Yield spreads on top-grade corporate bonds are near historically low levels, and despite an economic slowdown and the threat of falling profits, those spreads are expected to remain low and could pose hefty risks for long-term investors, according to RBC Dominion Securities Inc.

"The current benign environment for the pricing of credit risks may thus plant the seeds for the creation of a credit asset bubble," said Myles Zyblock, chief institutional strategist and director of capital markets research for RBC.

The RBC report is based on the yields of collateralized debt obligations (CDOs), which are securities backed by portfolios of assets such as bonds, loans, securitized receivables and other asset-backed securities.

It also analyzes the yields on credit default swaps (CDSs), which allow bondholders to essentially buy insurance against credit risks from private investors.

"The robust tone in credit markets contrasts with the negative trend in credit risk indicators, including expectations for economic growth, credit ratings and default rates," Mr. Zyblock said.

Typically, when the economy slows after the end of the Fed tightening cycle, credit spreads on investment grade bonds widen by an average of 51 basis points as investors begin to price in the likelihood of more moderate profit growth, according to the report.

Currently the spread between investment-grade corporate bonds and government securities is about 170 basis points, up from 152 in March. The spread on junk bonds (speculative bonds) is about 370 basis points, compared with 500 to 800 points between 2000 and 2003.

A drop in bond prices, which would increase the spread, may be muted -- or delayed -- in the current cycle as a result of the continuing appetite for riskier securities as investors chase yields, the financially strong corporate balance sheets and continued earnings strength because of the healthy global economy.

The aggressive pricing of corporate bonds globally also comes as registered funds are diversifying after years of being locked into Canadian bonds by foreign content rules. About 68 per cent or $17.6-billion of Canada's corporate bond market, are in "Maples," which are domestic bonds issued in Canadian dollars by foreign companies, according to National Bank Financial Inc.

Some bond investors had expected credit spreads around the world would have widened as a result of the boom in leveraged buyouts and mergers and acquisitions, large-scale share buybacks that lower the cash on the balance sheets along with rising dividend payouts, according to the RBC report. But that hasn't come to pass.

RBC analysts also believe the "explosive" development of credit derivatives such as CDOs and CDSs have increased the potential institutional demand for debt and resulted in narrowing spreads, Mr. Zyblock said. The derivative products allow greater diversification of holdings.

The evolving credit derivatives market has allowed holders of less liquid assets such as bank loans to pass on their risk to other financial institutions.

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