Managers make their case for active management in a low-yield market

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.

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.

Q: Given all the uncertainties that we have discussed, where does the individual investor in fixed-income securities stand?

McHugh: There’s a strong case for active investment. My view is that investors are not being adequately compensated for owning long-duration bonds in Canada. The low long-term bond yields are producing negative real yields, adjusted for inflation. These bonds are not providing a risk premium for investors.

Stonehouse: I am sanguine about the path of interest rates going forward. I’m not worried about a meaningful or a rapid rise in yields. Therefore, I don’t think that investors in long bonds are going to be materially harmed. I still think that you’re looking at a disinflationary environment. However, it’s hard to argue that long bonds represent a good investment, if you’re only going to make a 2% gross yield and say close to 0% net of inflation, and then you factor in other considerations such as taxes, it’s no longer a wealth-building strategy. It’s, at best, a wealth-preservation strategy. It’s certainly not a compelling investment opportunity.

Locke: Bonds are an integral component of a portfolio. David brings up wealth preservation. In this low-yield environment, holding bonds is a store of wealth against riskier components in the portfolio. This is something that we’ve seen from the beginning of this year to the end of August and over the past 12 months to the end of August, with equities down and bonds up.

McHugh: The FTSE TMX Canada Universe Bond Index, the benchmark for Canadian investment-grade securities which carry ratings of BBB or higher, had a total return from the beginning of the year to the end of August of 2.8% and 4.9% over the past 12 months to August-end, versus a negative total return of 3.5% and a negative total return of 8.7% for the S&P/TSX Composite Index, respectively.

Locke: This 2.8% total return year-to-date on the benchmark bond index represents both the yield on this index and price appreciation. Within that 2.8% overall return, corporate bonds with a total return of 2.1% underperformed government bonds with a 3% total return year-to-date. Over longer time frames, corporate debt tends to outperform government debt and it has paid to be overweight corporate debt.

Stonehouse: The problem is that investors have become used to receiving total annual returns from bonds in the upper-single-digit range. This will be hard to replicate on a sustained basis.

Locke: Investors have to modify their return expectations from bonds.

McHugh: In summary, current valuations and an uncertain landscape going forward create a challenging environment for fixed-income investors. This reinforces the case for active investment by professional portfolio managers. Variations in valuations create opportunities for changing the composition of a portfolio to reduce volatility or downside risk and contribute to higher or more stable returns, over time.

Stonehouse: Professional portfolio managers have investment opportunities that retail investors generally do not. It is difficult for advisors or retail investors to access portions of the debt market and to get a fair price when they buy or sell in those markets. Active professional managers have a distinct and significant advantage in this regard.

Locke: When you consider the history of investment-grade bond investing over the past 30 years, it was quite easy for investors to take one risk, an interest-rate risk. Even a passive approach rewarded investors. You took on this interest-rate risk and then watched yields go down. The current environment and the environment that we think will prevail over the next number of years — a low-yield environment influenced by volatility and maybe less predictable policy changes — demands a more active approach. It also demands a more flexible approach, where a professional manager can integrate different types of fixed-income risk in a client portfolio.

Q: Time to talk in more detail about the Canadian bond market.

Locke: Focusing on the Canadian investment-grade universe, we started the year with a yield of around 2.2% on the FTSE TMX Canada Bond Universe Index (which has an average term of 10.45 years and covers both public-sector and private-sector issuers.) The surprise rate cut by the Bank of Canada on Jan. 21 pushed the yield on this index down to about 1.8% at the end of January. We were just under 2%, or 1.96%, at the beginning of September. So, yields went down quickly at the beginning of the year and have traded in that low range ever since.

What of the Canadian yield curve? We can divide this up into its components. Let’s start with the short end of the curve, one to five years. With the Bank of Canada lowering its policy rates twice in the first eight months of this year, the short end of the curve came down markedly. We now have a flat front end of the yield curve and a low set of yields. Thereafter, the curve steepens out, when we look at five to 10 years, which is the mid-term, and at the 10-to-30-year yields, which is the long term.

McHugh: The 10-year Government of Canada bond yield is 1.45% and the 30-year-yield is 2.25%.

Stonehouse: The two-to-three-year Government of Canada yield is a little under 50 basis points, at 45 basis points.

Locke: The five-year Government of Canada bond yields about 75 basis points. Looking at the U.S. Treasury market, Canada has lower yields across the curve and this is dramatic at the front end. For the five-year term, for example, Government of Canada yields are 70 to 80 basis points lower than the U.S. Treasury yield. Going out to the 10-year area of the curve, the differential is just under 75 basis points. The U.S. economy has had an earlier path of expected recovery and therefore the rise in yields.

Q: Has there been a flight to quality in the Canadian bond market over the past 12 months to the end of August?

Stonehouse: Yes, to a moderate degree. The best way to determine that is to look at spreads, the Canadian corporate investment-grade spreads and provincial spreads relative to government bonds. These spreads have widened in the past year. There has been some degree of risk aversion in the capital markets in general over the past year. This could be reflecting the emerging-market turmoil and the impending Fed rate hike. A second factor has been the precipitous decline in the oil price. We’ve seen a widening of the spreads for energy corporate bonds, which have led the charge higher in terms of spread. Financials have been among the more stable, better performers.

McHugh: Using the Canadian investment-grade benchmark, the FTSE TMX Canada Universe Bond Index, corporate bonds in the energy sector produced a total return of 1.8% for the year to the end of August, the weakest performance of all bond categories in the index. Financials produced a total return of 3.5% and corporate bonds as a group a total return of 3.5% versus the overall return for the index of 4.9%. (Corporate bonds represent 29% of the index and financials, at 13% of the index, are under half of the overall corporate weight.)

Stonehouse: The high-yield bond market has also seen spreads widen. The Canadian high-yield market is small and quite narrow, so we focus on the U.S. market. The U.S. high-yield market saw a 200-basis-point increase in spreads over the past year.

Locke: The absolute spread differential for U.S. high-yield bonds over government bonds is currently 580 points. The average spread level over time has been about 530 basis points. One of the weakest areas of the corporate bond market has been the oil and gas and other commodity-related debt issuers. The U.S. high-yield market is an example of where the weakness in commodity prices is having a big influence. Energy and materials represent collectively around 19% of the U.S. high-yield bond index. I am expecting to see a rising level of defaults in energy-related high-yield bonds.

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