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If you're the right sort of investor, beaten-down blue-chip companies are starting to look like a smart buying opportunity.

Not the shares of these companies. That's a story well told already. Today, we're talking about bonds.

You may be aware that bonds have stood up comparatively well to the recent financial market turbulence, but have you noticed a key subtlety? Government bonds are hanging in, but corporate bonds are not. In fact, bonds issued even by solid blue-chip companies have fallen by shocking amounts in the past while.

“In some senses, corporate bonds have been harder hit than the equity markets,” said Hanif Mamdani, a vice-president at Phillips Hager & North Investment Management.

For an example, he uses a five-year Royal Bank of Canada bond. Over the past 10 years, this bond would have typically offered a yield that was about half a percentage point higher than an extremely safe five-year Government of Canada bond. In the financial market turbulence of the past month or so, the so-called spread shot up as high as three percentage points.

Bond prices move inversely to yields, which means the price of RBC bonds has plunged lately. Here's some context to show how severe the move has been. In the 1998 Russian debt crisis, the spread between the RBC bond and the Canada bond got close to a full percentage point. In the mini credit crunch of 2002, when Enron and Worldcom went bust, the spread got close to 0.75 of a point.

Higher spreads means you're taking on more risk in owning corporate bonds, but also getting higher returns. As Mr. Mamdani puts it: “There's a bit of an opportunity in all this carnage in the markets.”

His said there are two reasons why corporate bonds have plunged, the first of them being a fear of rising defaults as the economy weakens. The other reason has to do with the fact that corporate bonds were a component of those highly complex investment vehicles that the financial industry has been choking on lately. As these vehicles are being wound down, a glut of corporate bonds is hitting the marketplace.

Default risk is the prime consideration for individual investors buying corporate bonds. Companies must pay interest to their bondholders before they pay dividends to both common and preferred shareholders, so there is a greater safety margin in owning corporate bonds versus stocks. But defaults do happen, albeit rarely here in Canada.

Bond rater DBRS issued a study earlier this year that cited a total of 32 defaults from 1976 through the end of last year. By Canadian standards, two or three defaults in a year is high. The worst year tracked in the study was 1991, when four defaults were recorded.

Among the companies to default on a long-term bond issue include Canadian Commercial Bank and Northland Bank in 1985, Algoma Steel in 1991 and again in 2001, Olympia & York and Trizec in the early 1990s, Loewen Group in 1999 and Dana Corp. in 2006. So far this year, two Canadian companies have defaulted – Tembec and Quebecor World.

Another measure of distress in the corporate bond world is the prevalence of companies having their bond rating downgraded. DBRS says an above-average level of downgrades would mean that more than 10 per cent of the companies it covers are being lowered. The tally of downgrades was 7 per cent last year, up from 5.2 per cent in 2006 and 4.8 per cent in 2005. DBRS expects downgrades to increase as the economy weakens.

One way to protect yourself against default risk is to stick to bonds that are issued by the companies with the best credit ratings. Pension funds won't touch bonds that are below investment grade, which requires a rating of triple-B (low) from DBRS, triple-B-minus at Standard & Poor's or Baa3 at Moody's.

Another way to limit default risk is to buy instant diversification through an exchange-traded fund that invests in corporate bonds. There's a corporate bond ETF for both the Canadian and U.S. market, and each focuses on investment-grade bonds.

In the mutual fund world, most corporate bond funds tend to hold a lot of high-yield bonds, where the ratings are below investment grade. Default risk is substantially higher with high-yield bonds, which explains why they've been absolutely savaged lately. For somewhat conservative investors seeking a reliable stream of income, investment-grade corporate bonds make more sense.

A few mutual funds for corporate bond exposure are Bissett Corporate Bond, a tiny fund that focuses primarily on investment-grade bonds; PH&N Total Return Bond, with almost two-thirds of its assets in investment-grade debt (the rest is largely government bonds); and, TD Corporate Bond Capital Yield, with just under 20 per cent of its assets in high-yield debt and the rest in investment-grade corporates and a sprinkling of government bonds.

Buying your own corporate bonds is tricky because of the way that investment dealers, notably discount brokers, tend to gouge clients buying bonds. Prices are high, which means yields can be surprisingly low. One online broker was selling a four-year Government of Canada bond with a yield of 2.4 per cent this week, and a comparable bank bond with a yield of 4.4 per cent. It shouldn't be too difficult to find a four-year guaranteed investment certificate with a comparable yield that would come with the added bonus of deposit insurance.

Higher-yielding corporates are certainly available, even with an investment-grade weighting. But be mindful of the risks you're taking on because of economic weakness. Mr. Mamdani of PH&N said industrial and retailing companies would be the most vulnerable to a recession. Infrastructure bonds – issued by airport authorities, for example – are a less risky choice. At the top of his list are financial companies, specifically the big banks and insurers.

Mr. Mamdani said bonds issued by financial companies offer higher-than-usual yields, and the opportunity for capital gains once financial markets calm down and investors stop penalizing corporate bonds to the extent they are now.

“The areas of greatest opportunity, and perhaps safety, are some of our biggest financial institutions in Canada,” he said.