Thomas O'Gorman, senior vice-president and director of fixed income at Calgary-based Franklin Bissett Investment Management, says he continues to emphasize corporate bonds, despite the fact that there has been a slight erosion in the fundamentals of corporate issuers.
On corporate financial health, O'Gorman says that the "leverage ratios, which were substantially reduced in the wake of the global financial crisis, have increased somewhat." Some companies, he says, are using borrowed funds to increase their dividends and/or buy back shares.
Still, he says, corporate bonds should deliver superior risk-adjusted returns to their public-sector counterparts in 2014. A caveat, he says, is that returns on corporate bonds will not likely be as high as they were in the past. "The interest spread over government securities has narrowed substantially, since the financial crisis, and is now around 100 basis points."
This all means, he says, that the focus in the corporate-bond segment has to be increasingly on security selection, including a thorough credit assessment, rather than on simply overweighting the corporate-bond sleeve versus public-sector bonds.
On valuations, O'Gorman considers that fixed-income assets are generally "fairly priced over the near term." His call is that fixed-income total returns are likely to be "modest" for 2014, "ranging between a flat return for the year to low or middle single-digits; it really depends on the path of interest rates."
The Canadian bond market has held up well so far this year, says O'Gorman. Looking at Canadian investment-grade bonds, the FTSE TMX Canada Universe Bond Index (formerly the DEX Universe Bond Index) produced a total return of 3.3% for the first four months of 2014. The total return for the 12 months ended in April was more modest at 0.2%.
South of the border, the fixed-income benchmark Barclays U.S. Aggregate Index produced a total return of 2.7% in the first four months of 2014, while its return for the 12 months to the end of April was a negative 0.3%.
Despite expectations to the contrary, interest rates on both sides of the border have not continued to rise since last summer, but have pulled back, says O'Gorman. Over the longer term, "interest rates will move higher as economies and central-bank policies normalize."
 |
|
 |
|
| Thomas O'Gorman | |
|
|
|
|
|
The U.S. Federal Reserve Board is in the throes of reducing its purchases of fixed-income securities. Despite the U.S. economy's weak first quarter, the Fed has continued to cut these purchases, which were down to US$45 billion a month beginning in May, a significant reduction from US$85 billion in December. "This Fed tapering will likely be completed this year," O'Gorman says.
The key question is what the U.S. central bank will do with its trend-setting federal funds rate. At present, the Fed is maintaining its range of zero to 25 basis points, which has been in place since the end of 2008. The Bank of Canada is keeping its benchmark rate at 1%, where it has been since September 2010.
Recently, there was some speculation in financial markets that the central bank might lower the bank rate in order to bring inflation up to its target range, O'Gorman notes. "But I did not expect that it would." He points out that Canada's central bank is dealing with an overly leveraged consumer and a strong, possibly heated, housing market. "A lower rate would add fuel to this."
O'Gorman has 24 years in the investment business. Born and educated in the United States, he joined Franklin Bissett Investment Management in Calgary in 2010. Previously, he had held a number of senior postings at investment firms south of the border. For example, he was managing director of fixed-income at Munich Re Capital Management in New York, where his responsibilities included investing in Canadian fixed-income assets.
At Franklin Bissett Investment Management, which is part of Franklin Templeton Investments, O'Gorman and his team manage some $4 billion in assets. This includes the flagship Franklin Bissett Bond, Franklin Bissett Corporate Bond and the fixed-income component of the firm's balanced funds including Franklin Bissett Canadian Balanced, which at the end of March had 34.4% in fixed-income securities.
The Canadian team works closely with Franklin Templeton Investments' global fixed-income team, which includes country and sector specialists located around the globe. The global team is responsible for some $400 billion in assets.
The Calgary-based Canadian team develops big-picture themes for its Canadian-focused portfolio and uses extensive analysis to select individual securities.
At the end of March, Franklin Bissett Bond (assets $2.4 billion and 241 names) had 52.5% in corporate bonds including Canadian investment-grade bonds, Canadian high-yield bonds and U.S. high-yield bonds. Public-sector holdings in the portfolio at the end of March consisted of 28.5% in provincial bonds, 13.2% in federal bonds and 6.8% in municipal bonds.
Non-investment-grade securities represented some 10% of Franklin Bissett Bond. The mandate, which was adjusted last June, allows for high-yield securities to go to a maximum of 25%," says O'Gorman. "High-yield bonds are attractive, and while the bulk of issuers are in the United States, this market is growing in Canada."
Even after allowing for the fund's "out-of-index" exposure to U.S. issuers and high-yield bonds, the fund is still overweight in Canadian investment-grade corporate bonds relative to the Canadian benchmark corporate-bond weighting of 30.6% at the end of March. Conversely, the fund has a substantial underweight to Government of Canada debt, which was 37.7% in the benchmark at the end of March.
Duration (which measures bond-price sensitivity to changes in interest rates and is expressed in years) was 6.1 years compared with that of the Canadian benchmark at 6.8 years at the end of March. At that time, the fund had some 17% in floating-rate notes. "We are defensively positioned given our concerns about the prospect of rising interest rates," O'Gorman says.
Taking a closer look at the corporate-bond holdings in the fund, the sector emphasis is decidedly on the financial-services sector, including U.S. financials. These represent more than 50% of the corporate-bond sleeve or roughly 25% of the fund as a whole. In the FTSE TMX Canada Bond Universe Index, financials represent 15.05% of the index or roughly half of the corporate-bond weighting of 30.6%.
Another area of emphasis in the corporate-bond sleeve is energy, including energy producers and pipelines, says O'Gorman. "These weightings are the result of bottom-up security selection after thorough credit analysis, rather than a reflection of a top-down decision."
