The Globe and Mail, Report on Business
Published June 27, 2009

Over the past nine months, I've talked often in this space about risk being cheap. Investors can't let past losses blind them to the opportunities that have emerged from the banking crisis and recession.

From time to time I get a note from a frustrated reader who would like to take advantage of market weakness, but doesn't have the scope or time horizon to do so. Being further along in their investing cycle, they are looking for continuing income and can't absorb short-term losses.

For these investors, adding to equities might be appropriate to some extent, but there are other ways to take advantage of market opportunities. Indeed, they can amp up potential returns without straying from the bond market.

Fixed-income securities or funds are less volatile than the stocks, but bond investors are still taking risk – interest rate and credit risk.

Interest rate risk simply means that if rates go up, a lower-yielding bond will be worth less. On the other hand, if rates fall, the bond becomes more valuable and the price goes up. Longer-term bonds generally have higher yields and the potential to generate better returns, but they react more dramatically to changes in interest rates. So the longer the term of a bond (more interest rate risk), the more volatile the price will be.

Credit (or default) risk refers to the possibility that the borrower will not be able to make interest payments and/or repay the loan at maturity. Government-guaranteed bonds have no credit risk (we hope), while corporate bonds have varying degrees depending on the quality and stability of the company. The greater the chance of default (think Air Canada and Nortel), the higher the yield will be to reflect the additional risk.

Every bond has a different mix of interest rate and credit risk. A short-term government bond is least risky (modest interest rate risk and no credit risk), while a longer-term bond issued by a debt-laden, cyclical company is at the other end of the spectrum.

Over long periods of time, taking credit risk has paid off for investors. Owning a diversified portfolio of corporate bonds delivered higher overall returns, though there were years when they performed poorly. More often than not, the higher yields on corporates carried the day.

But that trend came to an abrupt halt in 2007, when there was an irresistible rush to safety, pushing government bond yields down. Meanwhile, buyers of corporate bonds demanded higher yields to compensate for skyrocketing credit risk (a weaker economy invariably leads to missed interest payments and more defaults). In 2007, government bonds beat corporates by 3.4 per cent.

Typically, corporates bounce back after a negative year, but that didn't happen: 2008 was worse, as government bond yields headed toward zero, and corporate yields moved up to reflect the uncertain outlook. Corporates again trailed governments, this time by a staggering 13.3 per cent.

Through this period, the yield spread (or gap) between corporate and government bonds widened dramatically. In the first part of 2007, the extra yield a corporate bond holder received was stable at about 80 basis points. The spread rose to 150 points by the end of the year and hit a high of 410 points at the peak of the crisis last January.

It was in this Depression-like context that I talked about taking more risk. Investors were being amply compensated for taking credit risk. Getting an extra 400 basis points of yield for owning a bank note seemed like a reasonable reward/risk bet.

So far in 2009, corporates are doing well. With more certainty in the banking sector and continued low yields on government bonds, buyers quickly reversed field and bid up the price of corporates. Meanwhile, the bond investors who fared well during the crisis by not owning corporates have seen a slightly negative return. The DEX All Government Index, which is a good proxy for safety, is down 0.5 per cent year to date.

The ups and downs in the bond market have resulted in the biggest divergence of returns that I've ever seen. Long-term track records were built and broken in a matter of a few quarters. Typically, a performance differential of 0.25 to 0.5 per cent between bond managers is considered significant, with first-quartile managers beating fourth by less than 1 per cent. But in 2007 and 2008, firms that took the right amount of credit risk (i.e., very little) ran ahead of their less fortunate competitors by 3 to 4 per cent a year. Some of Canada's top bond managers, which had superb credit records previously, were knocked off their pedestal, although in most cases they are roaring back in 2009.

The past two years remind us that not all bonds are the same and that seeking higher returns increases the volatility of a portfolio. But with safety still very expensive (products such as high-interest savings accounts and GICs are paying very little interest) it makes sense for income investors to prudently take some risk. The opportunities aren't as juicy today as at the beginning of the year, but the reward/risk balance is still in their favour.