David Stonehouse, vice-president and member of the fixed-income team at AGF Investments Inc., says that it could be challenging for the Canadian bond market to continue to deliver the high level of returns that it registered in the first quarter of 2015, following on its particularly strong performance in 2014.
The first three months of 2015 saw the benchmark FTSE TMX Canada Universe Bond Index register a total return of 4.2% following its 8.8% total return in 2014. (This index represents Canadian investment-grade fixed-income securities, which carry ratings of BBB or higher).
The current overall yield on this index is less than 2% and it is only 1.3% on federal government bonds, says Stonehouse. "To produce a strong total return from bonds, interest rates would have to fall significantly, thereby producing solid capital gains."
The first quarter of 2015 was "remarkably good" for bonds globally, including Canadian bonds, he says. On March 9, the European Central Bank began its extensive quantitative-easing program. Its plan is to purchase 60 billion euros worth of fixed-income securities per month until September 2016.
"The start of the ECB's program coincided with a reduction in policy rates by many central banks around the world." This helped to fuel the strong global rally in bonds in the first quarter, says Stonehouse, with yields falling "dramatically."
During this period, he says, there was a strong demand for bonds globally. This was accompanied by fund flows into the Canadian and U.S. bond market, given their relatively higher yields. But, he adds, in the last month or so yields around the world have "snapped back," having fallen "so far and so fast."
This selloff in the bond market has provided a buying opportunity, he says, "but it has crimped total returns." There is room, he cautions, for bonds to potentially sell off a little more, with rates going a little higher.
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A dedicated student of monetary policy and the movement of interest rates, Stonehouse believes the Bank of Canada is likely to hold its key policy rate "steady for a while." On Jan. 21, Canada's central bank surprised the financial market by lowering its target for the overnight rate by 25 basis points, bringing this down to 75 basis points. At that time, the financial markets expected that there would be a further cut at the Bank of Canada's March meeting. But governor Stephen Poloz kept the rate unchanged in March.
Stonehouse says Canada's central bank would probably raise its policy rate in the near term only if there is a "rapid and significant increase in the oil price to, say, US$80 to US$90 per barrel." In this situation, it might reverse its Jan. 21 move, he adds.
What would drive a further policy rate cut, he says, is if the Canadian economy, and specifically the housing market, shows signs of weakness. "A pullback in the Canadian housing market would adversely impact the Canadian chartered banks, which have a lot at stake in this market."
Both Canada and the United States are currently producing a rate of growth in gross domestic product in the order of 2%, says Stonehouse. "For the United States, this is far lower than the 3% to 4% per annum that the U.S. Federal Reserve Board had been forecasting over the last five years, looking two to three years out."
There has been much speculation in financial markets, he notes, about the likely timing of a hike in the federal funds rate following the completion last fall of the Fed's program of purchasing fixed-income securities.
"The Fed is looking to move to a more normalized fed funds rate," says Stonehouse. "But pundits who forecast that the Fed would stay on hold for longer than the market has been anticipating were on the mark." He points out that at the end of April the Fed, in a release, reaffirmed its view that the current target range of zero to 25 basis points for the fed funds rate "remains appropriate." Stonehouse's call is that a fed funds increase will "likely be later and more gradual than many financial-market participants are forecasting."
At AGF, Stonehouse is responsible for a wide range of income-generating mutual funds including AGF Fixed Income Plus, AGF Diversified Income and AGF Global Convertible Bond. His discipline is to evaluate the big economic picture, with a focus on monetary policy, and couple this with security selection.
AGF Fixed Income Plus, benchmarked against the FTSE TMX Canada Universe Bond Index, is required to have at least 70% in investment-grade bonds. In addition, the fund can invest in high-yield bonds, convertible debentures, emerging-market bonds and municipal debt. "These are the fund's alternative income-oriented investments," he says.
The duration of the fund is seven years, which is modestly lower than the duration of the benchmark index at 7.5 years. (Duration measures bond-price sensitivity to changes in interest rates.)
At recent count, government bonds, including some U.S. bonds and government agency bonds, constituted 26% of the fund and provincial bonds were 23%. Investment-grade corporate bonds represented 35% of the fund. Of the alternative investments, high-yield bonds were roughly 10% and convertible debentures 5%. The remainder was a small cash holding.
Looking at the investment-grade corporate bonds, Stonehouse says that he has a sizeable weighting in fixed-income securities of financial-services companies, given the overall strength of these companies' balance sheets. His holdings in this sector include U.S. financial-services debt, in addition to that of Canadian financial institutions. "The latter are vulnerable to a correction in the Canadian housing market." By contrast, he says, the U.S. real-estate market has already had a significant correction and is slowly recovering.
In general, he says that his investment-grade corporate portfolio is focused on the lower end of this credit spectrum, "as the spreads are wider here."
Stonehouse believes the high-yield bond market, which is predominantly a U.S. market, "looks quite attractive, at this stage." Last year, he says, high-yield securities underperformed the bond market as a whole. "Spreads have widened to a point where they are higher than their historic average." Currently, yields on these securities are more than 6% versus some 1% for Government of Canada bonds.
Furthermore, he notes, the creditworthiness of most of these issuers remains intact. "The risk of a recession on either side of the border is slim; rather, the current modest recovery is more probable." This, he adds, is a good environment for high-yield bonds."
Turning to convertible debentures, Stonehouse is optimistic about their medium-term prospects relative to regular bonds. These securities combine the features of a conventional debenture with the option of converting it, under specified circumstances, into the equity of the issuer. "As equities appear to offer higher return prospects than bonds, this conversion option is attractive."
These securities would be vulnerable, he says, if the conversion option is set at a higher price than the stock's market price. "The Canadian and U.S. equity markets have not had a significant correction for some time," he says. It is hard to forecast what might be a catalyst for this, he adds, but "a rise in the fed funds rate might hit both the bond and the stock markets." Stonehouse says he would view any such retrenchment as a "buying opportunity."
