Inflation worries are returning, driven by the economic recovery and the U.S. Federal Reserve Board’s announced plan to bring down the curtain on its US$600-billion reflationary encore, a.k.a. Quantitative Easing 2. The two factors will liberate the bond market in the U.S. from life support and return capital markets to being driven by fundamentals rather than artificial liquidity created by the central bank. The question is: what will happen to bond returns? Credit markets, aware that QE2 will officially end on June 30, are already pricing in higher interest rates.

That interest rates will rise is the consensus of bond managers and economists. The reasons are conventional: economic recovery implies growth of business demand for loans. What is different this time is that a large stimulus program is ending in the midst of a number of global crises that would make ordinary capital markets shiver: oil prices rising, widespread regional instability in the Middle East and an energy market poised to move higher as demand for coal, oil and natural gas replaces demand — at least, temporarily — for nuclear fuel.

There is also the growing likelihood that at least one European country — most likely Greece — will have to reschedule its junk-rated sovereign bonds, which were recently priced to yield a “default is imminent” rate of 12.83% per year to maturity.

Back home, the Government of Canada 10-year bond rate — 3.47% in mid-April — will drift up to 4.1% by the end of 2012, predicts Adrienne Warren, senior economist at Bank of Nova Scotia in Toronto, in spite of the April 12 Bank of Canada decision to hold the overnight rate at 1%.

In the U.S., the yield on 10-year Treasury bonds should rise from 3.6% in mid-April to 4.65% by the end of 2012, according to Scotiabank forecasts. These are movements back to bond market normality after two years of rate suppression by central banks.

In northern Europe and around the globe, the story is much the same. On April 7, the European Central Bank raised its overnight rate by a quarter of a point, to 1.25% — the first rate increase since July 2008. German two-year bunds followed, posting a four-basis-point rise to an annualized rate of 1.94% to maturity — the highest level since Dec. 17, 2008, according to Bloomberg LP.

Economic recovery and the end of QE2 will combine to make higher interest rates on government bonds a sure thing. The problem is to balance return with duration risk.

“In relative terms, corporate bonds and real-return bonds will do better than governments,” says Chris Kresic, partner and co-head of fixed-income at Jarislowsky Fraser Ltd. in Toronto. “But if you think that central banks are able to fight inflation well, then RRBs — which already have priced in a 2.6% inflation rate [in addition to the base rate of 1.2%] over the next 30 years — are an expensive way to get inflation insurance. [That’s because] the 30-year Canada pays 3.87% per year to maturity. If inflation runs at a lower rate, you will have done better with conventional bonds.”@page_break@Corporate fundamentals should improve and portfolios of good corporate bonds backed by companies with strong organic earnings growth should do well. The most liquid investment-grade corporates are five-year issues from chartered banks and insurance companies. Banks’ subordinated five-year debt offers a 50-bps premium over senior debt, which pays 4.35% per year to maturity.

The “carry trade,” in which banks have been able to invest cheap government short-term loans in longer-term bonds and earn a riskless return of a few percent per year, will eventually grind to a halt, predicts Benoît Poliquin, vice president and bond specialist with Pallas Athena Investment Counsel Inc. in Ottawa.

Banks will need to refinance their bonds that are coming due and should be offering competitive interest rates, says Rémi Roger, vice president and head of fixed-income with Seamark Asset Management Ltd. in Halifax.

“High resource prices support bonds from energy and materials companies,” adds Roger. “But these bonds are often vulnerable to a slowdown of global demand — really, Chinese demand — for their products. China is already tightening interest rates. These bonds could lose value if their issuers’ balance sheets suffer from lower exports or from increased borrowing. ”

Canada won’t be entirely at the mercy of global trends because we are not as connected with Europe as the U.S. is.

In addition, given the strength of the Canadian dollar, there won’t be a lot of pressure to jump on the U.S. bandwagon on June 30, when QE2 ends, says Tim Hicks, vice president at bond manager Canso Investment Counsel Ltd. in Richmond Hill, Ont. He notes that long corporates’ return premium will cover a lot of duration risk. And the less well known the issue, he adds, the more it pays.

“The extra yield on 15- to 30- year bonds, especially Maples, makes them quite attractive,” Hicks says. For example, a C$ issue of Commonwealth Bank of Australia due April 9, 2020, and rated AA by Standard & Poor’s Corp. would pay 160 bps over a Government of Canada bond of similar term.

In comparison, Hicks notes, a senior Royal Bank of Canada bond with a similar term would be priced to yield just 80 bps over Canadas that have recently been priced to yield 3.35% to maturity.

The additional yield will be preserved even as rates rise in the wake of the ending of QE2, Hicks observes: “The U.S. government is stepping back and hoping that the private sector will step up to the plate. Ultimately, lenders will demand a higher rate of interest. And with the U.S. Fed gone as a supplier of liquidity, the lenders — bond investors, in particular — are going to get it.” IE