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Bond investors face headwinds from central banks

Canadian market could outperform U.S., Dynamic managers say.

Sonita Horvitch 28 March, 2018 | 5:00PM
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Michael McHugh, vice-president and head of fixed income at 1832 Asset Management L.P., says that the team's analysis points to low returns from the bond market this year. "This reflects the headwind of rising bond yields, as central banks continue to reverse their ultra-easy monetary policy measures in the face of stronger global economic growth."

In this changed interest-rate environment, there is the potential, McHugh cautions, for lower returns from corporate bonds. These bonds have for some time been favoured by investors seeking income, he says. "In all, this makes a strong case for active management to mitigate losses and improve returns from fixed-income securities."

While the outlook for returns from the bond market on both sides of the border is modest, he says, it's possible that the Canadian bond market could outperform its U.S. counterpart over the course of this year.

Coming into 2018, "investors were underestimating the level of risk in the fixed-income and other financial markets," says McHugh. The subsequent volatility in both the equity and the bond markets highlighted the need for caution, he says.

Domenic Bellissimo, vice-president and portfolio manager (who heads up corporate credit for the fixed-income team), points out that at the end of January, the difference between the yield on government bonds and corporate bonds, (known as the credit spread), had contracted to its lowest level in a decade. "This was indicative of a lot of optimism among fixed-income investors."

Since the February selloff in the equity market, these credit spreads have widened, says, Bellissimo. "This is a valid move and it has been orderly," he says. "It is important to note that although credit spreads have widened and could continue to do so, corporate earnings growth, a key underpinning of corporate debt, remains strong."

Over the 12 months to the end of February, the Canadian bond market certainly produced a lacklustre performance. The FTSE TMX Canada Universe Bond Index, the benchmark for Canadian investment-grade securities, which carry ratings of BBB and higher, produced a total return of 1.01% for the 12 months to the end of February 2018.

Michael McHugh
Michael McHugh

Provincial bonds, with a weighting of 33.6% at the end of February, produced the strongest performance over that period with a 2.26% total return. The corporate sector, which had a weight of 28% at that date, recorded a total return of 1.72%.

Government fixed-income securities (with a weighting in the index of 36.6%) were the poorest performers. They produced a negative total return, losing 0.73%.

McHugh explains that this modest performance was a reflection of rising yields across the yield curve. "The central banks on both sides of the border have moved from an accommodative stance to a more hawkish stance in the United States and less so in Canada," says McHugh.

On March 21, the U.S. Federal Reserve raised its federal funds rate by 25 basis points (one basis point is one hundredth of 1%) to bring it to 1.75% and indicated that another two rate hikes were likely in 2018.

"The new Fed chairman, Jerome Powell, appears to be more aggressive in removing monetary policy accommodation than his predecessor Janet Yellen," says McHugh. The bond market, he adds, had anticipated this move and the yield on 10-year U.S. Treasuries, at around 2.9%, hardly changed. "Since early February, this yield has been going sideways."

Both the U.S. policy rate and the benchmark 10-year bond yield are higher than the comparables in Canada, he says. The Bank of Canada's target overnight rate is 1.25% and the yield on 10-year Government of Canada bonds is 2.27 %. "The Canadian bond yield has declined slightly since early February, he says.

At the Bank of Canada's March 7 meeting, governor Stephen Poloz announced that he was maintaining the policy rate. Poloz is "responding to the uncertainty over the North American Free Trade Agreement and the lingering concerns about the elevated level of Canadian household debt," says McHugh.

Domenic Bellissimo
Domenic Bellissimo

In managing its fixed-income mandates, Bellissimo reports that the team has been "selectively" reducing its holdings of those U.S. corporate bonds that have done well. The reasoning, he says, is threefold and ties into the macroeconomic picture of Canada versus the United States.

Firstly, he says, there is the prospect that U.S. bond yields will rise faster than Canadian bond yields, representing a greater headwind for U.S. bonds versus Canadian bonds.

Secondly, says Bellissimo, increased merger and acquisition and leveraged-buyout activity can be expected in the United States. These corporate actions are typical of the later stages of the credit cycle and tend to result in additional corporate borrowing, he adds. "Historically, U.S. companies have been more aggressive in these M&A activities than their Canadian counterparts."

Finally, says Bellissimo, those U.S. companies seeking to repatriate their foreign cash holdings following the recent positive change in U.S. tax law, might, as a result, sell their investments in U.S. corporate bonds. This move, along with expected increased M&A activity, could add to the supply of U.S. corporate bonds.

The yield curves on both sides of the border have been flattening, says McHugh. He points out that additional rate hikes by the Fed should keep the U.S. yield curve flat, "provided that the demand for longer-term bonds persists."

As for the Canadian yield curve, McHugh notes that Canadian short-term interest rates have been rising more than longer-term rates, which has contributed to a flattening of the curve. Longer-term yields have been suppressed, he says, by the net demand for longer-term fixed-income securities by institutional investors, such as pension funds and insurance companies.

At 1832 Asset Management, McHugh and his team manage a wide range of fixed-income mandates including Dynamic Canadian Bond and Dynamic Advantage Bond. The former is a predominantly Canadian portfolio of investment-grade securities. The latter is also a core Canadian bond fund, but has more latitude.

At mid-March, Dynamic Canadian Bond had 39.6% in federal fixed-income securities including 3.8% of the portfolio in real-return bonds, (which pay a rate of return that is adjusted for inflation), 30.8% in provincial bonds and 29.6% in corporate bonds.

By contrast, at that date, Dynamic Advantage Bond had 26.2% in federal government issues (including 16.1% of the portfolio in real-return bonds), 20.1% in provincial bonds and 53.7% in corporate bonds. Of the corporate bond holdings in this fund, investment-grade bonds represented 50.1% of the portfolio and high-yield bonds were 3.6%.

The duration on both funds was 5.25 years in mid-March. The fixed-income team increased this duration last fall and early this year, says McHugh, moving out of cash and short-term securities.

Still the portfolios' duration is lower than that of the FTSE TMX Canada Universe Bond Index, which was 7.36 years at the end of February. (Duration is a measure of the sensitivity of the price of a fixed-income security to a change in interest rates, expressed as a number of years.)

Within the corporate component of both funds, the bias remains toward high-quality issuers, says Bellissimo. "At this stage, adding credit risk by investing in lower-quality names would be premature, as the market is not yet compensating investors sufficiently for this."

Of the sectors, the team likes financials, says Bellissimo, "due to the solid economic backdrop." Higher-quality real estate investment trusts and pipelines are another focus, he says. "Both benefit from a high degree of contractual revenues." Another emphasis, he says, is Canadian cable and telecom companies, "given their stable performance and the expected lack of supply of these securities this year."

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Sonita Horvitch

Sonita Horvitch  

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