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Shelter from the storm

Michael Herring, of BMO Nesbitt Burns, says corporate bonds are offering generous yields.



Shelter from the storm

If you can get over the bond market's confusing nature, a haven from the rough equity seas is yours

Diane Malley

Feeling bearish about the stock market and glum about the economy? Are you closing in on retirement and worried about a deflationary depression? Then bonds might be a good fit for your RRSP portfolio.

For the uninitiated, however, bonds can be a bit confusing. "I find most people are very perplexed by the bond market," says Michael Herring, managing director and investment strategist at BMO Nesbitt Burns in Toronto.

When you buy a bond, you are lending money to a government or corporation for a fixed term in return for the promise to pay a set rate of interest (the coupon rate). When the bond matures in five, 10 or 20 years, you also get your principal back in full.

In the meantime, the bonds trade on the open market, where they soar and dive with market conditions, much as stocks do. The longer the term to maturity, the greater the bond's volatility - and the potential risks and rewards.

Investing in bonds involves a different mindset than buying stocks, Mr. Herring notes. "Most equity investors tend to be optimists, whereas in the fixed-income markets, for government bonds to do better, the economy has to be doing very poorly," causing demand for money (and hence interest rates) to fall.

Many small investors have overlooked bonds because their average returns, historically, lagged the stock market. A study by the Schwab Center for Financial Research, for example, found that stocks averaged a return of 8.2 per cent over a given 20-year period, compared with a scant 4 per cent for bonds.

But given the current economic climate, returns in the 5-per-cent range don't look that shabby to many investors. Bonds (and GICS) are also well-suited to RRSPs because dividend returns get preferential tax treatment.

The main argument for bonds now is that stock markets will not recover until all the turmoil in financial markets is resolved and banks start lending again, which could take a while.

And for many, the advantage of bonds is that you know you will get your money back in five or 10 years - no matter what the market does.

Real-return bonds

For those who prefer the safety of government bonds, TIPS (U.S. Treasury inflation protected securities) and Government of Canada RRBs (real-return bonds) hold special appeal because their interest and principal is adjusted regularly for inflation.

If and when inflation picks up, the price and coupon of RRBs will rise, rewarding investors who sell them with a capital gain and protecting those who hold them to maturity from a loss of purchasing power to inflation. Because of this feature, TIPS and RRBs are a good buy now, says Michael Hart, head bond trader at Friedberg Mercantile Group in Toronto.

Corporate bonds

Not only are corporate bonds currently offering generous yields - 5 per cent to 10 per cent for investment-grade securities - they also offer potential for "meaningful capital gains" as investor fear subsides, Mr. Herring notes.

For the daring, he also sees opportunity in some high-risk bonds, best bought through exchange traded bond funds known as ETFs - baskets of securities that trade like stocks on major stock exchanges. At nearly 15 per cent, yields on the high-risk ETFs are "pretty compelling," he says.

Exchange trade funds

Because diversification is important, especially when buying corporate bonds, a better way to buy multiple bonds might be through an ETF, Mr. Herring advises. (You could also buy a bond mutual fund, but they tend to have higher management expense ratios than ETFs.)

Bond ETFs are made up of bonds that mature at regular intervals, so they are effectively "laddered" to provide income over a period of years.

Unlike direct bonds, bond ETFs and bond mutual funds have no maturity date so if you want your money back you will have to sell on the open market at the prevailing price.

Special to The Globe and Mail

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