Why You Should Own Canadian Bonds Now

Deborah O'Malley's picture

Friday, February 13, 2015 - 12:00pm

by Deborah O'Malley

Volatility is heating up. Triple-digit moves in the Dow Jones Industrial Average are now an almost everyday occurrence. The CBOE Volatility Index (VIX), popularly known as the stock market's fear gauge, has been marching higher. The index, which uses options pricing to measure expected swings in the S&P 500, implies that investors expect more intense and frequent stock price swings in 2015. 

The fear gauge hovered around 14 much of last year, its lowest average since 2006. It jumped to around 20 in the first two weeks of 2015, hitting a one-month high above 22 on January 15. 

The Market Has Shown More Volatility This Year
 

Intraday swings -- the difference between the highest and lowest levels during the trading day -- are also greater. The S&P 500 saw swings of an average 29 points per day in January, or 1.4%, according to financial data firm FactSet. That puts 2015 on track for the widest swings in four years, since the index averaged swings 1.6% intraday in 2011. By comparison, the benchmark index in both 2013 and 2014 saw average intraday swings of about 0.9%. 

As volatility increases, investors have been seeking safe havens. One such place to consider is Canada.

In the past month, for example, Canadian REITs surged 8% and the super-safe "AAA" 10-year Government of Canada bond price jumped 5%, compared with just 2% during the last two years. By comparison, the broader S&P/TSX Composite

Index, weighed down by energy stocks, actually lost almost 1%, and the U.S. benchmark S&P 500 fared even worse with a 3% loss. 

But for an equally robust performance with far higher yields, corporate investment-grade bonds are an even better bet. The Bank of America Merrill Lynch Canadian Corporate BBB 5-10 Years Index gained 4% this past month but still carries an average yield of almost 3%, far better than the 1.3% you can get on a 10-year Government of Canada bond.

So why are bonds so reliable? Because bond payouts are fixed under legal contract. They are not discretionary. Payments must be made in full before dividends can be paid to shareholders. If an issuer runs into trouble and skips payment, then the company's credit rating can be cut. A lower credit rating means debt will need to be issued at higher rates to compensate investors for taking on more risk. As a result, the company will take on more debt expense. The expense can reduce earnings and, in turn, weigh on the share price. Given the many repercussions, a company does not want to tamper with its bond payments. 
 
Bonds have another safety feature that equities lack -- return of principal. At maturity, you get back the principal, which is usually the same as the issue price and represents most if not all of what you doled out in your original investment. Equities may gain value -- or lose value -- but if you hold bonds to maturity, you can count on preserving your capital. 

What about interest rates? It's true that if interest rates rise, you can incur an opportunity cost as newer bonds are issued at higher rates. The price of your bond also loses value to bring the yield more in line with going rates. Yields rise as bond prices fall. But if you hold to maturity, you don't actually lose money the way you would when a stock price falls. 

Laddering is also an appropriate strategy to combat rising interest rates. For example, say you buy a two-year, four-year and six-year bond. Then every two years, you can renew the maturing securities with a six-year bond so you get the higher rate offered on longer term investments. That way, you will always have securities that mature every two years. 

For today's screen, we looked for bonds that offered the highest yield for the greatest degree of safety we could find. We focused on intermediate-term bonds that mature in about two to five years, so you could benefit from higher rates than you would get from shorter-term maturities without tying up your capital too long. 

We also set our sights on corporate rather than government bonds. Corporates generally carry higher yields but also greater risk, so we focused on investment-grade corporates, with a minimum "BBB-" rating from Standard & Poor's or Canadian rating agency DBRS. To ensure you would benefit from return of principal at maturity, we eliminated bonds that converted to equity at maturity.

We searched out individual bonds, not bond funds. Funds do provide a diversified portfolio of bonds that can be traded as easily and transparently as stocks. The iShares Canadian Corporate Bond Index ETC (TSX: XCB) has 730 individual investment-grade Canadian corporate bonds. The fund carries a yield of better than 3% and charges a minimal management fee of 0.44% of net asset value. For a laddered portfolio, there's iShares 1-10 Years Laddered Corporate Bond Index ETF (TSX: CBH). 

These are just two of dozens of fund choices. For today's screen, however, in the interests of maximum yield for maximum safety, we set our sights on individual bonds that can provide the return of principal at maturity that funds do not. 

The individual bonds listed below are our top picks for maximum yield with maximum safety. All of them carry an investment-grade rating as senior unsecured debt of "BBB-" or higher.

Company (Cusip)  Feb 6. Price Yield Maturity Rating
Brookfield Asset MGMT (112585AB0) -- USD 108 5.4% 4/25/2017 A-
Brookfield Asset MGMT (112585AC8) 108 4.9% 4/25/2017 A-
Cominar ( 199910AH3) 105 4.1% 6/15/2017 BBB-
EnerCare Solutions ( 29270PAA4) 105 4.1% 11/30/2017 BBB+
TransAlta (89346DAC1) -- USD 112 5.9% 5/15/2018 BBB
Artis REIT (04315LAH8) 104 3.6% 3/27/2019 BBB-
 Dream Office(26153PAC8) 105 3.9% 1/21/2020 BBB-
Alimentation Couche-Tard (01626PAD8) 109 3.9% 8/21/2020 BBB
Reliance LP (759480AH9) 100 3.8% 9/15/2020 BBB-

All the bonds listed above are worth considering. We are especially interested in the TransAlta Utilities (NYSE: TAC; TSX: TA) note for its rich 6% yield, short three-year maturity and investment-grade credit rating. For U.S. residents who wish to avoid the potential currency volatility of Canadian dollar denominated bonds, this bond was issued in U.S. dollars and pays interest and principal in U.S. dollars. TAC is one of Canada's largest publicly traded power producers and marketers.

Risks To Consider: Each of the bonds above comes with different inherent risks. Like buying equity, before purchasing corporate bonds, be sure to fully vet the company.

Action To Take --> If you're looking to diversify your portfolio into international income plays, investment-grade Canadian corporate bonds are a safe bet. TransAlta's 6.65% bond offers a handsome yield for a three-year term and U.S. dollar interest as well as principal payments are secured by an investment-grade rating. If your broker doesn't have this particular bond in inventory, you may want to consider some of the other investment-grade bonds on our list. 

Each month StreetAuthority's premium newsletter High-Yield International highlights some of the best Canadian investments, like corporate bonds, in a column called Northern Lights. However, Canadian investments are just a fraction of the most lucrative international stocks available. In fact, if you're ignoring overseas markets, then you could be missing out on some of the market's biggest income opportunities. All told, we've found 93 companies paying 12%-plus yields -- and nearly a thousand more paying above 6%. For more information about High-Yield International and to get access to issues of Northern Lights (like the excerpt above), click here.

Deborah O'Malley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.