The decision by the Bank of Canada to raise interest rates in July came as a surprise to Steve Locke, senior vice-president and head of fixed income at Toronto-based Mackenzie Investments. He believes that, as the central bank continues to tighten monetary conditions, greater flexibility will be required to generate income and preserve capital.
"The Canadian economic picture had been reasonably strong although not with any inflationary trends that might cause a policy change. But the Bank of Canada did surprise us. And clearly you could see that it surprised the market as well," says Locke, who heads a team of 18 investment professionals that oversee about $18 billion in fixed-income assets. "It was a shock to the system and to the yield curve."
Locke notes, for instance, that the two-year bond yield jumped from 65 basis points (bps) to more than 100 bps. He says expectations of three interest-rate hikes over the next 12 months are priced into today's yield curve. That means overnight rates could jump to 1.5% by the summer of 2018.
"We thought that with a little softer growth and some political headwinds in the U.S., the Bank of Canada would be on hold for the rest of the year, and not do much, given the low-inflation environment at home," says Locke, whose mandates include the $227-million Mackenzie Strategic Bond SC. "The two emergency rate cuts in 2015 were due to the declining oil price and the headwinds it caused to the economy, especially in the more oil-dependent provinces."
Locke believes that after this week's rate hike, a second rate increase will come in early 2018. But this depends on the U.S. budget debate. "As we move toward the debt-ceiling debate in the U.S., will markets become nervous around the potential shutting down of the U.S. government? Will the debate threaten a temporary default on U.S. Treasuries?" Such an event might see risky assets such as high-yield bonds fall, he believes, but government bond yields will rise as investors look for safety.
Even as short-term bond yields are creeping higher, Locke maintains that the interest-rate environment will remain relatively low. "It may not be as low as a year ago, but it will likely be lower than in the prior decade," he says. He notes that in 2007, the U.S. federal funds rate was 5.25%, and the 10-year U.S. Treasury yield was around 5%. "You have to think about where the Fed funds rate can go in this cycle. The Fed itself has projected that the rate may go as high as 3%. That's far below the previous cycle.”
As active managers, Locke and his team manage interest-rate risk, which means shortening duration, or changing the positioning along the yield curve, or using other instruments that are less sensitive to changes in interest rates. "It's the combination of those three things that give us a defensive characteristic in our portfolios.”
Currently, about 47% of Mackenzie Strategic Bond's assets are held in investment-grade corporate bonds. The so-called "plus" aspect of the portfolio is reflected in 10% in a mixture of high-yield bonds and floating-rate loans. The latter is primarily made up of U.S. corporate loans, which are sourced from a liquid market worth about US$900 billion. The remainder of the portfolio is comprised of an amalgam of provincial bonds, Government of Canada and U.S. Treasury bonds. About 30% of the fund is in non-Canadian securities, whose exposure is hedged back to the Canadian dollar.
The non-investment-grade portion of the fund, says Locke, helps to deliver a higher yield than the benchmark FTSE TMX Canada Universe Bond Index. Overall, the portfolio has a running yield of just over 3%, before fees, versus 2.3% for the index.
Moreover, Locke notes that Mackenzie Strategic Bond's standard deviation has been lower than the Canadian bond market since its inception in May 2013. "It uses asset classes, such as floating-rate loans, which are less correlated with interest-rate risk. This is a robust way to manage interest-rate risk and deliver a higher yield to investors."
The other tool employed by Locke is managing duration -- a measure of sensitivity to interest-rate fluctuations. The fund's duration is 6.9 years, or 0.4 years shorter than the index's 7.3 years.
The fund's returns have been modest: 1.3% for the eight months ended Aug. 31, compared to 0.2% for the Canadian Fixed Income category, and an annualized 2.4% over three years, versus 2.2% for the category. However, Locke argues that fixed-income funds play a vital role.
"We are always looking to generate income and total return. But the product serves a purpose from a capital-preservation perspective," Locke says. "If investors added the bond product to their overall balanced portfolio they would get the counter-balance to an equity-market decline. That's an important context for understanding the use of bond funds -- even in a low-yield environment such as we've experienced for some years and are likely to continue to be in."
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