High-yield bonds performed well in 2006, thanks largely to strong corporate balance sheets and generally solid economic conditions. Although managers admit to being a little defensive about prospects down the road, they are still upbeat about 2007.

“The fundamentals that underpin why high-yield bonds are doing well are intact,” says Barry Allan, manager of Dynamic High-Yield Bond Fund and president of Toronto-based Marret Asset Management Inc. “For one thing, default rates are at record lows — the global default rate is 1.8% and it’s zero for Canadian companies.”

Even though there were signs of an economic slowdown last fall, Allan notes, “There is some evidence that the fourth quarter is starting to improve over the third. There was a fear that the U.S. housing situation would drag down the whole economy, but it hasn’t happened. We didn’t think it would happen because real interest rates are very accommodating.”

Real interest rates would have to rise to 4%-4.5%, he notes, before the economy would be hurt, but they are currently around 2%. “Monetary conditions remain relatively accommodating,” Allan says. “That’s supportive of the economy and why it’s starting to rebound.”

Allan expects the economy will surprise on the upside in 2007: “We don’t see the Federal Reserve Board cutting rates. The market is starting to price this in, as people realize the economy is not as weak as expected. We think interest rates will stay unchanged for the year, but will probably start rising next year. In the face of stable interest rates, a good economy, monetary conditions being accommodating and the fact that default rates are at record-low levels, the environment for high yield is pretty attractive.”

Allan notes that very high levels of liquidity have also been driving markets. “I look for another pretty attractive year,” he says.

Still, he concedes, spreads between high-yield bonds and government treasury bonds are relatively tight, and the market is in the latter stages of the cycle. “That’s why we’re taking steps to upgrade the credit quality of the portfolio, reflecting where we are in the cycle,” he says. “But I don’t see a situation that could lead to a dramatically weaker economy, higher interest rates and higher default rates. As long as global liquidity levels are high, high-yield bonds will do well — and do much better than virtually all other fixed- income asset classes.”

Running a 60-name fund, in which the top 15 account for almost half the fund by weight, Allan has been shifting out of sectors that are more cyclical in nature and sensitive to downturns. These include homebuilders, automotive firms and real estate companies. Conversely, he has been focusing on the forest products sec-tor, which accounts for 8% of the fund. “That sector does poorly in a recession,” he admits. “But it’s been beaten up so badly, because of the rising Canadian dollar. Now, the C$ is slipping, and we think it could keep falling closer to US80¢. This gives us an opportunity to buy an industry that is very stressed.”

Holdings that Allan acquired last fall include Abitibi-Consolidated Inc., with maturities rang-ing from five to 10 years and yielding almost 10% when he acquired it last fall. In a similar vein, he acquired Domtar Inc., which yields about 9%.

Although the Dynamic fund is fairly well diversified, it is dominated by its 15% energy weighting, which is reflected in core holdings such as Paramount Resources Ltd., whose bond matures in 2013 and yields 8.5%, and Western Oil Sands Inc., whose bond matures in 2012 and yields 6.5%. “Even though the oil price has declined a lot, and we are marginally negative on oil, the debt in the energy sector is very safe,” says Allan.



From a macroeconomic perspective, the U.S. economy is undergoing a slowdown that is particularly evident on the housing and consumer-spending sides, argues Greg Kocik, manager of TD High-Yield Income Fund and managing director at Toronto-based TD Asset Management Inc. “The economy will grow, but most of the growth will shift to a few areas. One of them has been our favourite — and that’s anything to do with the business side of the economy, such as business services and manufacturing. That area will offset the slowdown in housing.”

@page_break@Growth in 2007 will range between 2.5% and 3%. That level, Kocik argues, is acceptable because it will keep commodity prices and inflation low, thus keeping interest rates low as well. Indeed, Kocik expects that the Fed may cut rates by 25 basis points by the middle of the year, but benchmark 10-year U.S. government bond yields may stay at current levels of around 4.6%.

The key factor to watch, however, is that the spread between high-yield bonds and government treasuries remains close to the current 300 bps. “That matches the levels we saw between 1994 and 1998, when we had the ‘Goldilocks’ economy,” says Kocik. “We could have a similar situation for a while, with the U.S. having a soft landing now and chugging along at about 2.5%-3% a year for a few years.”

