When stock markets go through turbulent times, investors flock to the safety of government bonds. The rushto safety drives down the yield from these bonds and creates a problem
for people who rely upon them for income. These days, for instance, with government bond yields hovering around 3.5%, and average investment costs running about 1.5%, you’re left with next to no return from your investment after paying fees. The average bond fund that invests heavily in government bonds has become a ridiculously unattractive proposition. Fortunately, dark moments always have a bright side. The silver lining this time is that the recent sell-off in the bond market has resulted in some interesting opportunities for income-seeking investors.

I think one of the most tempting opportunities is in corporate bond funds. At a time when investors are treating corporate bonds like radioactive waste, my argument may seem counter-intuitive. But a successful investment strategy requires a mixture of boldness and caution. I think that right now is a good time to defy the herd instinct and load up on corporate bonds.

U.S. investors (and global investors, to a lesser extent) spent much of the past few years gorging on fixed-income investments backed by sub-prime mortgages in the U.S. These investments were supposed to be of investment-grade quality, which is a polite way of saying that they were supposed to be reliable, high-quality offerings with very few defaults.

Investors have realized only in recent months that the quality of these investments is far below investment grade. As a result, investors have run to safety and dumped any fixed income investment that was not a government bond. By doing so, they have pushed down the price of corporate bonds. When bond prices go down, yields go up. The net yield of a cheap corporate bond fund now ranges between 5% and 9%, depending on credit quality. This represents a mouth-watering advantage of 1.5 to 5.5 percentage points over government bonds, depending upon how much risk you are prepared to assume.

That risk is not to be ignored. With corporate bonds you face the risk that the issuer may default. If a default happens you lose some or all of your money. But
you can gauge the risk of such a disaster by looking at historical data. Consider, for example, investment-grade bonds. These are bonds issued by companies with strong
balance sheets. No more than 0.5% have historically gone into default in any single year. Given that those bonds yield a 1.5 percentage point premium over government bonds (which have a default risk close to zero), a corporate bond investor is likely to be left with a one percentage point advantage over government bonds after accounting for the risk of loss.

If you don’t mind taking on even more risk, you can spice up your portfolio with high-yield bonds issued by companies with weaker balance sheets. These are also known as non-investment grade bonds, or junk bonds. The average default rate of junk bonds has historically ranged between 1.5% and 10% a year. Defaults always decrease during good times and skyrocket during severe recessions, so with the U.S. now at risk of falling into a recession, analysts are predicting that the default rate on junk bonds may climb to 5% next year. To offset those potential losses, investors are demanding a 5.5 percentage point premium over government bonds to buy these high-risk bonds.

I believe that fears of mass defaults may be a tad exaggerated. So far, defaults have been limited and largely confined to subprime mortgages. While a U.S. recession is likely, it’s by no means certain that the downturn will be severe or long lasting. I believe that the accommodating monetary policy of central banks, particularly in the U.S., will help to stem corporate default rates. Even if your view is gloomier than mine, you have to admit that a 5.5 percentage point premium on junk bond yields is not a bad deal.

“Corporate climbers” (see table below) lists a handful of bond funds that are well positioned to take advantage of a turnaround in the corporate bond market. In addition, you should consider an exchange-traded fund that trades on the Toronto Stock Exchange. It’s the iShares Canadian Corporate Bond Index Fund (TSX: XCB) and it invests solely in investment-grade bonds. It was launched back in November 2006. The underlying portfolio’s average interest rate is 5% and the fund charges an extremely= small management expense ratio (MER) of only 0.40%, which is a percentage point or so less than most bond mutual funds. This would be my first choice for people who want broad exposure to the Canadian corporate bond market at the cheapest possible price.

If you’re looking for a higher risk alternative, take a look at the iShares iBoxx $ High Yield Corporate Bond Fund (Amex: HYG). This U.S. exchange-traded fund made its debut on the American Stock Exchange only last year. It invests in an index that tracks non-investment-grade bonds — junk, in other words. Its current yield is over 9%. In my view, investors who don’t mind a bit of risk should start building a moderate exposure to this fund — say, 10% or 15% of your portfolio. If yields go up further, you may want to consider adding even more to your position.

If you don’t like index funds, you may find something more to your taste in “Corporate climbers.” All the funds I’ve listed there are actively managed and their portfolio composition may tilt depending upon market conditions, but all are in the middle of the risk scale. I’ve ranked each of the funds on a five-diamond scale, with five being tops. One good pick is the Phillips, Hager & North High Yield Bond fund. Its current portfolio yield is around 5.6% after management expenses, reflecting a midway exposure between investment-grade bonds and their high-yield cousins.

Whether you prefer index funds or actively managed funds depends on your investing philosophy. In my view, by combining the two exchange-traded funds, you can achieve a portfolio blend similar to an actively managed fund, but at much lower cost. Remember that, with bond funds, the opportunity for spectacular gains is limited. Most of your return is the interest you collect, less management expenses. So cost matters.

Corporate climbers

These funds are well positioned to take advantage of the current
carnage in corporate bonds.