Fixed-income roundtable: Portfolio strategies from the pros

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.

Brian Miron, portfolio manager for Fidelity Investments in the fixed-income division of Fidelity Management & Research Co. Based in Merrimack, N.H., Miron manages a large number of mandates including Fidelity Canadian Bond, Fidelity Corporate Bond and Fidelity Tactical Fixed Income.

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, as well as the fixed-income components of the balanced offerings.

Q: We have discussed investment-grade Canadian bonds. What about high-yield bonds?

Locke: High-yield debt performs principally on credit-spread expansion and contraction more so than it does on yield movement. We look at the U.S. market. The Canadian high-yield market is growing, but it is still a shadow of the U.S. market. The U.S. high-yield spread over the five-year Treasury bond yield at 1.7% is currently 360 basis points.

McHugh: That is historically expensive. The current spread is lower than the historic average.

Miron: These securities have done well. The high-yield spread was 1,800 basis points during the peak of the global financial crisis.

Locke: You can still find value in the high-yield market. You just have to look a lot harder.

Miron: When you take a look at high-yield defaults, the trailing 12-month default rate is 1.9% versus the long-term average of 4.5%.

McHugh: There are vulnerabilities in this market. Some investors, who have not done their due diligence, have been purchasing these high-yield securities. Also, some investors have opted for high-yield ETFs to get exposure to this market. These ETFs are perceived to be liquid, a way of getting access to this market and divesting yourself of access. We are at a point that investor exposure to high-yield bonds is substantial.

Miron: If there is a rush for the exit, you could see a dramatic price drop and spread widening in the high-yield market. We saw exactly that at the end of July, beginning of August. We started to see significant outflows from the high-yield market and these spreads widened by about 100 basis points over a two-week period.

McHugh: Another vulnerability in this market ties into the more stringent regulatory requirements for investment dealers. As a result, they are no longer able or willing to provide liquidity for these markets.

Q: Time to talk about your portfolios. Let’s start with Brian. You have raised your corporate weighting since we last met some 18 months ago.

Miron: About 50% of Fidelity Canadian Bond is in corporate bonds, about 6% is in securitized product and the remainder is in federal, provincial and municipal bonds. The total federal-government exposure is about 15%. The bulk of the portfolio is in some form of spread product, whether it is provincial paper or corporate paper.

Roughly half the corporate weighting or 25% of the portfolio is in financial paper including that of banks and insurers. We have roughly 6% of the portfolio in energy, 5% in communications, 6% in real estate and 4% in infrastructure. Our largest sector overweight relative to the FTSE TMX Canada Universe Bond Index is financials. A large proportion of our overweight in corporate bonds and in financials is in bonds with less than five years to maturity. Although the overall corporate exposure looks large, the bulk of the exposure is in short- to intermediate- term paper.

Fidelity Canadian Bond is underweight in provincial bonds. We swapped out some of our short-term provincial paper for shorter-term corporate paper for a yield pick-up. We hold most provinces, but have an underweight in the province of Ontario. In part, this reflects valuations and, in part, it is due to credit concerns. Ontario’s credit ratings are under pressure and could remain so. There are also supply considerations. Ontario still has a lot of debt that it needs to raise.

In aggregate in the fund, we are moving up the credit-quality curve. The average credit quality of the portfolio is single-A high. The portfolio’s duration is similar to the benchmark’s duration.

Q: Michael, your portfolio?

McHugh: Let’s look at Dynamic Canadian Bond, though we have moved in the same direction in Dynamic Advantage Bond. We have become more defensive. We have reduced our duration as we feel we are closer to a catalyst for higher yields than we were a year ago. There is more interest-rate risk in the market now. On credit spreads, we feel that the valuations warrant a more defensive positioning. So, we reduced our corporate exposure over the course of the year. This move also reflects our concern that there will be greater volatility in the market and there could be opportunities to repurchase these securities at better valuations in the months ahead.

We have split our corporate exposure between mid and short-term bonds. We continue to have negligible weightings in the financial sector. At present, we are finding that valuations in this sector are not that compelling. Also, because of their prominence, they are typically used as a source of liquidity.

We continue to like the debt of companies with contractual revenues, such regulated utilities and pipelines. We have maintained an overweight position in real-estate operating companies, as we feel the valuations are attractive there. We have increased our holdings in communications. On credit quality in general, similar to Brian, we have upgraded this in the portfolios.

Q: Michael, what about Dynamic Advantage Bond?

McHugh: It is a core-plus mandate, with greater flexibility than Dynamic Canadian Bond, particularly in the corporate debt space. We can have up to 40% to 45% in non-investment-grade securities in this fund. We can therefore invest in high-yield securities and are currently at 8%. This is the lowest weighting in high-yield debt that we have ever had in this fund.

Q: Steve, your portfolios?

Locke: In Mackenzie Canadian Bond, our duration at 6.61 years is currently lower than that of the benchmark index at 7.27 years. We have increased the provincial weighting in this fund, since our last roundtable some 18 months ago. Our biggest weightings are in Ontario and Quebec, which are the largest provincial issuers by far. We are slightly underweight Ontario, and neutral in the case of Quebec. We have a small exposure to B.C. These are our only provincial holdings.

In the corporate space, we are overweight triple-B rated corporate debt. This has been the case for the past few years, as we found this area to be relatively cheap. Triple-B-rated debt is the lowest rung of credit quality in the investment-grade category. Given the spread compression, it is harder to find value in this area. Our overall credit quality for the portfolio is AA low. In general, we have been upgrading the credit quality and liquidity of the portfolio.

Q: What about Mackenzie Strategic Bond?

Locke: We launched in May 2013. It is a core-plus fund. We can do everything we can do in an investment-grade portfolio and, in addition, hold up to 25% in non-investment grade instruments including high-yield bonds and tradable bank loans. Over the course of the fund’s first year or so, we have held high-yield positions of roughly 19%. We did not believe that we were in the sweet spot of the high-yield cycle to be at the maximum. We have recently reduced our high-yield exposure down to about 15% and could be reducing that further. Valuation is tighter and we are starting to see some marginal deterioration, but not across the board. As we have talked about, we are looking for the best valuation and actively managing for all the risks in our funds.

This concludes the three-part roundtable on fixed-income investing.