David Stonehouse, portfolio manager and member of the fixed-income team at AGF Investments Inc., says that while total returns from bonds are likely to be fairly muted, the investment case for this asset class remains intact. "The declining interest-rate environment, which began in the late '80s and gave rise to a spectacular bond bull market, is most likely behind us."
Stonehouse believes the expected rise in interest rates will be gradual. "The economies of North America and other Western developed nations are not yet strong enough to withstand an interest-rate shock." Their subdued growth will, he says, put a cap on interest rates.
There is some room, he says, for bond yields to rise, though a "significant increase in interest rates, say greater than 100 basis points, is unlikely in the near term." His call is that the price impact of the rise in interest rates on bonds will be "milder" than the financial market is anticipating and, as such, be insufficient to trigger "a stampede out of bonds." There could, he says, be a "gradual shift" to other asset classes.
Total returns from Canadian bonds for the 12 months to the end of March this year were low by recent historic standards, Stonehouse notes. The DEX Universe Bond Index, the benchmark for the Canadian investment-grade fixed-income market, had a total return of 0.84%.
This low return, says Stonehouse, reflects "the spike in market interest rates last summer prompted by talk in May about the expected U.S. Federal Reserve Board's tapering program." For the first quarter of 2014, the DEX Universe's total return "was an improved 2.77%." This reflected an easing of interest rates "as fears in the fixed-income market regarding the timing of this program had subsided."
Looking back five years, the DEX's 12-month total return to the end of March 2014 of 0.84% was lower than the average annual return for the past two years of 2.67% and significantly lower than the five-year number to the end of March of 5.04%.
Looking ahead, Stonehouse considers that the total return outlook for Canadian investment-grade bonds could be on average 2% to 3% per annum for some time. This estimate reflects, he says, a continuing historically low coupon-rate environment, despite rising interest rates, and the possibility of a modest hit to capital due to these rising rates.
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Still, he emphasizes, the case for investing in fixed-income securities remains intact. "The single most important reason is risk mitigation; there is downside capital protection. Though it is not absolute, it is there."
Of the outlook for stocks, Stonehouse says he has been concerned about a possible significant correction in developed-market equities after their strong performance over the past few years. "This brings me to the case for diversification between asset classes, the hallmark of a prudent investment portfolio."
Finally, he notes that Canadian demographics are such that many investors are looking to fixed-income investments to provide them with a steady source of income.
An investment manager for 18 years, Stonehouse has both a degree in engineering and an MBA. Before joining AGF, he was a senior member of the team at Acuity Investment Management Inc. which, along with Acuity Funds Ltd., was acquired by AGF in early 2011.
At, AGF, Stonehouse is responsible for a wide range of income-generating mutual funds including AGF Fixed Income Plus, AGF Diversified Income and AGF Diversified Income Class. His discipline is to assess the big economic picture, with a focus on interest-rate movements, and couple this with a bottom-up approach to security selection.
AGF Fixed Income Plus, benchmarked against the DEX Universe Bond Index, is required to hold at least 70% in investment-grade bonds, with a minimum of 25% in government bonds. "This portion is designed to be conservative," says Stonehouse.
In addition, the fund can invest in high-yield bonds, convertible debentures, income trusts (including real estate investment trusts), emerging-market bonds and municipal debt. "These are the fund's alternative income-oriented investments," he says.
At recent count, AGF Fixed Income Plus had 31% in government bonds, 19% in provincial bonds and 36% in corporate investment-grade bonds. This made for a total of 86% in investment-grade securities.
The alternative-investment category represented 12% of the fund, reflecting, in the main, a weighting in high-yield bonds followed by a lesser weighting in convertible debentures. "No income trusts have been held in the fund in the last few years," he says. Cash was 2%.
The duration of this fund was 6.5 years, which is slightly lower than the duration on the DEX Universe Bond Index of 6.8 years at the end of March. (Duration measures bond-price sensitivity to changes in interest rates.)
The DEX Universe Bond Index is, says Stonehouse, highly interest-rate sensitive. The broader scope of AGF Fixed Income Plus reduces its interest-rate sensitivity and provides an opportunity to enhance returns, he says. "For example, in the case of high-yield bonds, performance is driven more by credit quality and less by interest rates and the yields on these securities are higher."
The risk premium on high-yield bonds versus government bonds is currently around 400 basis points, says Stonehouse. During the global financial crisis the interest-rate spread reached 2,000 basis points. This is high by historic standards, he says, since the more normal spread during a recession is around 1,000 to 1,400 basis points. At their tightest, during the peak in the economic cycle, these spreads can be as narrow as 250 basis points, he says.
Stonehouse reports that since the beginning of this year, he has been lowering the weighting in high-yield bonds and convertible debentures in AGF Fixed Income Plus. He has been investing the proceeds of these sales mainly in Canadian government securities and modestly adding to the fund's holdings of investment-grade corporate bonds.
Of the high-yield bonds, he says, the default rate in these securities is not rising, but the reduction in weighting was the result of an evaluation of individual securities. Of convertible debentures, he says a correction in the equity market would make these securities less attractive. "The equity market looks vulnerable in the near term."
On the whole, Stonehouse says, it is a time to be more conservative or defensive, since the Fed's tapering is a headwind for the financial markets.
