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Irrational exuberance, Chapter 2: Bond markets

awillis@globeandmail.com

Six months ago, bond prices reflected the end of the world as we know it. Now, the fixed-income crowd is behaving as if the economy is fixed, and the outlook couldn't be rosier.

We now know that the business outlook isn't as grim as it appeared in November, when the financial system was on the verge of collapse, and the cost of borrowing soared for banks and other corporations.

But bond market analysts are warning that the bond markets may be getting overheated, with Desjardins Securities analyst Jean-François Godin pointing out in a report this week that the corporate debt market is showing signs of irrational exuberance.

In simple terms, the cost of borrowing for Canadian corporations has gone from unprecedented highs to stunning lows. The premium charged to corporate borrowers, known as the spread, has narrowed sharply. Mr. Godin said: "Just as the move wider last fall might be described as exaggerated to the downside, so too the move [to tighter spreads] might have the same characteristics on the upside."

The Desjardins analyst pointed out that fixed-income investors are now being offered relatively little upside in return for shouldering the risks that come with owning debt that is well down a company's credit hierarchy. Mr. Godin called this "sector compression," and it typically takes place during benign credit markets, a description that hardly applies to today's environment.

Desjardins' report showed that, in January, relatively risky five-year subordinated debt from Canadian banks changed hands at a 225-basis-point premium to the banks' less risky senior secured paper. Now, that spread is just 60 basis points. Among the domestic insurers, the spread between senior and subordinated debt narrowed from 350 basis points to just 50. (A basis point is 1/100th of a percentage point.)

Mr. Godin's advice to investors is to use the strong interest in corporate debt as an opportunity to upgrade the quality of portfolios: Sell lower-grade debt at premium prices, then buy higher-quality bonds. For Corporate Canada, the market has seldom been better. Mr. Godin said: "Issuers take note: 'If you bring a deal, buyers will come' ... for now."

OFFERING STRIKES GOLD

Inmet Mining IMN-T, which hasn't sold stock in a decade, is feeling the love from investors this week. Inmet bumped up the size of an equity offering to $348-million from $300-million in the face of strong demand.

The deal marks a sea change in sentiment for commodity plays, which were unable to finance just a few months ago, when investors were preoccupied by fears that the economy would stay in the tank, stifling demand for base metals. Inmet mines copper, zinc and gold.

Inmet financed at $44.50 a share, an 8-per-cent discount to where stock was trading prior to news of the financing. This deal caught the market's newfound infatuation with companies that will prosper in an economic upturn.

Credit Suisse and CIBC World Markets led the bought deal, and have the option of increasing the offering to $400-million.

HEDGIES REJOICE

Hedge funds had something to celebrate in May, as a number of money management strategies had their best month in a decade on the back of improving credit markets and signs of stability in U.S. real estate.

As economic sentiment improved and the U.S. housing market showed signs that it had reached some sort of bottom, a service called HedgeFund Intelligence found mortgage-backed hedge funds posed a 10.3-per-cent gain in May. That's the best performance seen since the group began compiling data in 2009. Year to date, this group is up 14.3 per cent.

Convertible arbitrage funds, which buy convertible bonds, are also reporting their best results since the surveys started, gaining 5 per cent in May, boosting the year-to-date gains to 20 per cent.

"Mortgage-backed securities and convertible bonds were decimated by the financial crisis last year and had lots of room to move up," said a commentary on these results from HedgeFund Intelligence.

Technology-focused funds were the second-best-performing strategy in May, gaining about 7.74 per cent, and now are up 14 per cent for the year.

ON THE MOVE

Top-ranked market strategist Peter Gibson is heading to CIBC World Markets.

Mr. Gibson and colleague Jeff Evans left Desjardins Securities this week and are expected to roll out their quantitative models at CIBC in early July. The two analysts have worked together for nine years and have consistently topped institutional client surveys.

The two analysts' quant models of markets help institutions make decisions on asset allocation, sector weighting and stock selection. They will work with CIBC's incumbent quant team of Derek Euale and Matthew Black.

See Andrew Willis's Streetwise Blog at ReportonBusiness.com

© 2007 The Globe and Mail. All rights reserved.

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