Protection from rising interest rates will be an essential factor when investing in the bond market in 2011. Government bonds with no credit issues will lose market value, but there’s still much value in corporate bonds that will be helped by the improved business conditions that go along with rising interest rates.

Michael Ho, senior vice president with DBRS Ltd. in Toronto, considers the Canadian corporate bond market to be healthy now. A big reason for this, he says, is that corporate bond yields are appealing.

For example, a Molson Coors Brewing Co. bond with a 3.95% coupon due Oct. 6, 2017, and rated BBB High by DBRS has recently been priced at $96.50 to yield 4.55% to maturity. The brewery business is competitive but less cyclical than oil and gas and, as a result, provides a good trade-off of risk for return, says Chris Kresic, co-head of fixed-income with Montreal-based Jarislowsky Fraser Ltd. in Toronto.

Another potentially good buy is Rogers Communications Inc.’s 4.7% bond due Sept. 29, 2020, which was recently priced at $98, with a 5% yield to maturity. Kresic thinks that bond, rated BBB, is likely to be upgraded over time.

Kresic also considers financial services bonds relatively cheap on the basis of fundamentals: “If you are going to take an aggressive position, you want to be in the lower ranges of the capital structure. That means you would want their subordinated debt, especially the Tier 1 ‘shock absorbers’.”

Typically, the Tier 1s, issued to allow banks to absorb major loan defaults, were sold with yields of 10% or more at the bottom of the market swoon in 2008 and had resets at the rate payable on Government of Canada five-year bonds plus 500 basis points. However, there are special risks in these bonds. Basel III regulatory changes will cause these bonds to have declining value as bank capital after 2013 — and have none at all after 2023.

This could create an incentive for Toronto-Dominion Bank and other issuers to call these bonds. Call dates vary from Bank of Montreal’s 10.22% issue, due in Dec. 31, 2107, with a call on Dec. 31, 2018, to longer calls such as the TD 10% and a Canadian Imperial Bank of Commerce 10.25% issue due June 30, 2108, that’s also callable June 30, 2039. The 2039s can be called at par — with the loss of the premium over the issue price.

But bond strategists are betting the banks won’t call these issues. “The economic benefits to the banks of early calls are not large because the issues were small,” says Christine Horoyski, senior vice president for fixed-income with Aurion Capital Management Inc. in Toronto. “If the banks do call the Tier 1s and force holders to take losses, they risk alienating the investors who were buyers at the depths of the credit crisis and arguably are long-term supporters of the institutions.”

Adds Heather Mason-Wood, vice president of Richmond Hill, Ont.-based Canso Investment Counsel Ltd. : “It is more likely that the banks will treat the bonds as though Basel III had not demoted them, and therefore pay full value at par or at call.”

When it comes to high-yield, junk bonds, the one certainty is that those who invest in this space need to pay for research, risk management and diversification. Still, there can be good returns. Managed high-yield portfolios had an average return of 10.59% for the year ended Dec. 31, 2010 — far ahead of the 5.52% return for all Canadian bond funds.

The questions this year are whether high-yield will do well again and whether the potential returns are worth the high risk of default. Barry Allan, president of Marret Asset Management Inc. , a high-yield bond specialist in Toronto, says that with the spread over a blended index of U.S. Treasury bonds of similar maturity above the long-term average, junk is a currently good deal by historical standards.

But, says Caroline Nalbantoglu, registered financial planner with PWL Advisors Inc. in Montreal: “When I buy a bond, I want one that is certain to return its principal. And you certainly don’t get that with junk.”

She acknowledges that one good year can produce great returns, but adds that doesn’t make up for the risk in the down years. IE