Corporate bonds can boost your returns

With yields still near historic lows, bond investors can get more interest by swapping government issues for corporates.

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From the Summer 2013 issue of the magazine.

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bonds_bail_322As a teen, and in university, the board game Risk was a popular pastime. It has a political map, with armies out to conquer the world. I never had much luck at the game: there’s lots of strategy but ultimately a roll of the dice determines the winner. Risk has taken on a whole new meaning of late, especially for bond investors.

Historically low interest rates are accepted as the norm right now. Yet there’s much uncertainty as to where they may they go next. That uncertainty is a risk.

Investors engage in a mental trade-off: I’ll accept more risk if I can offset it with more reward. With bonds, higher risk is measured by credit. Government bonds have the highest credit ratings because governments are likely to be around in the future to pay back the principal. Corporations may not; think of ex-behemoths like Nortel Networks and appreciate that risk.

The reality of low rates leaves government bonds paying paltry yields. Central banks around the world have actively suppressed interest rates to stimulate the economy. They’ve been doing that, in part, by buying government bonds. Some governments like the United States and Canada are seen as safe havens and attract funds despite low yields. Over the past year $50 to $75 billion in foreign funds has found its way into the Canadian fixed-income marketplace, including government-issued bonds but also corporate bonds.

The higher risk embodied in corporate bonds is offset by higher yields. In Canada, investment-grade corporates have historically traded on average a full percentage point (100 “basis points”) above Government of Canada yields. Not so long ago the spread was half that, as low as 50 basis points. Recently, investment-grade corporates yielded on average 115 basis points above government bonds. That spread is 25 basis points lower than at the start of the year.

The tightening in corporate spreads is due in part to lack of issuance by Canadian corporations. There are many reasons why corporations aren’t issuing bonds; with solid balance sheets many don’t need to. Also, corporations are uncertain about the future of the economy and don’t want to raise funds before knowing how to deploy them. Still, there is on average $75 to $85 billion in issuance each year. That’s more than what’s absorbed by maturing bonds ($55 to $60 billion a year) and interest income from all other bonds of $15 to $20 billion a year. Never mind new inflows from investors hungry for yield.

It’s important to quantify risk. Bond-rating firms like Standard & Poor’s use different designations, with upper- and lower-case letters ‘A’ and ‘B’ identifying a bond’s credit quality rating. ‘AAA’ and ‘AA’ (high credit quality) and ‘A’ and ‘BBB’ (medium quality) are considered investment grade. Anything below—Cs and Ds—is considered junk or, more politely, high-yield debt.

For example, the Government of Canada has AAA-rated bonds (4.25% due 1/6/2018) maturing in five years with an annual yield of 1.6%. In comparison, Manulife Financial (5.505% due 26/6/2018) is rated as A and yields 2.76%. Shaw Communications (5.65% due 10/2019) is BBB– and yields 3.2%. (Yields calculated using June prices/ratings, for illustrative purposes only).

The Canadian corporate market is a valid destination for bond investors, but there are cautions. Ed Devlin, head of Canadian portfolio management at Pimco, among the world’s biggest bond managers, has warned for years that Canadian bonds are among the least diversified and most expensive in the world. The top 10 issuers represent 38% of the market, versus only 16% in Europe or the U.S. You get an extra 29 basis points in the U.S., versus Canadian corporates. He warns that relying solely on the Canadian market to pick up bond yields poses another type of risk. The solution is to add international corporate bonds to portfolios.

There are logistical challenges with corporates. Brokers may require a minimum investment, like $5,000, limiting the ability to diversify. If you find a suitable candidate you must purchase directly from the broker. There’s no central exchange to get quotes or transact. What’s reassuring is you know your risk exactly: will the issuer default?

Mutual funds and ETFs hold corporate bonds, diversifying away the risk of holding individual issues. Mutual funds have professionally managed mandates. ETFs have trading advantages and provide instant access to global issuers and markets. But these can’t be easily tailored to the exact risk and income flow investors may need.

The ‘Risk’ game was produced by Parker Brothers. It was invented by a Frenchman and was originally named “La Conquête du Monde.” Conquering the world of corporate bonds is not child’s play, but if mastered can add handsome incremental returns within the confines of quantifiable and acceptable risk…depending on how you like to play the game.

Pat Bolland is a veteran financial broadcaster currently with Sun News Network. His Twitter handle is @patbolland.

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