Strategies for a choppy bond market

Chong says that the yield curve on Government of Canada bonds is positive with shorter-term rates lower than long-term ones. But real interest rates on Canada issues (nominal rates adjusted for the rate of inflation) are negative along most of the curve. "These negative real rates of interest, which are not the historic norm, cannot persist."

Canada has fully recovered from the 2008 recession, "both recapturing the jobs that were lost and creating additional ones," says Chong. The same cannot be said for the United States, he says, which went into a recession earlier than Canada and continues to have a historically high unemployment rate of around 8%.

Furthermore, he says that in contrast to the United States, which experienced sharp declines in residential real-estate prices, Canada's housing prices held up well and have continued to climb. "Given the strength of Canadian real estate, you would expect Canadian interest rates to be higher than they are."

Rex Chong

Of the corporate-bond market, Chong says that Europe's well documented troubles plus concerns about the growth outlook for two major emerging economies -- China and India -- are having their impact. "This market tends to experience similar volatility to the equity market."

The spread on investment-grade corporate bonds (those with a rating of BBB or higher) is currently some 200 basis points above the rate on a basket of Government of Canada five- to-10-year bonds, says Chong. "The historic spread is 125 to 150 basis points."

Chong reports that he and his team are being "highly selective and patient in their corporate-bond strategy in the face of the choppiness in the corporate bond market." Their tactic is to wait for a downdraft in the price of a targeted bond, "so as to purchase it at our price point." To Chong, "an important value added is the Trimark fixed-income team's ability to assess corporate credit risk."

At Invesco Canada, Chong's wide-ranging fixed-income responsibilities include Trimark Advantage Bond  , Trimark Canadian Bond   and the fixed-income allocations of Trimark balanced funds. The team also manages Trimark Floating Rate Income  , a specialty income fund.

Trimark Canadian Bond's duration (a measure of the sensitivity of the price of the bond to a change in interest rates expressed as a number of years) is 5.9 years versus 6.7 for the DEX Universe Bond Index, the benchmark for the Canadian bond market. "This shorter duration is defensive and reflects our expectation that interest rates are headed higher."

At the end of May, Trimark Canadian Bond had roughly 37% in Government of Canada bonds, 6% Government of Canada agencies' bonds and 14% in provincial government bonds for a total of 57% in public-sector bonds. "Public sector debt is usually 50% or less," says Chong. "We would like to add more corporate debt, but are biding our time."

The fund's exposure to provincial debt is roughly half that of the weighting in the benchmark, he notes. "Provincial bonds have had a strong run and we took profits." The bulk of the fund's provincial holdings are in Government of Ontario bonds. "The spread over other provincial bonds widened as a result of Ontario's fiscal challenges."

Corporate bonds represented some 35% of the fund at the end of May, with 30% in investment-grade bonds and 5% in high-yield bonds. Chong is highlighting three investment-grade bonds to illustrate what he and his team look for.

One of the biggest corporate holdings in Trimark Canadian Bond is Reliance LP, which "is in the stable water-heater rental business in Canada." For Reliance's customers, this represents non-discretionary spending, he notes. The rentals are contractual and there is good cash-flow predictability.

"We also like the management team," says Chong. This security, which matures in April 2013, has been in the portfolio since it was issued in 2008. It has a BBB rating and carries a yield that is 300 basis points above the Government of Canada bond with the same maturity, says Chong.

Another defensive holding is Alliance Pipeline Limited Partnership, the Canadian entity. Trimark Canadian Bond owns an Alliance Pipeline security maturing in June of 2023. It carries a single-A rating and has a yield that is 245 basis points above the comparable Government of Canada bond.

The Alliance pipeline, says Chong, moves natural gas from northeastern B.C. and northwestern Alberta to Chicago. "The business is a contractual one and provides good cash-flow visibility for bond investors."

Alliance has the benefit of ship-or-pay contracts, "which mean that it gets paid under the contract whether the gas is shipped or not." The pipeline is constructed to transport both dry (traditional gas) and wet gas or liquids-rich gas. "This gives it flexibility; wet gas is more lucrative."

The real-estate developer First Capital Realty Inc. is another example, says Chong, of an investment-grade corporate-bond issuer in the portfolio. The security held by the fund matures in March of 2021 and has a rating of BBB. It offers a 245-basis-points spread above the comparable Government of Canada bond.

First Capital Realty develops and operates supermarket- and drugstore-anchored neighbourhood and community shopping centres located in growing urban areas across Canada. Its tenant mix focuses on consumer-staple retailers, says Chong. Management is "prudent in terms of mitigating development risk." Also, the company has "strong" debt covenants that help to limit the risk to bondholders," he says.

In keeping with their discipline, Chong and his team have taken profits and sold their holdings in Thomson Reuters Corp. and Corus Entertainment Inc. from Trimark Canadian Bond.