Every financial advisor faces the same problem in building and managing a client’s bond portfolio: how to help that client make a living when interest rates remain close to historical lows.

The solution is to cut back on low-yield government bonds and add investment-grade and/or high-yield corporate bonds. Every move away from short-term government debt has some term or credit risk; but with short rates still near zero, taking on such reasonable risk pays well.

The best place to look at what investment-grade corporates are offering vs government bonds is at the nine-year point on the yield curve, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto, because that is the point at which “you pick up 130 basis points [bps] over Government of Canada bonds.”

For example, as of early January, a Canada bond due in 2022 yielded 2.6% to maturity, whereas an AA-rated GE Capital Canada Funding Co. issue with a similar term pays 125 bps more – a yield to maturity of 3.85%.

What to do for greater yield

For more yield, you can extend terms and add duration risk or look farther down on the credit-quality scale. The knack is to get paid for taking on additional term and credit risks. For example, a Loblaw Cos. Ltd. BBB-rated 10-year bond pays 4.55% to maturity, 179 bps over a 10-year Canada bond that pays 2.76% to maturity. And a Canadian Tire Corp. Ltd. 10-year bond rated BBB+ pays 169 bps over the 10-year Canada, yielding 4.45% to maturity.

Bonds issued by Corus Entertainment Inc., Rogers Communications Inc. and Shaw Communications Inc. are similar. For example, a Corus 4.25% bond due Feb. 11, 2020, with a BBB rating on the lower edge of investment-grade and recently priced at $96.63 has a yield to maturity of 4.89%. In contrast, a Canada bond due June 1, 2020, with a 3.5% coupon was recently priced at $108.23 for a 2.13% yield to maturity.

There are intrinsic risks for all these corporates that are reflected in their ratings. Retailers face tough competition, and entertainment and telecommunications giants have to deal with both changing technology and the fickle public.

A variety of risks and payoffs

Meanwhile, high-yield bonds have a variety of risks and payoffs associated with them. In the B- rating space, there’s credit risk – but a good deal of compensation for it. A typical bond in this category is that of North American Energy Partners Inc., an oil and gas services firm based in Alberta, which was issued in 2010 with 9.125% coupon. This issue was recently priced at $104.50 to yield 7.56% to maturity. Similarly, Fort McMurray, Alta.-based oil and gas services firm Tervita Corp. has a U.S.-dollar bond issued in January 2013 with an 8% coupon due Nov. 15, 2018, was recently priced at $104 to yield 7.02% to maturity.

Are high-yield bonds worth this extra pickup in yield?

“Yes,” says Adrian Prenc, vice president and portfolio manager with Marret Asset Management Inc. in Toronto. “The fundamental argument for high-yield [bonds], which is enhanced returns, remains sound because of negative real returns on short-term government bonds.”

Next: Spectacular returns
Spectacular returns

Moreover, returns in the high-yield bond market were spectacular in 2013. The Bank of America Merrill Lynch master II high-yield index produced a return (in U.S. dollars) of 7.42% for the 12 months ended Dec. 31, 2013, and yields 6.38% to maturity with an average term of 6.7 years. In comparison, U.S. T-bills with seven-year terms recently have yielded 2.21%.

Just don’t forget that high-yield bonds have equities-like risks.

The final frontier for fixed-income investing is in global bonds. These range from senior markets such as the U.K., Australia and Germany to bonds of dubious creditworthiness issued by governments of some developing countries. Not surprising, global bonds come with a wide divergence of returns. For example, 10-year U.K. “gilts” pay 3.02% to maturity, up from 2.74% a year ago, while Germany 10-year bunds pay 1.92% to maturity vs 1.29% a year ago, and Australia 10-year issues pay 4.23% to maturity compared with 3.12% a year ago.

Default is a way of life

When you move into the global high-yield space, you can find years of nail-biting in Portugal 10-year government bonds paying 6.02%, Greece’s federal 10-year bonds paying 8.45% to maturity or India’s troubled national bonds offering 8.95% to maturity.

However, when you add in foreign-exchange risk and/or liquidity concerns that rise as credit quality declines, the argument for putting money directly into international markets other than the U.S., northern Europe, Australia, New Zealand and the U.K. (all of which are liquid and readily accessible) diminishes.

In the highest-yielding markets in Africa and some parts of South America, default is not just a chance – it’s a way of life. So, if your client has no reason to invest there, then why swim in those dangerous waters?IE

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