Low interest rates have been a lifeboat for the struggling Canadian economy. But they will soon be–gin to rise. And when they do, clients who invest heavily in government and investment-grade corporate bonds will want to run for shelter as bond prices sink.

There was a hint of what is to come in the Reserve Bank of Australia’s decision on Oct. 7 to raise its benchmark interest rate by 25 basis points to 3.25%. The Australian dollar is a commodities-based currency, much like the loonie; Australia trades more heavily with China and the Far East than does Canada, which anchors its trade in the moribund U.S. economy.

Still, bond markets are already pricing in higher interest rates. The yield for a Government of Canada 10-year bond rose by 79 bps between March 19, when it was 2.7%, and Oct. 20, when it was 3.49%.

Says Randy LeClair, senior vice president and global bond portfolio manager with Portland Investment Counsel Inc. in Burlington, Ont.: “You could argue that the move in long-term rates has anticipated what the short-term market is already pricing in — a return to normal conditions.”

Indeed, in the 30 days ended Oct. 26, yields on two-year Canadas rose by 25 bps to 1.5%. In the coming months, fixed-income markets will anticipate further interest rate rises. The first to rise will be the BofC’s administered short rate.

“We all know that interest rates will not stay down forever,” says Chris Kresic, senior vice president and head of fixed-income with Mackenzie Financial Corp.in Toronto. “It is now only a question of timing. The market is a leading indicator of the hikes to come.”

Government bonds will be the most sensitive to interest rate changes. Bank of Nova Scotia’s economics department predicts that three-month Canada treasury bills will go from yielding 0.23% in the third quarter of this year to 1.3% a year from now. By the end of 2010, the three-month T-bill will pay 2.25%, Scotiabank predicts, almost 10 times higher than the present rate.

Long-bond rates, which reflect inflationary expectations more than central bank policy, will climb as well. The yield on 10-year Canada bonds, about 3.3% in Q3, is expected to climb to 4.45% a year from now. By the end of the 2010, the 10-year Canada should pay 4.70%, Scotiabank predicts. The pickup in the long bond’s yield will, therefore, be a relatively modest 42%.

As rates rise, short-dated bonds will mature into cash and bear only brief, transitional losses on paper before they revert to cash. At the other end of the date spectrum, stripped bonds will be badly hammered. For example, a 30-year Canada coupon due in November 2039 would lose 30% of market price for each percentage point rise in interest rates. Not surprising, the tendency will be to sell or avoid long bonds and put money into shorts. That process will flatten the yield curve, reducing the premium for going long. The implication is that the payoff for going long will decrease.

The simplest strategy is to shorten terms ahead of the market. But this move gives up potential income on longer-term bonds.

A compromise is to employ a barbell strategy, in which you would put half of your client’s bond portfolio into T-bills and the other half in 10-year bonds. The effect is to reduce exposure to rate rises — although, Kresic notes, it does not eliminate all potential losses.

An alternative strategy reduces portfolio sensitivity to rising rates by substituting default risk for interest rate risk. You would sell government bonds and buy corporates on the expectation that the recovering economy will improve balance sheets, raise credit ratings and boost bond prices.

“Corporate yield spreads over governments are still wide on a historical basis and should move tighter,” LeClair suggests. Moreover, the lower the quality of a bond, the less it is hostage to central bank policy and the more responsive it is to the issuer’s own business condition.

Junk bonds should be a haven in a time of rising rates, as they tend to be priced on their issuers’ business prospects, notes Barry Allan, president of Marrett Asset Management Inc. in Toronto: “High-yield bond prices tend to resist central bank interest rate changes.”

Resetting a bond portfolio for rising rates is not without cost or risk. The costs are trading expenses, of course, and reduced cash yield if you choose to shorten terms. The alternative of taking on default risk also has a potential downside.

@page_break@Vivek Verma, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont., says, “Default rates will go higher for the next year or so.” His view is that the recovery in junk-bond prices — reflected in yields that hit 23% as prices slumped in the deepest part of the liquidity crisis this past winter — has been overdone: “Given how corporate bonds are priced, their spreads reflect an expectation that default rates will go higher for a while.”

Active management in a bond mutual fund takes care of reinvestment of returns and keeps money invested in the sector. But mutual fund fees that average about 1.6% a year take a lot out of the average return. Alternatively, you can recommend clients to buy a bond fund, such as Claymore 1-5 Year Laddered Government Bond Fund, with its 0.15% management expense ratio, or the Claymore 1-5 Year Laddered Corporate Bond Fund, with its 0.25% MER.

Each fund follows its respective DEX index, with bonds evenly weighted over the five years. Each also combines low durations with a mechanism for riding the short end of the yield curve — the part that will have the most dramatic income gains in the coming year, according to forecasts.

“A short bond ladder is a pretty good way to go,” says industry analyst Dan Hallett, president of Dan Hallett & Associates Inc. in Windsor, Ont. “You give up some yield, but it is not a lot. You are cutting a lot of risk for a little cost.” IE