Corporate Bonds for an RRSP or TFSA in 2009 - an Opportunity?

Investors may be wondering what to buy in the new Tax-Free Savings Account (TFSA) that started up January 1st or in their RRSP account. One intriguing possibility right now is corporate bonds. Why?

1. Tax - the tax-exempt status of the TFSA or the tax-deferred RRSP makes it reasonable to hold within them such bonds, since they produce income in the form of interest, which is taxed at highest marginal rates
   
2. Higher Returns Than Usual - compare current rates

• Cash deposit rates of about 2% and 5-year GICs of 2-3% (see rates on Canoe)
  
• Government of Canada bonds at just over 2%,
  
• Yields on bonds of the highest-rated corporations > 4%, e.g. Bank of Montreal as of February 5th maturing April 30, 2014 yields 4.2% (see rates for 2014 maturity on Canadian Fixed Income).

The credit crunch crisis that started in 2007 and reached a peak in October 2008 caused severe market dislocations and has created this potential opportunity.

The chart below of two ETFs that track Canadian government bonds (iShares XGB on TSX) and corporate bonds (XCB) illustrates a dramatic change in relationship.

Up to mid 2007 the price of the two funds closely followed each other. Then XCB began to fall - a fall in bond prices means the yield has gone up (see Investopedia's Bond Basics: Yield, Price and Other Confusion) and now there is a huge gap. The lower the quality of the bond (as measured by ratings of bond rating agencies such as Standard and Poors, DBRS and Moody's, the higher the yield. Lower-rated but still investment grade Bell-Aliant's 2014 bond now yields 6.7%.

Recession and Default Risk
Recessions are bad times for ordinary people and they are bad for business too. Profits disappear and corporations fail, resulting in some bonds going into default with an investor having to face whole or partial loss of capital. The big question is whether markets have over-reacted and the risk of default has now gone up to the extent prices seem to suggest. Is it likely the Royal Bank or Bank of Montreal will go under, or Bell-Aliant? These companies have continued to pay handsome dividends yet they are legally bound to pay bond interest before dividends. If there isn't enough money down the road, dividends will be cut first.

Though the past is never an absolute guide to the future the table below from a memorandum published on the website of the Canadian Institute of Actuaries and covering periods of past recessions shows that from 1989 to 2007 there has not been a default by a Canadian corporation rated A or higher. .... There's always a first time though.
Corporate Bond Choices
There are several ways to buy bonds. All are available through discount brokerages.

1. Individual bonds - under trading or quotes sections, look for fixed income and narrow the search to corporate; minimum purchase is usually $5000
   
2. ETFs - iShares Cdn Corporate Bond Index Fund (TSX: XCB) with 252 different bonds of varying maturities, all of investment grade; currently yielding 5.7%
3. Mutual Funds - only a few seem to specialize in corporate bonds as most hold a balance of government and corporate bonds; some that do specialize - Bissett Corporate Bond Series A (mostly Canada, some US), Quadrus GWLIM Corporate Bond (holdings with "high level of coupon interest income consistent with reasonable of safety of capital")

Of course, the above is not investment advice from me, it just input for you to consider in making your own decision, as all self-directed investors should do.