The sweet spot for fixed income at TDAM

This helps to determine the team's portfolio-construction strategy and its security selection. "There is a lot of math involved in our bond analysis," Pemberton says.

On the macro outlook, Pemberton says the developing world will continue to be the driver of global economic growth. "But the pace of that growth has been slowing." As for the developed world, the United States has the most promising prospects, he says, but even those are sub-par. "There remain concerns about the strength of the U.S. labour market, for example."

Within financial markets, the focus, he says, has been on the timing of the U.S. Federal Reserve Board's tapering of its purchase of US$85 billion in bonds a month, or US$1.1 trillion a year. This is known as its quantitative-easing program.

Robert Pemberton

This May, Pemberton says, certain Federal Reserve members suggested that it was time to begin paring back the bond purchases. They argued that the U.S. recovery was, at that stage, self-sustaining. "This prospect drove rates higher at the longer end of the yield curve, with the 10-year U.S. Treasury rate reaching 3%."

In September, the Fed did not taper. This "surprised" the financial markets, says Pemberton, and "brought interest rates at the longer end of the curve down from the levels registered at the height of the taper tantrum, but they are still higher than pre-tantrum."

The timing of the Fed's tapering remains uncertain, as are the amounts of each reduction in its purchases, says Pemberton. "But the expectation is that it will begin in early 2014 and occur gradually." The market also expects that the Fed's whole quantitative-easing program will finally draw to a close in the latter part of 2015, he says.

For the bond market, this means that central bank rates will likely remain "anchored" at low levels, at least until the end of 2015. "Medium and long-term rates will likely increase in the meantime."

From a yield-curve perspective, TDAM is underweight in longer-term bonds and has been shortening duration, say Pemberton. "Duration is an active, not a static number, and is part of our portfolio-construction strategy, a key goal of which is capital preservation."

The team's portfolio construction "remains focused on maximizing income, the most stable component of fixed-income total return and on minimizing the impact of prices, the more volatile aspect of the return."

TDAM's total assets under management are $250.5 billion, which include two flagship fixed-income funds: TD Canadian Bond   with assets of $10.4 billion and TD Canadian Core Plus Bond with assets of $5.8 billion, at the end of September.

In all, TDAM's fixed-income team is responsible for both active and passive fixed-income portfolios, as well as managing the North American suite of money-market portfolios.

TD Canadian Bond and TD Canadian Core Plus are benchmarked against the DEX Universe Bond Index, which covers investment-grade debt. These are securities that attract a BBB credit rating and above.

Each fund's duration is "at present marginally shorter than that of the benchmark," says Pemberton. Furthermore, each fund's average credit quality is slightly less than that of the benchmark. "This plays into our ability to assess credit and, as a result, enhance income."

Both funds, says Pemberton, have overweight positions in corporate bonds and are underweight in government securities. "This corporate overweight enhances the income of the two funds." Corporate-bond maturities are at the shorter end of the yield curve, he notes, while provincial and federal government bond maturities are at the longer end of the curve.

TD Canadian Bond focuses on investment-grade Canadian securities. By contrast, TD Canadian Core Plus invests in Canadian investment-grade securities at its core (a minimum of 70% of the fund) but has "more arrows in its quiver," Pemberton says.

TD Canadian Core Plus can invest in global investment-grade bonds, North American and global high-yield bonds, global inflation-linked bonds and emerging-market sovereign debt. This wide-ranging mandate also allows for the modest use of foreign currency positioning, another means of adding value.

Foreign content in TD Canadian Core Plus is currently 12%, versus the maximum of 30%. The foreign content is predominantly in high-yield securities, "due to current relative valuations," says Pemberton. "This Core Plus fund broadens the opportunity set, increases the scope for portfolio diversification and allows for income generation beyond the investment-grade market into the high-yield market." The whole Canadian fixed-income market at about $1.3 trillion is roughly equal to the U.S. high-yield market, he notes.

On the decision to overweight corporate bonds in the two funds, Pemberton says the yield spread above government securities compensates for corporate-debt risk at the shorter end of the yield curve. "As you move further out the term to maturity, the compensation decreases," he says. "We are overweight corporate bonds that have 10-year maturities and under."

The TDAM fixed-income team has a general preference for shorter-term corporate credit, he says. This allows for "greater clarity in assessing management strategy and the financial strength and stability of the business."

When it comes to government debt, these two funds hold provincial and federal debt in the 10-year-plus maturity categories, the longer end of the yield curve, he says. Of the provincial holdings, the largest positions are in Ontario and B.C. "We look for both yield and relative liquidity in our provincial holdings." In the portfolios, "these securities are used for liquidity, curve and duration positioning."