In a time of crisis, investing in “dull” bonds is good if it lets you sleep at night

Because the word “mortgage” is considered risky these days, Canada Mortgage Bonds (CMBs) are paying premium rates — even though they are issued by Canada Mortgage and Housing Corp. and have a Government of Canada guarantee.

The financial meltdown now underway has devastated every sector of the stock market from fertilizer stocks like Potash Corp., to drug makers and consumer discretionaries. Even gold stocks have tumbled as investors have headed for safety in bonds and cash.

In the present time of troubles, which will be tamed — at best — by the US$800 billion bailout (it was US$700 billion before pork got tacked on), the new watchword is “return of capital, not return on capital.”

For the moment, bonds are the place to be. There are three main classes of safe bonds: one, government bonds; two, supranational and global bonds with government guarantees; and three, domestic bank bonds that have suffered in the world meltdown of financial services.

What you have to know is a single fact: In this market, even the banks are afraid to lend to one another. In the wake of the failure of Lehman Bros., Washington Mutual, the shotgun marriage of Bear Stearns and J. P. Morgan Chase, and the near death experience of Merrill Lynch (bought in the nick of time by the Bank of America), it is clear that providing capital to a bank can be financially harmful to the investor.

The evidence for this? The London Interbank on Offer Rate (LIBOR), which is what banks charge one another for lending U. S. dollars, soared to 7.75 per cent on an annualized basis in the first week of October. A year ago, the rate was about 2.2 per cent. Credit markets have frozen up and even AAA corporate bonds have dropped to 20-year lows as investors have rushed to buy government bonds.

Look at mortgage bonds

Friends, there is a choice to be made. You can buy terrific stocks with great dividends at the risk that they will drop further. Or you can buy a government bond that pays little but has no default risk. At the time of writing at the end of the first week of October, a two-year U. S. Treasury bond pays 1.65 per cent to maturity. Inflation in the U. S. is running at 3.5 per cent per year but may drop to 2.0 per cent when revised for lower oil prices. Take off inflation and taxes and you have a negative return. Two-year Canada bonds offer a 2.6 per cent yield to maturity. Take off inflation at, say, 2.7 per cent and taxes, and you also get a negative return.

Here is where some bond technicalities can help boost yield. In the present market, global investors shun any bond with the word “mortgage” or any bond with any name other than Government of (put in a G-7 name here), so Canada Mortgage Bonds (CMBs) are paying premium rates — even though they are issued by Canada Mortgage and Housing Corp. and have a Government of Canada guarantee. You can get 3.45 per cent per year to maturity in a three-year CMB, which is 0.45 points more than the yield on a Government of Canada bond with the same term. CMBs are generic and there are hundreds of issues with no tricks, no calls and no complications. You will not make a fortune, but you will also not lose your shirt.

A little riskier

In the present climate of fear, investors see a lot of risk in bank bonds. But Canada is different. Our banks are less leveraged than American and European banks and they have the life vest of their oligopoly positions. At the moment, you can buy a Bank of Nova Scotia senior deposit note due February 15, 2011 priced to yield 4.50 per cent per year to maturity, which is 1.5 percentage points more than a Government of Canada bond of the same term.

If you want to buy some deeply subordinate bank bonds, try a Toronto-Dominion Bank bond due December 31, 2018, which was recently priced to yield 7.7 per cent to maturity. This is 4.05 percentage points more than the 3.65 per cent per year that a 10-year Government of Canada bond pays to maturity. This bond, designated Tier 1 capital, will be the first to go in an insolvency after the stockholders have been ruined. So beware of the risks.

Want to take on more bond risk for a stunning and theoretically locked-in return?

Warren Buffett put US$5 billion into Goldman Sachs for a whack of 10 per cent custom-made preferred stock. You can buy a less risky “maple” bond — that’s a foreign issue priced in loonies — from Goldman Sachs that has recently been priced to yield 8.0 per cent per year to maturity, which is 4.5 percentage points more than a comparable eight-year Government of Canada bond. The Goldman Sachs maple bond has an AA-low rating, which used to be good enough for most insurance companies, but that rating is now just a bunch of letters in a market that has seen AA investment banks become insolvent.

Want more risk? Try a Morgan Stanley loonie-denominated issue due in 2012 recently priced to yield 13 per cent per year to maturity. Heather Mason-Wood, a vice-president of specialist bond manager Canso Investment Counsel Ltd. in Richmond Hill, Ontario, said of these critters: “These financial services issues from great investment houses are being priced like very risky bonds.” In fact, the standard index of junk bonds, the Merrill Lynch Master II High Yield Index, has an implicit return of about 8.3 per cent, which is a good deal less than the paper from formerly aristocratic investment banks now pays.

Look globally

Next idea for safety and some yield: global bond with government guarantees. Global bonds are issued outside of Canada and in currencies other than loonies. They have some interest rate risk, maybe some credit risk if they are corporate issues, and they have exchange risk. The loonie may rise or fall against their native currencies of issue.

You can, however, finesse a good deal by buying an agency bond guaranteed by a foreign government. Thus a Federal Republic of Germanybacked issue from the Kreditanstalt Fur Wiederaufbau (which translates as “Bank for Reconstruction”), a specialist in fixing up for the former East Germany, with a 10-year maturity was recently priced to yield 4.65 per cent to maturity. This is about one percentage point more than a Government of Canada bond of the same term.

And so we come to the last idea of getting some extra yield out of bonds. Junk, alias “high-yield bonds,” get paid before any money is left for stockholders. Not all of it is bad. This is no market for civilians who do not have staffs of accountants and financial analysts, however. In this part of the world, it is wise to use a high-yield bond fund. There are good ones run by Phillips Hager & North (now owned by the Royal Bank), CI Funds, Trimark, Dynamic Funds, and AGF. This is a year when shrewd moves in the bond market will pay handsomely.

If you want safety, stick to Government of Canada issues and those CMBs with Government of Canada backing. For more yield, try senior bank bonds. For yet more yield, look at subordinate bank bonds and some global bonds with currency risk. And beyond that, buy junk.

None of this stuff will provide the daily thrills and chills of the stock market. But then some of the best investments are the dullest. With bonds, you can sleep through the night.

Andrew Allentuck’s book, Bonds for Canadians, was published by John Wiley & Sons in 2006. His newest book, When Can I Retire?, will be published in January by Viking Canada.

About the author

Columnist

Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.

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