Still, echoing Allan, Kocik says this is a time to be defensive and increase credit quality in the portfolio. “As long as you are in the right sectors, you’ll be OK. But you won’t generate significant capital gains in this environment. We have a coupon-clipping situation,” says Kocik. Noting that coupon payments range from 7% to 9%, he adds, “That’s not a bad return for a bond fund. But you have to prepare the portfolio for what may happen two years from now.”

Strategically, Kocik has raised the TD fund’s overall portfolio credit in the past year from B- to around B to B-plus. His goal is BB- within a couple of years. As well, Kocik is shortening duration, currently at 3.8 years, and aiming for about 3.25 years. His benchmark, a blend of the Merrill Lynch U.S. high-yield master II index and the Merrill Lynch global high-yield Canadian issuers index, is 4.2 years. “We’re not being paid as much as last year to take on risk, so we’re slowly increasing our defensive posture.”

From a sector standpoint, the largest exposure in the 80-name TD fund is in forest products, at 9%, including firms such as Cascades Inc., Abitibi-Consolidated Inc. and Domtar Inc. “The companies have restructured a lot of their operations to deal with the high C$,” says Kocik. “The C$ has eased off a bit. Energy costs have come down. And we believe the decline in the consumption of newspapers will start to dissipate.”

There is also 6% in telecommunications and cable providers, including names such as Rogers Communications Inc. and Shaw Communications Inc. As well, Kocik has allocated 6% to a catch-all category he describes as “super-retail,” which encompasses well-known retailers such as Sears Canada Inc. and Bon-Ton Stores Inc., a U.S.-based department-store chain. There are smaller weightings in other sectors, such as 5.5% in industrial building materials, 4% in chemicals, 5.5% in steel producers and 3% in capital goods.



Although bullish, Tristan Sones, lead manager of AGF Canadian High-Yield Bond Fund and vice president at Toronto-based AGF Funds Inc. , also admits it is time to be more cautious. “There are opportunities, for sure. But we need to be more selective and defensive than we have been over the past few years,” he says.

“This year will be an OK year as well — returns could range between 5% and 6%,” he adds. “The health of corporations is very strong. They have a lot of cash and are looking for investment. They often end up buying one another.”

Indeed, merger and acquisition activity will continue as stronger companies look to expand by buying competitors. “That is good if you own the debt of a weaker company that is bought by a stronger player,” Sones says.

Although there is some risk that spreads could widen and cause bond performance to deteriorate, Sones maintains that there is strong investor demand for income-generating securities and bonds in general.

“When we have seen any kind of spread widening, it’s usually met with a lot of buying,” he says. “Portfolio managers have seen good inflows into the fixed-
income sector. When there is a backing-up and bonds become cheaper, it’s a buying opportunity.”

Moreover, adds Tom Nakamura, associate portfolio manager and co-manager of the AGF fund, high-yield bonds may attract more investors, thanks to the federal government’s decision regarding the taxation of income trusts.

Strong liquidity has also been a key factor. “Globally, we have been in a period in which there are high levels of liquidity and financial market volatility has been low,” says Nakamura. “This has been conducive to sectors such as high yield or emerging markets.”

Even though some central banks have started to tighten, as they have in China and Japan, “it’s still a positive environment for these instruments,” he adds.

From a structural viewpoint, the managers of the AGF fund have taken advantage of the fund’s flexible mandate and allocated the 60-name portfolio across a range of assets: 27.7% in high-yield bonds, 13.2% in federal bonds, 12.3% in provincials, 18.7% in emerging markets bonds, 15% in cash and smaller holdings in investment-grade corporate bonds and income trusts. Larger holdings include bonds issued by Rogers Wireless Inc., Shaw Communications Inc. and Rogers Cable Inc.

The AGF fund’s duration is five years, compared with 4.5 years for the benchmark Scotia Capital high-yield bond index.

Intriguingly, the emerging markets bond exposure — which encompasses countries such as Brazil, Indonesia and Vietnam — is split between US$-denominated issues and local currencies.

“One of the trends we’re seeing is that more emerging markets are opening up their debt markets to be more attractive to foreigners,” says Nakamura. “It drives down local interest rates and allows better efficiencies in the corporate sector. Going forward, in the next few years, we expect countries such as the Philippines to open up their local debt market.” IE