Michael McHugh, vice-president and head of fixed income at 1832 Asset Management L.P., says that the conditions that contributed to last year's weakness in the Canadian bond market are likely to remain in place for the remainder of 2016.
"Valuations on bonds are expensive, the nominal yields on federal government securities are low and there are headwinds in the corporate credit market reflecting ongoing late-credit-cycle pressures." In all, investors in the fixed-income market would be well served to adopt a conservative approach to the interest-rate and credit risks in the bond market in 2016, McHugh says. "This is our ongoing strategy in the core fixed-income portfolios."
While bond yields around the world remain historically low, says McHugh, there is a "prolonged" bottoming-out process under way. "This creates both volatility and opportunity for active fixed-income managers."
Central-bank monetary policies remain accommodative, says McHugh. "The central bankers are keeping policy rates low in the light of the challenges to global economic growth."
The Bank of Canada, for its part, would like to maintain its overnight target rate at 0.5% in 2016 and into 2017, he says. "Any further decline in this key rate would indicate its concerns about a deceleration of the Canadian economy."
McHugh notes that the Bank of Canada has already addressed the shock to the domestic economy from declining commodity prices, particularly the oil-price drop, by lowering its policy rate twice in 2015.
"Provided any additional declines in commodity prices are fairly muted in both duration and magnitude, the Bank of Canada will not need to respond." Also, he says, Canada's central bank is concerned about the already high levels of individual debt in Canada and wary of further fueling the housing market.
South of the border, the Federal Reserve Board would like to increase its federal funds rate to more normal levels, says McHugh. Domestically, rising inflation from low levels to currently around 2% would support higher rates, he says. "But challenges to global growth and the potential negative impact of this on the U.S. economy, is making the Fed cautious." There is thus not a clear path to Fed rate hikes, he says. "It is important to point out that the Fed is not in tightening mode, but is reducing the magnitude of its accommodation."
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| Michael McHugh | |
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The Canadian bond market was modestly weak last year, says McHugh. The FTSE TMX Canada Universe Bond Index, the benchmark for Canadian investment-grade securities, which carry ratings of BBB or higher, had a negative total return for the 12 months to the end of February of 0.33%. (During that period, the S&P/TSX Composite Index produced a negative total return of almost 13%.)
McHugh says that weakness in the Canadian bond market, over the 12 months to the end of February, reflected the fact that "rising credit spreads over Government of Canada securities collectively generated a loss that was greater than the capital gains earned on declining Government of Canada bond yields."
Within the Canada Universe Bond Index, corporate credit, which constitutes 27.4% of this index, produced a total negative return of 1% for the 12 months to the end of February. Energy was the poorest performer in the whole index, chalking up a negative total return of 5% over that time.
The performance of the Canadian high-yield market was considerably weaker than that of investment-grade corporate credit during the 12 months to the end of February. The FTSE TMX High Yield Bond Index recorded a negative total return of 7%, with high-yield energy issuers registering a negative total return of almost 13%.
Domenic Bellissimo, vice-president and portfolio manager, who heads up the corporate-credit area for the fixed-income team, says that weakness in the corporate credit market reflects a number of forces. "We are in the later stages of the credit cycle, corporate earnings have been weaker over the past year or so, and the investor selloff in corporate fixed-income securities in the energy and materials sectors has extended into other industries."
Many corporations, says Bellissimo, are finding it challenging to grow revenues. Also, he says, profit margins, which had peaked a while ago, are coming down. "Understandably, some companies' balance sheets are starting to show strains and defaults will likely rise," says Bellissimo. "Some of this will be commodity-related and will represent those companies that are over-leveraged and have limited access to either the equity or debt markets."
At 1832 Asset Management, McHugh and his team manage a wide range of fixed-income mandates including Dynamic Canadian Bond (assets $2 billion) and Dynamic Advantage Bond (assets $1.3 billion). The former, says McHugh, is a "high quality" predominantly Canadian portfolio of investment-grade securities. Dynamic Advantage Bond is also a core Canadian bond fund, but it has greater flexibility, he says. It can, for example, invest in securities that are below investment-grade and it tends to have higher foreign content.
1832 Asset Management's fixed-income team's strategy across its core mandates addresses both the current interest-rate and credit-quality risks, says McHugh. The team has, for some time, been keeping the portfolios' duration low "to insulate them from capital losses, given the price sensitivity to even a small rise in yields in this low-yield environment." (Duration, expressed as a number of years, is a measure of the sensitivity of the price of a fixed-income security to a change in interest rates.)
Floating-rate notes are, he says, among the short-term holdings in Dynamic Canadian Bond and a way of reducing the fund's exposure to rising interest rates.
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| Domenic Bellissimo | |
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The fixed-income team also continues to migrate to securities with higher credit quality, says Bellissimo, "given our concerns that the financial health of certain corporate issuers is deteriorating."
Dynamic Canadian Bond's duration was three years versus that of the FTSE TMX Canada Universe Bond Index of 7.4 years, at the end of February. At that date, the fund had 35.2% in provincial government bonds and 18.3% in floating-rate notes, which are predominantly provincial. (Floating-rate notes are bonds that have a variable coupon equal to a money-market reference rate plus a quoted margin, which remains constant.)
McHugh says that the fixed-income team raised this fund's exposure to provincial securities beginning last November, with the focus on the more liquid Quebec and Ontario provincial debt markets. "This move was based on attractive valuations relative to federal government securities."
Within the corporate component of Dynamic Canadian Bond, financial issuers constituted 8.3% of the fund and energy 6.5%, at the end of February. "We have been favouring financial issuers and steadily adding to them," says Bellissimo. The weighting in the fund's energy sector has declined over the past year, he says, "due to our strategy to gradually sell down our holdings in this sector."
Although the Dynamic Advantage Bond mandate allows for investments in high-yield bonds, the fund had only 1.8% in Canadian high-yield bonds and 1.8% in foreign high-yield bonds at the end of February. "We have been reducing our exposure to the high-yield market and focusing on the higher-quality issuers (of high-yield securities) that have a BB and a BB plus rating," says Bellissimo. A focus, he says, is on those candidates that are expected to qualify for rating upgrades to investment-grade status, he says. "We are also emphasizing high-yield securities with short-term maturities."
At the end of February, Canadian government real-return bonds constituted 19.4% of Dynamic Advantage Bond. "We have increased our exposure to these real-return-bonds, as they represented better relative value than the nominal federal government bonds, which are expensive," say McHugh. It was a tactical decision, he adds. "Our swing scenarios on these bonds tend to be between 5% and 20%; indicative of the greater latitude that we have in Dynamic Advantage Bond versus Dynamic Canadian Bond."
