With Canadian interest rates expected to rise later in the year, you should consider shifting your clients’ fixed-income holdings more toward corporate bonds — with shorter durations, in general — and fewer government bonds.

As interest rates rise, prices of existing bonds will fall; however, not all bonds will decline to the same extent. That’s because government bonds have no default risk and, as a result, are the most sensitive to interest rate hikes. Highly rated AA or AAA corporate bonds aren’t much better because there’s also little potential for ratings upgrades. Rather, it’s the middle ground — A to BB investment-grade bonds — in which there’s much more potential for upgrades; and, in an improving economic environment, these bonds are also more sensitive to balance-sheet improvements than to interest rate hikes.

Benoît Poliquin, vice president of Pallas Athena Investment Counsel Inc. in Ottawa, says that a reasonable bond allocation for early 2011 is 80% investment-grade corporates, 10% government bonds — split between federal bonds and liquid issues of provincial bonds — and 10% real-return bonds. He also recommends keeping terms to two to five years and being patient.

The consensus of marketwatchers and bond portfolio managers is that Canadian interest rates will start to rise sometime between the second and fourth quarters of 2011. The increases aren’t expected to be large — given expectations of moderate economic growth — and they will be concentrated at the short end of the yield curve.

For instance, Tom Czitron, managing director and chief investment officer with Mor-rison Williams Investment Man-age-ment LP in Toronto, expects an increase of “perhaps 50 basis points” at the short end of the yield curve before the end of the year, with the long end of the yield curve up by just 10 bps. As of Dec. 31, 2010, the Bank of Canada’s overnight rate was 1%, while 10- and 30-year bonds were yielding 3.11% and 3.52% annually to maturity, respectively.

The present inflation rate of 1.7% isn’t enough to push the BofC to raise rates immediately. The central bank also won’t move until excess capacity begins to decline, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

Furthermore, the BofC has to take what’s happening with U.S. rates into consideration when timing its rate increases. If Canada’s rates get too much higher than those south of the border, there will be upward pressure on the Canadian dollar as investors seek the higher returns on Canadian bonds, which will be negative for the economy because it will make Canadian manufactured goods less competitive in the U.S.

The U.S. is doing all it can to get its economy moving again. The U.S. is hoping that its second round of quantitative easing, which saw US$600 billion being pumped into the U.S. banking system with the purchase bank-held bonds, will work.

“If the U.S. moves do produce a sustainable recovery, then the BofC will have room to raise rates,” says Chris Kresic, co-head of fixed-income with Montreal-based Jarislowsky Fraser Ltd. in Toronto. “QE2 should work, as the banks got almost free money that they can spend [on] either buying bonds or lending at what should be low rates.”

But if there’s “another crisis of confidence,” Kresic warns, lending could slow, U.S. rates would remain low and the BofC could postpone its interest rate hikes.@page_break@So, how should your clients position themselves? Although they will be most affected by rising interest rates, there will still be value in government bonds — and your clients shouldn’t rush out and sell them. Clients holding defaultproof government bonds will get a definite return of capital if the bonds are held to maturity.

Nevertheless, trimming some government holdings and increasing corporates is not a bad idea. “With rates rising, we’d cut durations and move into higher-quality corporate bonds as spreads contract,” says Heather Mason-Wood, vice president with Richmond Hill, Ont.-based Canso Investment Counsel Ltd. “We have seen more money move into corporate debt. That trend could continue and force spreads to contract further.”

Her advice: purchasing corporates in the A to BBB space — and riding them as their prices rise — is a normal play on improving fundamentals.

What works for investment-grade bonds will work even better with high-yield bonds because the latter quickly become more attractive as the economy improves and defaults decline.

The nominal yield of the Merrill Lynch master II high-yield index was recently 7.71%, which is 439 bps above the average term of 10-year U.S. Treasury bonds. So, the buyer of a diversified portfolio of managed high-yield mutual funds or appropriate exchange-traded funds will be positioned for gains, says Michael McHugh, vice president of fixed-income and portfolio manager with Dynamic Mutual Funds Ltd. in Toronto. Improving balance sheets will support higher bond prices and that effect, which narrows the yield spread over government debt, means potentially large capital gains for holders of high-yield bond issues.

Another way to play the expected global economic recovery is global bonds. Problems of sovereign debt issuers in Europe have reduced security. But Irish bonds are a possibility. “Other countries with debt problems are in worse shape,” Czitron notes, “so Irish bonds are appealing.”

Emerging-markets bonds also are promising. The senior issuers in this sector are the “BRIC” nations of Brazil, Russia, India and China; the recent performance of these countries’ bonds has been striking. Brazil’s two- to 10-year sovereign bonds are yielding about 12%, in U.S.-dollar terms, reflecting investor worries about potential government controls on movements of foreign capital and the recent imposition of nonrefundable withholding taxes. This sector is difficult to invest in directly, but mutual funds and ETFs can do so relatively efficiently.

With inflation’s currently low rate, real-return bonds don’t have much appeal. RRBs add a consumer price index compensation payment on top of the underlying rate of interest. RRBs have recently been priced to anticipate a 2.4% rate of inflation, notes Poliquin. These bonds tend to behave like long-term bonds, but conventional long bonds are often a better deal — as they are now: the real yield on RRBs is 1.2% and the nominal average yield on long Canada bonds is 3.6%. Thus, RRBs are expensive.

Still, for a client with a multi-decade time horizon and the expectation that inflation could return to 3%, Poliquin concludes, RRBs have a place in a portfolio.

So, should you buy RRBs for clients? “On the one hand, inflation expectations have been increasing — and that has driven up the premium over their modest underlying yield,” says Christine Horoyski, senior vice president of fixed-income with Aurion Capital Management Inc. in Toronto. “But just as for long bonds, their real yield of just 1.2% is too little. When [gross domestic product] growth expectations rise, then it might be time to buy into RRBs.” IE