Fixed-income roundtable: Corporate bonds favoured in quest for higher yields

Steve Locke, senior vice-president and head of the fixed-income team at Mackenzie Investments.

Brian Miron, portfolio manager for Fidelity Investments in the fixed-income division of Fidelity Management & Research Co.

Michael McHugh, vice-president and head of fixed-income at GCIC Ltd., the sponsor of the Dynamic stable of mutual funds.

Q: The DEX Universe Bond Index, (the benchmark for Canadian investment-grade fixed-income securities) had an overall total return of 4.5% over the 12 months to March 31. How did the different market segments perform?

Locke: The federal government sector produced a total return of 3.2% over the year to March 31. The corporate sector almost doubled that at 6.3%. There was a preference for corporate debt, which narrowed its yield spread or yield premium over the government yield curve, in general.

McHugh: The total return on provincial bonds for the 12 months to March 31 was 4.8%. The relative performance of the different segments of the Canadian bond market was more as a result of the flow of funds than an improvement in the credit quality of the different issuers. There is this ongoing search for yield by investors.

Locke: In the provincial sector, unlike the corporate sector, it was a sideways year for spreads. These have gone up and down a little over the past 12 months, but within a fairly distinct range.

Miron: Yes, for example, Ontario government spreads on 10-year securities have been fairly range-bound over the past year. By contrast, the DEX corporate spread has come down significantly since the beginning of 2012 and is currently at 117 basis points. The long-term spread is around 100 basis points. [This spread was 356 basis points in December 2008, the peak of the global financial crisis.]

Locke: High-yield corporate bonds are about 400 basis points higher than the federal government curve. Over the last 12 months, we have seen those yield premiums squeeze in quite a bit, as has been the case in the investment-grade corporate sector.

Q: Can we have a brief discussion about the market for Canadian provincial bonds, before going on to discuss your portfolios?

Miron: There is approximately $500 billion in provincial debt outstanding and approximately $600 billion in federal government debt outstanding. Of the provinces, the biggest issuers are Ontario and Quebec.

The provinces have been struggling to control their deficits since the financial crisis, and that struggle continues. Over the past year or so, we’ve seen rating agencies step in and cut their ratings. There have been some upgrades, but net-net the provincial ratings have been under pressure. We need to see these provinces execute on their deficit-reduction plans in order to stabilize their ratings.

Locke: The provincial bond market is more liquid than the corporate market and the maturities tend to be longer term.

McHugh: The corporate bond market is much more differentiated by issuer than the provincial bond market, where the issuers are seen as more generic.

Q: Time to talk about your flagship Canadian bond portfolios. All three of these portfolios are overweight corporate bonds.

Miron: In terms of our most significant weightings, Fidelity Canadian Bond, which is benchmarked against the DEX Universe Bond Index, has some 22% in federal government debt. This represents a significant decline over the last year or so. Provincial holdings are about 26% of the portfolio, an increase since the beginning of 2012, but still an underweight position. The bulk of these purchases were Ontario and Quebec bonds.

We have about 41% in corporate bonds, an overweight position. We increased that corporate weight over the past 12 to 15 months. In particular, we’ve increased our holdings in financial institutions and in real-estate debt. We now have roughly 23% of the portfolio in financial services. We’ve also added a little to our telecom and communications holdings. Finally, in addition, we have about 6% in structured products or asset-backed securities. We manage our duration in this fund close to the DEX Universe Bond Index, which is about seven years. We manage $16 billion in assets, of which Fidelity Canadian Bond is roughly half.

Locke: We manage close to $20 billion in assets. In Mackenzie Sentinel Bond [which will be renamed Mackenzie Canadian Bond in mid-July] our long-term strategy is to be overweight corporate debt. The current weighting in corporate bonds, including securitized products, is 45%. We’ve been favouring bonds with a BBB credit rating over the past two years. They are currently 16% of the mandate. A sector we’ve liked is real estate, in particular the bonds of the Canadian real estate investment trusts. These bonds have performed very well, reflecting the demand for yield, and the spreads have narrowed significantly since we invested in them. We’ve done a little lightening up there.

Provincial bonds are now about 20%. We’ve reduced our holding in Ontario and increased our weighting in Quebec, reflecting the relative valuation between the two provinces. Right now, we’re favouring the 10-year part of the yield curve in provincial bonds.

Miron: We have a similar strategy.

McHugh: We’re also more concentrated in the 10-year part of the yield curve for provincial bonds.

Locke: It’s a fairly liquid area of the market and facilitates active management. We have 35% in federal government bonds. This includes 8% of the portfolio in mortgage-backed securities that are backed by the Canada Mortgage and Housing Corp. and therefore by the government of Canada. The duration of the portfolio right now is close to the index at 6.9 years.

Q: Michael, can we discuss Dynamic Canadian Bond? Your portfolio differs substantially from those of Brian and Steve.

McHugh: Federal government bonds represent 8% of Dynamic Canadian Bond, a significant underweight position. We don’t have any mortgage-backed securities backed by the federal government. One of the themes within the mandates is to avoid businesses that are very dependent on credit expansion. In all, we’re responsible for managing $8.7 billion in assets.

The provincial weighting in Dynamic Canadian Bond is 43%, which includes some 10% of the portfolio in provincial floating-rate notes. We have more of an overweight exposure to Ontario. It provides good liquidity. We have a healthy weighting in B.C., which was initially driven by the province’s retention of its AAA rating. This high rating is scarce in the global bond market and therefore a catalyst to attract capital flows.

The corporate weighting is 49%. We are overweight and have been adding to the telecom area. We are more aggressively overweight and have been aggressively adding to pipelines. These are stable businesses whether they operate in a regulated or unregulated framework. We like corporations developing high-quality commercial real estate. We also like consumer-related companies and the debt of diversified industrial companies, which is where we’ve been migrating to in the United States. We maintain a significant underweight in the financial sector. It’s not a reflection on the credit profile of the Canadian banking sector. But rather it’s a reflection of an environment that we’re in, where high financial leverage could be a significant headwind.

Our duration is four years. We’re at the lower end of our range of two to eight years. This is a reflection of our risk-management discipline. As I’ve mentioned, the prices of fixed-income securities in a low-yield environment have a much higher sensitivity to a change in interest rates, than is the case in a higher-yield environment.

This is the final instalment of a three-part discussion with three Canadian fixed-income managers.