A worthy consideration for core fixed income exposure

Leith Wheeler Core Bond's returns have beaten the average fund in the Canadian Fixed Income category.

Shehryar Khan, CFA 2 January, 2018 | 6:00PM
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Leith Wheeler's CEO and head of fixed income Jim Gilliland took over Leith Wheeler Core Bond in 2009 and since then has refined the investment process, built out the team, and improved the risk-management capabilities. These moves put the odds of long-term success in the team's favour and thus far have produced strong performance relative to peers in the Canadian Fixed Income category. This fund, which invests primarily in investment-grade and government bonds, is a worthy consideration for a core domestic bond holding and provides valuable diversification from equities, according to research performed by Morningstar Investment Management LLC.

Gilliland has a team of seven people contributing to this fund. Given his substantial firm-level responsibilities, it's encouraging that he's backed by a growing, if still partly new cast. Eric Lam, for example, oversees the portfolio on a day-to-day basis in addition to his credit research responsibilities.

Leith Wheeler's value-driven investment philosophy shines through in its fixed-income approach. The team's process starts with the development of 12-month and three-year interest rate forecasts. This dual time horizon helps the team identify sectors and parts of the yield curve that might be undervalued. It is also an effective form of risk management that helps the team size its interest rate calls, which are harder to get right in the long run on a consistent basis. For instance, despite their longer-term view that interest rates are likely to increase, they are more cautious on the Canadian economy in the short term.

Each view independently may have led to larger one-way bets on interest rates but taken together, the team, as of October 2017, chose a neutral view on duration (a measure of interest-rate sensitivity) relative to the benchmark. Currently their forecast and valuations have led them to their lowest credit weighting in some time of just over 44%, with much of them with a term of 5 years or less. The team's work on corporate bonds tells them it rarely pays to hold a corporate bond with a longer maturity unless the yield curve is quite steep.

When selecting bond issues for the portfolio, the team considers factors such as the borrower's financial strength, the covenant structure of the bond and the liquidity of both the firm and the issue being considered. They analyze how any addition would affect the risk and return profile of the portfolio, and each bond is assigned a liquidity score that drives the security's weight in the portfolio, with more liquid names assigned higher weightings. To manage risk, the team will stress the portfolio through both hypothetical and historical stress tests, and use tools to compare their positioning to the benchmark and understand the drivers of their returns.

Fixed-income investing is a game of inches, and during Jim Gilliland's roughly seven-year tenure through November 2017, the fund returned 4.1% annualized and underperformed the FTSE TMX Canada Universe Bond Index by 35 basis points per year. The fund's return matched that of the iShares Core Canadian Universe Bond ETF (XBB) but was significantly better than the average fund in the Canadian Fixed Income category, which returned 3.75%. Despite the index-like returns, investors concerned with rising interest rates should expect the fund to keep pace with the benchmark while providing protection from rising yields.

The Leith Wheeler fixed-income fund sports a management-expense ratio (MER) of 0.79%. Unlike equity funds that have trading expense ratios (TER), bond funds don't have explicit costs as they trade on a spread. The fund is catered toward do-it-yourself investors and does not pay an embedded trailer. Against other funds in the same distribution channel the fund's costs rank as average.

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Shehryar Khan, CFA

Shehryar Khan, CFA  Shehryar Khan, CFA, is a senior investment analyst for Morningstar’s Investment Management group.

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