Corporate bonds took a beating over the winter, as fixed-income markets priced in a worsening economic environment and spreads over government bonds widened. Yet despite the market's skeptical tone, Thomas O'Gorman, senior vice-president and director of fixed income at Calgary-based Franklin Bissett Investment Management, argues that corporate bonds are more attractive than they have been in years.
"When we look at any investment we look at three things: the fundamentals, valuations and technical factors such as supply and demand and liquidity," says O'Gorman, lead manager of the flagship $2.4-billion Franklin Bissett Core Plus Bond. "When you think about corporate credit, it's been a very long credit cycle and that's partly because central banks have been working hard to support economies in the post-crisis environment. That's allowed many companies to re-finance themselves at very low rates."
From a fundamental perspective, the broader corporate sector is in good health, although the energy and materials space is facing hard times and its defaults are starting to turn up, says O'Gorman. "We do a lot of bottom-up work and do not believe we are in the late stages of the credit cycle. We're in the sixth or seventh inning -- and certainly not the ninth."
Last fall, though, conditions started to turn gloomy when China suddenly devalued its currency, in a move to stabilize exports. That, combined with a prominent U.S. fund-management firm that in December closed its corporate-bond fund to redemptions, and the swooning price of crude oil, sent investors scurrying for shelter. "Spreads got as cheap as they have been for years," says O'Gorman, noting that spreads on Canadian BBB-rated bonds rose as high as 250 basis points (bps) over government bonds, versus 130 bps at the tightest point earlier in the year.
"It was an illiquid time and sentiment was extremely negative," recalls O'Gorman, who joined the unit of Toronto-based Franklin Templeton Investments in 2010 and now oversees about $5 billion in fixed-income assets.
Toward the end of February and through the end of March, credit spreads tightened significantly, recouping all of the widening from earlier in the year, says O'Gorman. He noted that commodity-oriented issues were among the best performing. Still, the asset class has a long way to go before it recoups its losses from 2015.
What investors should be aware of is that, given that the average yield on 10-year government bonds is 1.22%, the spread as a percentage of the all-in yield is very high, says O'Gorman. "So when a spread that as a percentage of yield is in excess of 70% -- which is where we were in February -- that's a really high portion of yield that is coming from the spread versus just the underlying benchmark. Anytime we've seen that in the past, credit has tended to outperform. This time is no different."
Previous instances when credit became cheap occurred in the fall of 2011, when the European sovereign debt crisis boiled over and U.S. government debt was downgraded, and the 2008-09 global financial crisis. "All had different factors behind them," says O'Gorman. "But all drove spreads to high levels."
O'Gorman, who works with a team of six in Calgary and relies on the broader Franklin Templeton fixed-income team of 160 investment professionals, has increased the fund's corporate-bond weighting to about 57% of assets. The remainder is held mostly in provincial bonds.
At the same time, he's been modestly defensive on interest-rate risk. The fund's duration -- a measure of sensitivity to changes in interest rates -- stands at about seven years, versus 7.6 years for the benchmark FTSE TMX Canada Universe Bond Index.
With a focus on a company's fundamentals, such as the quality of management, cash-flow-generating strength and low debt, O'Gorman likes investment-grade bonds issued by some battered resource players such as Canadian Natural Resources Ltd., Husky Energy Inc. and Cenovus Energy Inc. "The weakening of this sector was way over-done," he says.
O'Gorman also holds bonds issued by real estate investment trusts. "At one point, REITs were cheaper than investment-grade energy. Not now. But they were for a while during the risk-off period in late 2015." Among the bond issuers that O'Gorman likes are Smart REIT and H&R REIT.
Though Franklin Bissett Core Plus Bond lagged its peer group last year and in early 2016, O'Gorman is upbeat. He points to an improvement in performance stemming from the credit rebound in March. "We don't take this risk for free," says O'Gorman. "We earn a large yield advantage over the benchmark. At the peak in yields, our yield was 4%, or double the benchmark's 2% yield. Spreads have come in a bit and the yield advantage is now 1.7%. But time is our friend and this (environment) sets us up for a good risk-adjusted return for investors."
