were to increase by 1% and spreads on a corporate bond came in by the same amount, the bond price would be virtually unchanged.

And remember, a corporate bond pays back its face value at maturity. Yes, that stock might be cheap today, but there's no guarantee it will go up. With bonds, on the other hand, you get what you pay for-and sometimes more.