Michael McHugh, vice-president and head of fixed income at 1832 Asset Management L.P., says the U.S. Federal Reserve Board's intention to migrate to a more normalized monetary policy means that there is a case for bond investors to remain defensive.
He cautions that "it is going to be a slow and bumpy ride as the Fed's quantitative-easing program is wound down, and there are gradual but growing expectations of an eventual Fed funds rate hike."
This trend-setting rate has, McHugh says, been kept at "extremely low levels of zero to 25 basis points since December 2008." The Fed's goal, he says, was to adopt a range of measures, including low interest rates, to foster an economic recovery in the wake of the global financial crisis in the fall of 2008.
"In the bond market, we are now in transition from talk of Fed tapering to talk of Fed tightening," says McHugh. Given the prospect of rising interest rates, it is therefore prudent, he says, for investors to keep the duration of their fixed-income portfolio at a low level, so as to preserve capital. (Duration measures bond-price sensitivity to a change in interest rates.)
The Fed's tapering program is well under way, he notes. As it announced at the end of 2013, the U.S. central bank started to reduce the amount of its monthly fixed-income securities purchases at the beginning of this year and it has continued on this path since then, says McHugh.
Starting this month (April), the Fed will add to its holdings of fixed-income securities at the pace of US$55 billion per month. In 2013, the Fed made purchases of US$85 billion a month.
Also significant for all financial markets, says McHugh, is that the Fed recently moved from quantitative forward guidance to qualitative forward guidance. It had previously identified actual unemployment and inflation targets that would have to be met before it changed its course. "Its qualitative approach, based on its subjective assessment of the health of the economy, gives it greater flexibility."
One of the reasons prompting this shift, says McHugh, was the fact that the easing U.S. unemployment rate is approaching the 6.5% level. This level, he says, had been identified as the principal economic target that needed to be met for the Fed to consider raising the federal funds rate.
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| Michael McHugh | |
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But, he adds, the new Fed chair Janet Yellen recently expressed concern that this 6.5% jobless rate masked the steady decline in the labour-force participation rate since the beginning of the recovery.
The qualitative forward-guidance approach involves great uncertainty, says McHugh, and greater speculation as to the timing of the Fed's rate hike. "This will likely lead to greater volatility in the fixed-income market, which in turn provides opportunities for tactical changes in a bond portfolio."
At 1832 Asset Management, McHugh and his team manage $8 billion in fixed-income securities including Dynamic Canadian Bond and Dynamic Advantage Bond. McHugh and his team have been keeping the duration in the bond portfolios they manage at the lower end of their historical ranges, although the team alters duration opportunistically to take advantage of short-term changes in the fixed-income markets.
A key member of McHugh's fixed-income team, Domenic Bellissimo, heads up the corporate-credit area. His process includes monitoring the leverage levels on a corporate borrower's balance sheet and assessing the company's debt-servicing capability by looking at metrics such as earnings and cash flow.
Dynamic Advantage Bond has considerable scope for active fixed-income management, says McHugh. The fund's holdings, he says, include government and investment-grade corporate securities, high-yield bonds and "inflation-protection securities" such as real-return bonds and floating-rate notes. The team can also invest in convertible debentures and use a range of hedging strategies for this fund.
"We tend to view a 50% weighting in corporate credit as a neutral weight for this portfolio; this weight is currently 55% and was as high as 65% last fall," says McHugh. "We have been increasing our weighting in select government securities -- including federal government bonds and provincial floating-rate notes. The latter, he says, "assist in insulating the portfolio from the expected upward pressure on bond yields." The strategy to boost government securities has reduced credit risk in the portfolio, he notes.
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| Domenic Bellissimo | |
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Bellissimo explains that the reduction in the portfolio's weighting in corporate debt reflects the fact that "corporate-debt fundamentals are on a negative trajectory and, at the same time, the valuations on these securities are less attractive."
Companies, he says, are moving "from a defensive approach in the aftermath of the global financial crisis now that the economy has improved." They are raising debt and increasing the leverage on their balance sheets. This is at a faster pace than their income. They are using borrowed funds, for example, to buy back shares and increase their dividends, says Bellissimo. "They are also, for the first time since the financial crisis, focusing on growth and some are increasing their capital expenditure."
On valuation, Bellissimo says that there has been a decrease in both absolute and relative yields on investment-grade and high-yield corporate bonds. Their risk premiums, or yield spreads over those of government securities, have declined in the last year toward the levels seen in early 2007, he notes. "There will be ongoing volatility in these spreads, and it is this volatility that provides tactical opportunities."
When it comes to the sector emphasis in the corporate component of Dynamic Advantage Bond, the biggest weightings continue to be in energy (with the focus on pipelines), real estate and telecommunication services. Of the pipeline holdings, Bellissimo says: "We have some of the higher-quality names such as Pembina Pipeline Corp. and Inter Pipeline Ltd."
The real-estate fixed-income securities include those of First Capital Realty Inc., he says, while the telecom-services holdings include debt issues of all three major companies: Telus Corp., BCE Inc. and Rogers Communications Inc.Although financial-institution issues dominate the investment-grade corporate-debt market in Canada, McHugh and Bellissimo note that their corporate fixed-income portfolios continue to have minimal exposure to the sector.
"In the aftermath of the global financial crisis, we were concerned about the contagion effect on the health of Canada's financial institutions," says McHugh. "Today they are more structurally sound than during the financial crisis, but their fixed-income securities have rallied a lot and our approach is to buy them on weakness."
