Michael McHugh, vice-president and head of fixed income at GCIC Ltd., says that the widespread selloff in the Canadian bond market from the late spring into early fall created a number of tactical opportunities for active managers.
"A 30-year decline in bond yields to historically low levels allowed for a more passive approach to investing in this asset class," he says. "This year, bond yields rose significantly, reinforcing the case for a more active approach to managing bond portfolios," says McHugh, whose responsibilities at GCIC include managing key fixed-income portfolios in the Dynamic family of mutual funds.
"It is important for investors to realize that at lower levels of bond yields, there is greater price sensitivity to a change in interest rates than in a high-bond-yield environment."
The Canadian bond market started 2013 with valuations that were "on the expensive side," says McHugh. May was a "turning point" in both the Canadian and U.S. bond markets. "Bond yields began to rise and valuations to transition from expensive to cheap by the end of September." Yields peaked in the first week of September, McHugh notes.
Then, in late September and early October, the bond market returned to "fairer value," as bond prices along the curve rose and yields came down. The cheap valuations had attracted investors, McHugh says.
He notes that May saw the start of a "confluence of selling" by a wide range of bond investors. These included retail investors in both mutual funds and exchange-traded funds, hedge funds with leveraged bond portfolios and commercial banks selling down their own bond investments.
Emerging-market central banks also moved to reduce their developed-market debt holdings, McHugh says. "The objective was to support their currencies, which were weakening as investors sold emerging-market debt."
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| Michael McHugh | |
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The tipping point for the bond market in May, says McHugh, was the concern that the U.S. Federal Reserve Board was poised to begin reducing the amount of bonds it was purchasing in its quantitative-easing program. "By August, investor sentiment towards bonds had turned extremely negative and the market became oversold."
Bond yields rose "to levels not justified by the economic fundamentals (slow economic growth and low inflation) and the policy commitments by central bankers in developed economies, including the United States, to continue their accommodative monetary policies."
McHugh says his team uses duration, which measures bond-price sensitivity to a change in bond yields, as a tool to add value and reduce risk in portfolios, against the backdrop of the volatile bond market.
In early May, for example, the team reduced the duration in the bond portfolios they manage in advance of rising bond yields, so as to protect capital.
They then increased duration in the portfolios as bond yields rose to their peak in the first half of September, "to take advantage of cheaper valuations or higher yields along the curve." They subsequently began to reduce duration after the peak, "to insulate the portfolio from price declines, should yields rise again."
There was, says McHugh, a compelling case for opting for a shorter duration in bond portfolios this year. Using the official indexes, McHugh notes that the benchmark DEX Universe Bond Index, which covers investment-grade bonds, and had a duration of 6.68 years at the end of September, produced a negative total return of 1.57% for the first nine months of this year.
In contrast, the DEX Short-Term Bond Index (one to five years), with its duration of 2.71 years, produced a positive total return of 0.98%. For the DEX Mid-Term Bond Index (five to 10 years), with its duration of 6.32 years, the negative total return was 1.03%, "a better performance than the DEX Universe."
Focused on the long end of the yield curve, the DEX Long-Term Bond Index (10 years plus), with its duration of 13.53 years, produced a negative total return of 5.93%.
At GCIC, McHugh and his team's responsibilities include Dynamic Canadian Bond 
with assets of $1.4 billion and the $1.1-billion Dynamic Advantage Bond.
The current duration in Dynamic Canadian Bond is 5.25 years versus the benchmark's 6.68 years. The fund's duration was as low as 3.75 years in early May, McHugh says.
When it comes to bond issuers, Dynamic Canadian Bond had a substantial overweight position in corporate bonds at 41.6% of the portfolio versus 29.76% in the benchmark, at the end of September.
McHugh's colleague on the fixed-income team, Domenic Bellissimo, is a portfolio manager who focuses on corporate issuers. "The fundamentals of the corporate debt market are strong," he says. "The global economy is improving and corporate profit margins are stable to rising."
Also, Bellissimo notes, corporations' access to external financing remains intact. "The result is that the corporate default rate is at the low end of its historic range and expected to remain so in the near term."
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| Domenic Bellissimo | |
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While the portfolio's weighting in corporate debt has remained fairly constant over the past six months, says Bellissimo, the team lengthened the term of its corporate-debt holdings. "We sold some shorter-dated corporate debt and bought longer-term securities up to the 10-year term."
The objective was to take advantage of higher credit-risk premiums, or widening yield spreads, along the curve, as the yield curve steepened, he says. "Typically, when the Government of Canada yield curve steepens, the corporate risk spread or yield spread narrows," he says. "A steepening government yield curve usually indicates an improving economy and a reduction in the risk attached to corporate bonds."
Starting this May and into the summer, "both government yields and corporate risk premiums rose, which is not typical," he says.
Of the sectors within Dynamic Canadian Bond's corporate-bond holdings, Bellissimo reports that the fixed-income team has increased its exposure to pipelines -- "they have a healthy contractual cash flow" -- and to the telecommunications sector.
The credit-risk premiums on Canadian cable and telecom debt securities rose sharply on the negative news about the possible entry of U.S. player Verizon Communications Inc. into the Canadian telecom industry, says Bellissimo.
"We saw this as a buying opportunity," he says. "We assessed the fundamentals and believed that the existing oligopoly in the Canadian telecom industry would remain intact; also the risk of a major foreign entrant was more than priced into these securities."
