Fixed-income roundtable: Looking at yield and credit quality

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

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

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

Q: What are the consequences of the quantitative easing and historically low interest rates for individual investors?

McHugh: In the bond market, it has resulted in lower bond yields and higher bond prices. It has also influenced the pricing of riskier assets. Individual investors, reacting to the low returns available, have progressively migrated to higher-yielding securities with a higher risk profile. There’s evidence of growing complacency toward credit risk. There’s a return of structured products that are replicating the poor credit qualities that existed in 2008. A quote that has been attributed to Mark Twain and is relevant here is: “History doesn’t repeat itself, but it does rhyme.”

Q: Is there still a case for investing in bonds? We are not sure if interest rates are going to go back up any time soon. If they do not, it would be tough for them to go much lower than they are already and drive bond prices.

Locke: Bonds generate a yield. They provide diversification in an overall portfolio. Also, investment-grade bonds can provide stability in the context of the fragility that we’ve talked about. The early 1980s saw the start of the 30-year secular trend to lower yields that we’ve experienced. Bonds have been and continue to be a lower-volatility asset class.

Miron: Looking at the DEX universe bond index, the Canadian benchmark for investment-grade securities, bonds have provided a healthy, stable return in the last 10 years. From 1940 to 1981, a period of secular rising interest rates, and using U.S. data, the largest one-year loss that bonds experienced was minus 5%. During those 40 years plus, you would have had negative one-year returns only 10% of the time, whereas in the equity market it would be close to 25%.

McHugh: One of the implications of lower bond yields is greater price sensitivity to a change in interest rates than in a high-yield environment. We’re at a level in bond yields where an individual won’t get rich investing in the bond market. But the value of bonds in this environment is that investors are not likely to experience a sustained erosion of their principal. Investors should focus on higher-credit-quality investments, because the valuations on higher-risk investments are stretched.

Q: Is the big retreat by individual investors out of equities into bonds since the financial crisis over? Looking at more recent performance, the S&P/TSX composite index outperformed the DEX universe bond index in the three months to the end of March 2013 and in the 12 months to the end of March.

McHugh: One of the consequences of the 2008 financial crisis was a rebalancing of portfolios and a re-evaluation of portfolio attributes. At that time, investors found that they had more equities than they felt comfortable with and there was some migration to fixed-income assets. There was also an enhanced recognition of the value of income in the total-return profile. This sustained the move into bonds. The flows have stemmed from individual investors, pension funds and other institutional investors.

Fast forward from March 2009 to March 2013. The return profile from bonds has diminished and equity markets have benefitted from material appreciation. What’s next? The implication is probably a lower return profile for both asset classes over time. There will also be more volatility. Equity-market appreciation will have to be supported by earnings-growth expectations.

Q: What challenges do retail investors face in accessing the Canadian corporate-bond market, which offers a yield pick-up over Government of Canada bonds?

McHugh: It’s predominantly an institutional market. It’s an over-the-counter market and information isn’t readily available. It’s difficult for retail investors to access the corporate-bond market. It’s getting worse, not better. Dealers are not providing the same liquidity to the market as they did in the past.

Miron: We don’t have published data for Canada. But in the United States, the dealer inventory of corporate bonds is roughly 25% of what it was pre-crisis. It’s similar to what’s happening to the liquidity in the corporate market in Canada.

The corporate-bond market in Canada is tight. In 2013, there will be roughly $55 billion in corporate-bond maturities. Coupon payments on existing corporate bonds will be another $15 billion. Together, that totals $70 billion. Corporations are projected to issue debt in the $80- to $90-billion range. So, most of the issuance is spoken for.

The Canadian corporate-bond market is roughly $325 billion, of which about $100 billion is in the form of bank debt. There are significant regulatory changes in the wings affecting segments of Canadian bank debt. There is uncertainty surrounding the timing and details of these changes. But, the expectation is that these changes will be benign.

Q: Can we briefly discuss other key developments affecting the Canadian bond market?

Locke: The Bank of Canada has left its trend-setting rate at 1% since September 2010. There was some thought toward the end of 2012 and the beginning of 2013 that the Bank of Canada might have to raise rates. But the growth in Canada’s gross domestic product for 2012 was sub-par, below 2%. It’s looking quite soft in 2013. We’re looking at a lower growth profile and a lower inflation rate over the next few quarters.

McHugh: There continues to be a strong flow of funds from international investors into the Canadian bond market. Most of the flow of funds has been from foreign institutions or sovereign-wealth funds seeking high-quality, liquid securities rather than from individuals.

Miron: Since the global financial crisis began, foreigners have invested roughly one quarter of a trillion dollars into the Canadian bond market. It’s across the board in all issuers. Some economists have estimated that the Fed’s quantitative easing has lowered U.S. interest rates by 100 basis points, one full percentage point. It’s estimated that Canadian interest rates have been pushed down by roughly the same magnitude, as a result of these foreign inflows.

Q: How do rates on 10-year Government of Canada bonds stack up against other countries?

Miron: At the end of April, Canada’s was 1.7% versus 1.67% for the United States and 1.2% for Germany. Sweden’s was 1.57% and Switzerland at 0.55%. The Canadian bond market is one of the largest, most liquid bond markets in the world.

Q: What has happened to the duration of the DEX universe bond index?

Miron: Over the past 30 years, it has roughly increased from five to seven years. In the United States, the opposite is the case. The U.S. duration has actually declined and it is now roughly 4.5 years. If you look at the interest-rate sensitivity of both markets and the potential impact of a rising interest-rate environment on bonds in each market, the DEX is definitely more interest-rate sensitive.

This is the second part of a three-part discussion with fixed-income fund managers.