page of newspaper with words government bonds

The certainty of getting paid interest, combined with the eventual repayment of principal, is the very essence of a bond’s price and return. Yet as every bond investor knows, not all debts are equal. Some, such as government bonds of the most developed nations, are regarded as almost riskless whereas high-yield “junk” corporate bonds are at risk of default. Investors who get their bond risks right can make out very well.

The FTSE Canada universe bond index, a surrogate for the broad Canadian bond market, returned an average 4.4% annually during the last 10 years while the S&P/TSX composite index returned an average of 4.5% annually during that same period — but with far more risk. Meanwhile, the FTSE Canada all corporate bond index produced returns of 5.4% year during the same period, according to Richmond Hill, Ont.-based Canso Investment Counsel Ltd.’s Corporate Bond Newsletter, published in June. That’s 90 basis points (bps) more than the return on stocks — and with much less drama.

Were it that simple, you would balance risk and return by loading up on investment-grade corporate bonds for the fixed-income portion of clients’ portfolios. But it’s not that simple. With the continuing flattening of the yield curve, the inflation premium is shrinking while the relative proportion of payment for default risk is rising.

Says Edward Jong, vice president at T.I.P. Wealth Manager Inc. in Toronto: “Investors who stick with government bonds give up a lot of return. They’re paying a high price for certainty.”

Interest rate spreads demonstrate that point. At the time of writing, a 10-year Government of Canada bond paid 2.23% a year to maturity whereas a Canadian National Railway Co. bond of the same maturity offers 3.25% a year. The premium for that corporate bond’s default risk adds 102 bps to the government bond return. The dilemma comes down to two opposing realities: mid to long government bonds have yields suppressed by low inflation expectations; and mid to long corporate bonds reflect issuers’ profits based on low borrowing costs.

Canadian corporate bond spreads have widened recently. That’s a process that began in 2014. A report entitled What Explains the Recent Increase in Canadian Corporate Bond Spreads published in March 2017 by the Bank of Canada’s financial markets department reveals that two-third of the total 120 bps increase in corporate bond spreads in the two years ended Sept. 30, 2016 was due to higher compensation for potential default. The other third is non-default risk — specifically, liquidity risk.

The riskier the corporate bond, the more influential the default risk premium is in the total spread. Thus, energy bonds have the largest fraction of yield premium attributable to default risk while the smallest default premium belongs to financial services firms thanks to the chartered banks, which are widely seen as unlikely to fail.

“In hindsight, investors who bought corporate bonds were well paid because the market rallied in the past decade,” says Chris Kresic, head of fixed-income and asset-allocation at Jarislowsky Fraser Ltd. in Toronto. “But going forward, given that we are near at a 10-year low in interest rates, the largest determinant of 10-year and over returns is today’s valuation on credit spreads. Relative to the inflation component of the return, credit spreads are at historical highs. So, 10 years from now, returns should be lower than they were in the past decade. Today, investors in corporate debt are getting an excess premium. It will last until the composition of return provides more inflation protection. Investors who select government bonds are giving up the default premium.”

The hefty premium that corporate bonds have attributable to default risk or, looked at another way, the cost of avoiding default, will last as long as the yield curve remains flat. If the long end of the yield curve rises, then a greater proportion of the return in corporate bonds will go toward inflation compensation and less will go toward covering default risk.

This is the third in a four-part series on fixed-income investing.