What managers favour in pursuit of higher yields

David Stonehouse, vice-president and member of the fixed-income team at AGF Investments Inc. He is responsible for a wide range of income-generating mandates including AGF Fixed Income Plus, AGF Diversified Income and AGF Global Convertible Bond.

Michael McHugh, vice-president and head of fixed-income at 1832 Asset Management L.P. His responsibilities include Dynamic Canadian Bond and Dynamic Advantage Bond.

Steve Locke, senior vice-president and head of the fixed-income team at Mackenzie Investments. Locke and his team manage a wide range of mandates including Mackenzie Canadian Bond and Mackenzie Strategic Bond.

The roundtable, which began on Monday and continued on Wednesday, was convened and moderated by Morningstar columnist Sonita Horvitch.

Q: What is the outlook for the corporate bond market?

Stonehouse: If we don’t have a recession and the financial markets stabilize, corporate debt has cheapened substantially in the last year and it might present an interesting investment opportunity. The biggest medium-term challenge is that we’re six years into a recovery and you’re near the end of the credit cycle and that’s something that we’re mindful of.

Locke: We’ve been investing our funds based on our opinion that we’re getting to be later in the credit cycle. We have been feeling this way for the past 18 months. It’s not that every industry is running into problems. It’s just that you have to become more selective and cannot simply take a blanket approach to corporate debt. You have to identify the risk factors, separating the liquidity risk from the credit risk in individual investments. As we progress through this cycle, we think that there are still more gains to be made in high-yield and investment-grade corporate debt. Given the recent pullback in the market, there are opportunities.

McHugh: To mirror some of Steve’s comments, we consider that we are approaching the later stages of the credit cycle. Near-term economic and policy positions remain favourable, though some of the dynamics of corporate credit are deteriorating. Over the last year, we’ve responded by changing the composition of our corporate-credit exposure significantly. We’ve also become highly selective. We have eliminated those high-yield bonds where we have concerns. It’ll generally be a more challenging time to manage corporate debt exposure within a portfolio.

Q: Time to talk in more detail about portfolios and strategies. The focus is on investment-grade-plus portfolios that can hold a wide range of other fixed-income securities, including high-yield bonds. As part of the discussion, please identify the duration of the fund. (Duration measures bond-price sensitivity to changes in interest rates and is measured in years.)

Stonehouse: The duration of AGF Fixed Income Plus at 7.2 years is modestly shorter than that of the FTSE TMX Canada Universe Bond Index at 7.4 years. This is a mildly cautious stance. We still believe in a low-yield environment and don’t worry too much about substantially rising interest rates. This would be one reason to have a very short duration. Also, if you think about Steve’s comments earlier on about the yield curve being steep, you get paid more to be further out in the future.

In terms of the asset mix, we are one-third in federal government securities and a little more than 20% in provincial bonds. We have been taking down our corporate exposure modestly over the past 12 months. We have about 32% in investment-grade corporate bonds.

Of alternative investments, we’re running about 4% in convertible debentures. (These securities combine the features of a conventional debenture with the option of converting it, under specified circumstances, into the equity of the issuer.) High-yield bonds constitute 8% of the fund. We’ve generally shied away from real-return bonds over the past decade, as we consider that we are in a disinflationary environment. (Real-return bonds have their principal and interest linked to an inflation index.) We have negligible cash. The overall foreign content is around 18%. We actively hedge the currency exposure.

Q: In all, David, you have slightly more than 50% in government bonds and less than 50% in corporate bonds in AGF Fixed Income Plus. Why convertible bonds?

Stonehouse: We talked about the challenging return environment that investors face going forward, given the low yields. Over the medium term, convertibles can provide an additional return and good diversification benefits.

When it comes to investment-grade corporate bonds, financials are a sector that we’ve been favouring this year. We favour American banks over Canadian banks, because the U.S. banks are at a better point in the cycle. The U.S. real-estate market has corrected, stabilized and is on the rise again whereas the Canadian real- estate market is at a different point in the cycle.

Q: Steve, what about Mackenzie Strategic Bond?

Locke: We have 27% in non-Canadian bonds. This is predominantly in U.S.-pay floating-rate loans, U.S. high-yield bonds and U.S. Treasury bonds.

Non-investment-grade securities represent about 15% of the portfolio versus the 25% limit in this mandate. At present, 10% of the portfolio is in floating-rate corporate loans and 5% is in high-yield bonds. We began tilting the portfolio toward these floating-rate loans in the second half of 2014. These are corporate loans originated by banks and they can be traded. These are syndicated loans. They are a direct obligation of the company to the investor. The reason we like them is that these floating-rate loans are generally a first lien on the company’s assets and generally rank higher on a company’s balance sheet than high-yield bonds, in the event of a default.

Q: Steve, what are the issuer allocations in the Mackenzie Strategic Bond, and what is its duration?

Locke: We have about 20% in Government of Canada securities, 27% in provincial bonds, for a total of 47%. We’ve recently added to the provincial exposure mainly through Province of Ontario and Province of Quebec. These are the most liquid provincial bonds. The corporate holdings are just over 50% of this mandate, with the 15% of the portfolio in non-investment-grade securities, as I discussed. In the investment-grade corporate segment, the portfolio is underweight energy and slightly overweight financials. The duration of the overall portfolio is seven, or about half a year short of the benchmark’s 7.4 years. We hedge most of the foreign-pay exposure in the fund, at all times. We don’t want to increase volatility in the fund by holding foreign-pay bonds that are not hedged.

Q: Michael, can we discuss Dynamic Advantage Bond?

McHugh: The portfolio currently has about 50% in government securities and 50% in corporate securities. In government securities, we have about 10% of the portfolio in floating-rate notes, which are largely provincial, and 20% of the portfolio in federal government real-return bonds, which represents a recent increase from 7.5%. The rationale for this increase in real-return bonds is that they had become inexpensive relative to nominal bonds, so we made a tactical allocation to this area. Our swing scenarios on these real-return-bond allocations tend to be between 5% and 20%.

Of the 50% in government securities, the exposure to federal-government nominal bonds is 3% of the portfolio. The provincial holdings constitute 17% of the portfolio, most of which is in Ontario and Quebec because of their liquidity. In the corporate segment, the portfolio has 45.5% in investment-grade securities and 4.5% in high-quality, high-yield bonds.

We’ve been fairly active in the high-yield segment. In June 2014, the portfolio had roughly 5% in high-yield bonds and then this went as high as 20% of the portfolio in December. A number of months ago, we took it down again to 5%. With the volatility in the high-yield market and deteriorating credit quality in some issues, we’re staying with a low weighting in high-yield bonds.

Our overall theme in the corporate portfolio has been to increase the credit quality. So we have been favouring investment-grade securities over the high-yield. We’ve been favouring financials and we’ve been adding to them over the past 12 months. Here, we’ve been investing in Canadian-bank deposit notes as a source of liquidity and a safe haven in the corporate space.

The duration of the portfolio is three years. In this mandate, the duration would tend to range from three to eight years. The reason for the three-year duration is the expensive valuation of nominal government bonds and the high price sensitivity to a change in interest rates, at these current low-yield levels. We look at duration as being a material source of price risk within a portfolio.

We have 88% of the portfolio in Canada and 12% in U.S. securities. That 12% is all in the corporate component of the portfolio. We hedge our currency exposure. It ranges between 50% and 100%. Currently, our U.S.-dollar exposure is 100% hedged. At current levels, the Canadian dollar is vulnerable to wide swings. We are removing that risk from the portfolio.

Part three of a three-part fixed-income roundtable.