Editor's note: Coverage of our roundtable on fixed-income investing concludes today with the managers discussing how they're positioning their portfolios to beat their market benchmarks. They spoke to Morningstar columnist Sonita Horvitch, author of this week's exclusive three-part series.
Our panelists:
Michael McHugh, vice-president and head of fixed income at GCIC Ltd., the sponsor of the Dynamic stable of mutual funds.
Steve Locke, team lead of the Mackenzie Sentinel funds at Mackenzie Investments and responsible for a wide range of fixed-income mandates.
Brian Miron, who is based in Merrimack, N.H., and is a portfolio manager for Fidelity Investments in the fixed-income division of Fidelity Management & Research Co.
Q: Time to discuss your portfolios?
Locke: At Mackenzie, the strategy in our investment-grade fixed-income portfolios is to overweight corporate issuers for the long term. We build sustainable risk-adjusted total returns based on our fundamental bottom-up credit decision-making. The corporate-bond weighting is sometimes double the weighting in the DEX Universe Bond Index. Over the past year or so, we have reduced this. We had a weighting of 50% to 55% and it is now down to around 40%, including securitized debt -- commercial mortgage-backed securities and asset-backed securities at 9%. Besides this corporate weighting, Mackenzie Sentinel Bond, with assets of $1.3 billion, has about 30% in provincial bonds and municipal bonds. Its big underweight is the 30% in Government of Canada bonds.
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| Brian Miron, Michael McHugh and Steve Locke | |
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Some of the yield advantage between corporate bonds and other credit sectors has eroded. Spreads have narrowed and corporate bonds have performed well. We have traded away from corporate bonds and, at the same time, reduced our credit risk. An example is a trade away from a corporate utility bond to a bond of the province where the utility is domiciled.
The volatility around certain corporate bonds in areas of the market that are less liquid has increased. It is this liquidity risk that has also driven our reduction in corporate bonds, as well as the narrowing of spreads. The spread for provincial bonds has expanded and these bonds offer good liquidity. Our biggest provincial weightings are firstly Ontario and secondly Quebec, the two biggest provincial issuers. They represent 90% of our provincial-bond holdings.
McHugh: Ontario, despite its warts, is deemed to be a fairly strong destination for capital. Dominion Bond Rating Service has Ontario at AA (low) and Quebec at A (high), one notch different. There is a scarcity of AAA securities globally and strong AA debt securities are also in high demand. Ontario is in this universe.
Q: Steve, what about duration? (This captures the impact of both the bond coupon rate and its time to maturity on the bond's market-price volatility, if interest rates change. It is expressed in years.)
Locke: The duration of the DEX Universe Bond Index is 6.9 years and we are close to that.
Q: Brian?
Miron: Fidelity Canadian Bond had $6.5 billion in assets at the end of August. We are active fund managers and will overweight and underweight individual names and sectors based on a combination of top-down and bottom-up fundamental research. We have roughly 35% in corporate bonds and 8% in structured products -- asset-backed securities and commercial mortgage-backed securities. Both are overweight positions relative to the benchmark. We are underweight provincial bonds at 21% versus 29% in the index and have 3% to 4% in municipal bonds. The remainder is federal government securities at roughly 35% versus 43% in the index.
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| Brian Miron, Michael McHugh and Steve Locke | |
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We have taken the allocation to corporate bonds down over the past six to nine months. We took our exposure to the provinces up more recently, as provincial spreads had widened. If we get another increase in provincial spreads, we would be interested in further increasing the allocation to provincial bonds. The portfolio is underweight Ontario and underweight Quebec.
Locke: Mackenzie Sentinel Bond is slightly overweight both provinces.
Miron: Fidelity Canadian Bond has an overweight position in three Atlantic provinces -- Nova Scotia, Newfoundland and P.E.I., as well as in Manitoba. We are underweight British Columbia and Alberta. Ontario's 10-year spreads are about 95 basis points above Government of Canada 10-year bonds. They were as wide as 105, pushing 110 basis points. They have come in about 10 basis points over the past couple of months. B.C. and Alberta's spreads over Government of Canada bonds would be closer to 80 to 85 basis points. These two provinces have a higher credit rating than Ontario. Quebec would be a little less than 20 basis points above Ontario, 105 to 110.
Q: Brian, duration?
Miron: We manage the duration to be similar to that of the index, which is about seven years. We can lean long or short of that by about one third of a year. Our constraints are tighter than Steve's.
Locke: We can alter duration significantly. We have not over the past year. We are reticent to take our duration long in this environment, as this is adding rate risk to the portfolio.
Q: Michael, Dynamic Canadian Bond?
McHugh: The philosophy that drives our portfolio construction is active risk management. We identify where the principal risks reside within the debt markets and mitigate those risks. I consider that the principal risk to capital preservation now is that of duration risk, [associated with longer-term lower coupon bonds.] The duration in Dynamic Canadian Bond is currently 4.5 years. The strategy is to have low duration and lower credit quality. We see the duration risk as being much greater than the credit risk. With the low-yield environment, the percentage-spread differential of a corporate bond provides a historically attractive relative-risk allocation within the context of our fundamental credit assessment.
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| Michael McHugh and Steve Locke | |
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We have about 30% of the portfolio in provincial bonds, which reflects additions beginning in late May. We also have about 15% in provincial floating-rate notes. This is the result of the selling of longer-duration Government of Canada bonds and buying floating-rate notes. These notes are principally Government of Ontario and Government of Quebec. In the provincial-bond component, excluding the floating-rate notes, we have large relative weightings in B.C. and Saskatchewan. We have about 12% in Government of Canada securities and have 43% in corporate debt. Within the corporate holdings, probably the biggest difference between this fund and other Canadian bond funds is that we do not have any financial issuers.
Q: The financials make up almost 50% of the corporate-bond segment in the DEX Universe Bond Index and 13% of the index as a whole.
Locke: Financials represent 35% of our corporate holdings and 13.5% of the total portfolio.
Miron: We have 18% of our total portfolio in financials. Our corporate holdings represent 35% of the total holdings. So financials represent roughly half of that, with an emphasis on the Big Six banks. The Canadian banks are strong and have become even more so since the financial crisis.
McHugh: We are steering away from business models that are dependent on financial leverage. We are in a world that has excessive debt. The financial institutions, as major lenders, have some loans on their balance sheets that may not be repaid. The European banking system is currently most at risk. We saw in 2008 that there is no such thing as a localized banking crisis. The global banking system is inter-connected and the crisis tends to spread. The Canadian banks are fundamentally strong and have implicit government backing in a time of crisis. But in a distressed time, bank debt would become more volatile and our view is that you are not being paid an adequate premium for the risks associated with this debt.
Photos: paullawrencephotography.com
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