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Key to corporate bonds: Be very selective

INVESTMENT REPORTER

It has been a good year for bonds, and even though gains were outpaced by those of the North American stock indexes, bondholders probably slept better than shareholders during one of the most dramatic trading years on record.

During 2009, investors in Canada pumped more money into bond funds than any other category, eschewing the safety and miserly returns of money market funds for a calculated middle ground somewhere between stocks and savings accounts.

The best returns were in corporate issues, with the DEX all corporate bond index up 16 per cent on the year, followed by a balance of corporate and government paper, with the DEX universe bond index returning 5.2 per cent on the year.

In comparison, the broad U.S. stock market index, the S&P 500, increased by 24 per cent in the same period and the Toronto benchmark for stocks, the S&P/TSX composite, rose 29 per cent.

Are bonds, and more specifically corporate bonds, still a good bet for 2010? "A lot of the low-hanging fruit has been picked," says Ric Palombi, portfolio manager with McLean & Partners Wealth Management in Calgary.

There are several risks to consider with the bond market in the coming year, including rising supply, a faltering economy and higher interest rates. A lot of companies issued new debt in 2009 and if the trend increases in 2010, some deals could collapse, which would drive up the yields and send down bond prices. Likewise, if the economic recovery stumbles, default rates could inch up and put upward pressure on yields. And when central banks finally start to push up government rates, expect bond prices to fall.

But even with these risks in mind, corporate bonds will remain an important class of assets for an investor to hold in 2010, especially for refugees from the income trust sector, Mr. Palombi says.

The key to success will be greater selectiveness as it gets harder to make money. Investors will need to choose the right companies, the right part of the yield curve and the right credit. To get a decent return may require moving further down the timeline to a five- or 10-year issue. Another option will be choosing some lower rated bonds, such as BBBs that perch on the edge of investment grade, with a maturity of five years or less. Prices of these riskier bonds can drop quickly, however, if ratings agencies issue a downgrade.

Default risks on corporate bonds have been historically high during the credit crisis, but they are declining and will continue to do so in 2010, according to a November report from UBS AG.

Since the 1980s, the average default rate on high-yield corporate bonds (defined as below BBB), has been 4.4 per cent, and investors were typically able to recover only 40 per cent of their principal in a default.

The default rate on high-yield issues is currently at 13 per cent, according to UBS strategists Bernhard Obenhuber and Stephen Freedman. They expect that rate to decline to between 6 per cent and 8 per cent in 2010 and to slip back to 4.4 per cent in 2011.

Of course, it's the higher risk that is giving investors higher returns today. For example, the spread between yields on mid-term corporate bonds rated AAA and those rated BBB are on average 140 basis points (1.4 percentage points) today, compared with just 100 basis points in more normal times. "The spreads are still pricing in a slower type of recovery," says Darcy Briggs, vice-president of fixed income and portfolio manager at Bissett Investment Management in Calgary.

In this environment, he recommends buying shorter-term, investment grade, corporate bonds, in the range of one to three years, and he says that holding them to maturity is one acceptable strategy, as long as the investor understands default risk rises with time.

"The outsized returns we have seen last year are likely not going to be repeated," he advises. "We are kind of in uncertain territory."

With central bank interest rates sitting near zero they only have one direction to go, and it's just a matter of when. As rates rise, bond prices fall. Historically, however, corporate bonds offer more protection against rate hikes than government bonds. In 1994, for example, as rates shot up after the recession, the returns on government and corporate bonds in aggregate was a negative 4 per cent. Corporate bonds themselves declined only 3 per cent and short-term corporate debt remained mostly stable, he says.

There are several options for getting into the corporate bond market. Individuals can buy bonds directly through a discount trading firm and hold them for their interest payments or try to sell them for capital gains. This approach lets an investor cherry pick individual bonds for their yields and performance.

But there are shortfalls to this method, largely because bonds are bought and sold by traders in what is essentially an over-the-counter market. It's a forum that lacks transparency and liquidity for the retail investor, who won't get the same price as a large institutional buyer or seller. "It's all about flow," says Mr. Palombi. "If you're not in the flow, you can't execute your strategy."

It's also very difficult for an individual investor to build a diverse portfolio of bonds because there are more characteristics to consider than there are for a stock. In addition to industry sector, spreads and credit, investors must weigh the different characteristics of the many bonds a company may issue.

Another option for buying corporate bonds is exchanged-traded funds, which hold a basket of bonds to track a specific index and which charge less than 1 per cent in management fees. Companies offering these include BlackRock's iShares, Claymore Investments and Bank of Montreal.

These ETFs give good exposure to the bond market and can deliver cash income. But one shortfall of a bond ETF is it doesn't hold the issues until maturity. That means investors who buy at the wrong moment in the cycle can lose money, very much as if they bought a stock at the wrong time.

Professional money managers say when it comes to buying bonds, getting advice can be even more essential than when buying stocks.

***

Bond returns 2009

Year to date - Dec 22

DEX All corporate bond index 16 per cent

DEX Universe bond index 5.2 per cent

DEX Long term bond index 4.6 per cent

DEX Short term bond index 4.6 per cent

DEX All government bond index 1.4 per cent

Source: BlackRock iShares

© 2007 The Globe and Mail. All rights reserved.

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