Apocalypse now?

How bad is the economy going to get? Credit markets have been tightening and asset values falling around the world. Bill Gross, the famous bond manager, fears that we are witnessing “the breakdown of our modern day banking system.”

We don’t think the situation is quite that dire yet. But you should understand how we stumbled into the current problems—and how you can protect yourself going forward.

Let’s start with a bit of history. It is the nature of investors to seek higher returns. This works so long as risk and return are kept in balance—or, to put things another way, so long as fear and greed keep each other in check. Unfortunately, cheap money and complex financial engineering have distorted the balance between these forces.

Lenders traditionally had to keep a close eye on the capacity of borrowers to repay loans. Banks and other lenders knew that if they lent money to bad credit risks, they could have the loans turn sour on them.

But as interest rates fell in recent years lenders became more inventive in finding ways to make better returns. Among other strategies, they began to lend money to ever more precarious borrowers. A practice common in the U.S. was to offer mortgages at “introductory” rates that were set as low as possible. Just about anyone could qualify for a mortgage under such conditions and just about anyone did. Thus, the “sub-prime” mortgage boom was born.

Why would lenders push money into the hands of people who couldn’t afford to repay it? Because the lenders didn’t have to keep the loans. Investment bankers could repackage mixtures of high- and low-quality loans into collateralized debt obligations, or CDOs, and those CDOs could then be sold to other investors.

It now seems clear that the specialists who put together CDOs did not understand all the risk characteristics of such loans. Nonetheless, credit rating agencies gave high ratings to these investments.

Then the perfect storm hit. Inflationary concerns caused interest rates to rise just as the U.S. housing market slowed. Mortgages started to go into default. As asset values fell, so did the value of the complex securities based upon them. Investors began to run for cover as they realized they really didn’t know the underlying risks.

The rush to safety was reflected in the yield spread, which measures the difference between the interest rates charged to risky borrowers and the rates charged to less risky borrowers. Widening yield spreads generally indicate increasing anxiety. Corporate bonds had yielded only half a percentage point more than supersafe Government of Canada bonds in early 2007; by the end of September, that spread had widened to a full percentage point. Fears grew that we could be caught in a classic credit crunch in which lenders stop lending money—or demand higher and higher interest rates to do so—and the economy slides into recession.

That’s where we are now. So, what can a retail investor do? Start by realizing that risk and return are related. If you’re offered an investment that has a return substantially higher than riskless Treasury bills, don’t kid yourself—you’re taking on risk. If you want those higher returns, you have to be prepared to suffer losses. Be honest with yourself as to what your appetite for risk truly is, and how much you can afford to lose. Once you’ve established your tolerance for risk, make it a point to know what you’re investing in. If your adviser can’t explain it in plain English, don’t buy it.

Here are a few investments with competitive yields you may want to look at:

• Bank of Nova Scotia Preferred J (BNS. PR.J) at $24.75 yields 5.3%. Once you adjust for the tax advantages of dividends, holding these preferred shares is equivalent to having a bond that yields 6.8%.

• Consumers’ Waterheater Income Fund (CWI.UN) at $15.05 yields 8.5%. This income trust generates cash from renting water heaters. Its revenues are stable and its balance sheet is in good shape. Its capital expenditures increase incrementally with growth, so the trust won’t be forced to take on a load of debt to pay for them.

• Yields have declined on low-risk bonds such as Provincial or Government of Canada guaranteed issues. Still, you can get a reasonable yield of 4.7% by buying threemonth Banker’s Acceptances (BA s) from the major Canadian banks. BA s are shortterm investments that carry a major bank’s credit rating and yield more than Treasury bills. BA s should generally be available through your broker in $1,000 increments above $10,000.