Fears of a global recession, which began in 2018, are beginning to crest, argues Jim Gilliland, president and CEO of Vancouver-based Leith Wheeler Investment Counsel Ltd. Yet interest rates have also declined appreciably, making it more challenging to generate income for investors.
“We were in a manufacturing-led slowdown in 2019, which is not that dissimilar from the slowdowns in 2011 and 2015,” says Gilliland, lead manager of the 3-star rated $76.8 million Leith Wheeler Income Advantage Fund. “In each of those [slowdowns], we were fortunate that they were not substantive enough to cause a significant retraction in terms of employment. We are now far enough into the slowdown that we are gaining confidence that it will be a similar result. Meanwhile, central banks have moved from tightening to easing and are much more stimulating in terms of supporting economies.”
Moreover, Gilliland argues that there are signs of more openness towards fiscal spending by governments. “As countries look at the effectiveness of fiscal spending and how you can finance it at record-low interest rates, then that will be supportive of economies longer-term,” says Gilliland, a 26-year industry veteran who heads the firm’s bond team and joined Leith Wheeler in 2009, after working for HSBC Asset Management/M.K. Wong & Associates, and Barclays Global Investors. “Rates are reasonably low. And central banks are more accommodating. We are seeing the ‘troughing’ of this slowdown. It’s a pretty reasonable background for capital markets in general.”
Rates after inflation are reason for concern
Still, the so-called real rate of return, after adjusting for inflation, is troubling, Gilliland admits. “In late 1990, the government of Canada issued the first inflation-linked bond. It yielded 4.25%. So in 1991 you could protect your capital from the effects of inflation and have a real return of 4.25%.” Today, a similar bond is yielding 0.25%, Gilliland notes. “Instead of being able to spend 4.25% of your capital and still preserve it from the effects of inflation, if you bought the same instrument today, it would yield 0.25%. It’s not only a Canadian issue, but a global one as rates are exceptionally low. In the U.S. [real] rates are around 0.25% and in most of Europe rates are negative.”
Year-to-date, Leith Wheeler Income Advantage Series F returned 9.14% (as of Dec. 5), compared to 8.77% for the median fund in the Canadian Fixed Income Balanced category. On a three-year basis, the fund averaged 3.46%, versus 3.81% for the category.
It’s a really challenging backdrop to be able to deliver higher returns, says Gilliland. “The key is you have to look at different bonds than those issued by the government of Canada. Unfortunately, the only way you can really preserve your purchasing power and still able to have a reasonable level of income is by embracing a little more volatility and more sensitivity to the economy. Any instruments that are going to be able to deliver real returns over and above the government of Canada come with added volatility. There are solutions, but it comes with more sensitivity to the overall economy. You can’t just stay in the bond market. You need to look at hybrid instruments and a fuller menu of income sources to be able to deliver the same level of income.”
An array of actions to complete an income approach
From a strategic viewpoint, Gilliland and the Leith Wheeler team follow a total return path for their portfolio, consisting of a wide range of instruments. The fund was launched in a B series in Dec. 2010, with a view to generating income from a balanced strategy that encompasses investment-grade and high yield corporate bonds, dividend-paying stocks, preferred shares and loans and executes it in a way to produce volatility similar to the broad universe bond market. “We take a total return approach, but with a higher proportion coming from income than a typical balanced strategy.”
The F series fund, launched in Sept. 2015, has a running yield of 3.53% before fees of 0.75%. “Close to half of the strategy is in investment-grade primarily Canadian bonds, with a weighted duration of 4.5 years,” says Gilliland, noting that this portion yields closer to 2.5%. “This is the ballast in the strategy and is in names such as Telus Corp. (T), and Royal Bank of Canada (RY). These are investment-grade names.”
Gilliland adds that he purchases the bonds as close to par as possible, which ensures he is not over-paying for the income. “Paying $120 for a bond may generate more income in the near term. But it is less tax-effective because you are paying tax on those higher levels.”
From there, Gilliland generates income from asset classes such as preferred shares. This weighting tends to move up and down, depending on the opportunities available. “If they are quite expensive, we will get income from other sources and are comfortable have a smaller preferred weighting. When they are attractive, as they are now, we’re comfortable having upwards of 10% of the whole portfolio.”
Because of their volatility, Gilliland limits the preferred shares’ exposure to about 10% of the fund. “We don’t want the portfolio to have too much volatility and get pushed up or down based on that one asset class,” says Gilliland, adding that the exposure is achieved through the Leith Wheeler Preferred Shares Fund. There is also about 7% in Leith Wheeler Multi-Credit Fund, which invests in a mix of high-yield bonds, senior loans and investment-grade corporate bonds. The preferred share fund yields about 5.4%, and the multi-credit fund generates 5.8%, after fees. (There is no additional layer of fees on the underlying funds.)
Seeking sustainable (and growing) dividend payouts
Canadian dividend-paying stocks, which are held in the Leith Wheeler Canadian Dividend Fund, account for about 37% of the fund. This portion yields about 3.8%. The dividend fund, which has about 30 holdings, is heavily weighted to banks, such as Royal Bank of Canada and Toronto-Dominion Bank (TD), as well as industrials such as Toromont Industries Ltd. (TIH).
“What we are looking for aren’t necessarily the highest-yielding names because at this point those names are quite expensive relative to their earnings power. They might be distributing all of their earnings, or even more than earnings, in terms of a payout ratio,” says Gilliland.
“We are looking at those that can grow their earnings over time and still have a reasonable 2.5-3.5% yield,” adds Gilliland, pointing to holdings such as Canadian Tire Corp (CTC.A). “More important, they can provide some growth to offset the effects of inflation. The main inflation offset will come from the Canadian dividend-paying stocks so that the overall fund has some capital gains. This way, your capital can grow as the economy, and inflation, grows.” Based on current figures, capital gains account for more than half of the total return.
Market risks will continue to complicate
Looking ahead, Gilliland is reluctant to predict whether 2020 will be a repeat of 2019 when markets soared or 2018 when markets crashed. “What’s different from 2018 is that central banks have been decreasing interest rates and most likely rates will be stable in 2020. You have an economy growing 2-2.5%. It’s not a terrible backdrop for stocks. But I will say that there are parts of the markets that we are uncomfortable with. When it comes to an income strategy, it really depends on what is under the hood. Having spent many years in fixed income, there is no free lunch when it comes to generating income in capital markets.”
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