Fixed-income markets are bracing for further statements by the U.S. Federal Reserve Board about its plans to reduce its bond-buying program – so-called “tapering” – as the U.S. economy is showing signs of improvement.
Given the jump in long-bond yields this past summer, Canadian fixed-income fund portfolio managers have become wary of further market volatility and are focusing on corporate bonds that provide better risk/return characteristics than government-issued securities.
“I don’t think that economies have been improving faster than anticipated,” says Dagmara Fijalkowski, senior vice president and head of global fixed-income with Toronto-based RBC Global Asset Management Inc. (RBCGAM) and lead manager of RBC Bond Fund. “When we left the great financial crisis behind, our view was that over the next several years, economic growth would be suppressed. Growth would be 2%, plus or minus half a per cent. That’s what we have seen – and it’s a fairly good assumption for this year.”
The sudden spike in interest rates has more to do with monetary authorities’ comments on reducing quantitative easing (QE), Part 3, which pushed benchmark 10-year U.S. bond yields to around 2.75%, from 1.6% in April.
“We also have a new central bank in Japan, which started its own QE program,” adds Fijalkowski. ” That led in April to the markets getting way ahead of themselves. Markets were worried not about growth but the lack of supply of government bonds; each central bank was buying about US$1 trillion worth of bonds.”
By late June, as the markets calmed down, the Fed decided that the U.S. economy no longer was on life support, says Fijalkowski: “The steady economic improvement has made the Fed consider taking its foot off the QE pedal and start putting in place a plan to remove the extraordinary easing monetary policy.”
But now that long government bonds are yielding 2.75%, Fijalkowski argues, they are closer to fair value. That’s where they were in mid-2011, when talk of a European Union breakup sent yields plummeting. “Here we are two years later,” she says, “going back to normalized levels.”
Fijalkowski and her team have become less defensive, from a duration perspective, and opportunistic in terms of specific bonds. “We had taken risk down prior to June,” she says, “which was an opportunity to find some bonds that had been more expensive earlier.” Duration has been raised moderately to 6.4 years, vs 6.5 years for the DEX index.
The RBCGAM team, with its focus on protecting the RBC fund against further market volatility, has reduced the federal government bond exposure to 9% of the fund’s assets under management (AUM) vs 40% in the DEX. The fund also holds 37% of AUM in provincial bonds, 44% in investment-grade corporate bonds, 4.7% in high-yield, 2.5% in emerging markets and some cash.
“We use a number of tools, not just managing duration, to protect the total return in a time of rising interest rates,” says Fijalkowski, adding that the corporate-bond weighting has been reduced.
Among the top holdings in the RBC fund’s portfolio of more than 500 positions is a National Bank of Canada bond that matures in 2018 and yields 2.75%.
Investors had better get used to the steepening yield curve, says Connor O’Brien, president and chief investment officer with Montreal-based Stanton Asset Management Inc. and portfolio manager of O’Leary Canadian Bond Yield Fund.
“We think the trend is upward,” O’Brien says. “What we are seeing is a reversion to the mean, as yields return to more normalized levels. Ten-year bond yields could climb to about 4% in the next 18 to 24 months. By 2015, the short end of the curve could hit 2%-plus.”
O’Brien maintains that the U.S. economy is in better shape than many believe: “The U.S. was the first country or region to start with quantitative easing. It will be the first to see results.”
The steepening yield curve, he says, “will be a positive for corporate bonds, taking some of the sting out of the yield curve steepening.” He adds that in 2007, investment-grade corporate bonds were trading at around 50 basis points (bps) over government bonds. Now, they offer a spread of 120 bps. “We see that gradually tightening over the next 18 to 24 months, to below 100 bps,” says O’Brien. “That’s good for corporate bond performance.” (On the other hand, 10-year Government of Canada bonds had a negative 6.3% return for the period since last May.)
Spreads for high-yield bonds are around 510 bps, and may trend downward to 400 or 350 bps over the next 24 months. “You are safer being in corporate bonds and in high-yield corporate bonds,” says O’Brien. “Rising rates will have a negative impact on longer-maturity bonds.”
The O’Leary fund has no government bond exposure, having sold all of those positions by late 2008, and focuses exclusively on Canadian investment-grade corporate bonds. O’Brien notes that holding corporate bonds in 2009-11 was all about taking advantage of opportunities: “Now, it’s all about safety; you get more yield with lower duration risk. The yield on the 10-year [Canada] bond had hit 2%, and we thought, ‘That’s it.’ The rush to participate in government bonds was no longer for us.”
The O’Leary fund holds bonds issued by 40 to 50 companies. About 40% of the fund’s AUM is in financial services firms, 17% is in telecommunications, 8% is in utilities, 7% is in industrials and there are small holdings in sectors such as consumer staples and pipelines. O’Brien says the fund’s average duration is 4.9 years.
One typical holding is a subordinated-debt issue by a U.S.-based unit of Toronto-Dominion Bank that is maturing in 2017, rated BBB and yielding 6.3%.
Chris Case, vice president, active fixed-income, with Toronto-based TD Asset Management Inc. (TDAM) and lead portfolio manager of TD Canadian Core Plus Bond Fund, notes that the Fed has yet to take action and has only talked about tapering its bond-buying program: “The market is trying to figure out whether it’s going to be September or October. That doesn’t really matter because the market is being proactive in pricing in the Fed’s decision. But while interest rates are up, they are still very low. Just remember that before the financial crisis, they were in the 5% range.”
Moreover, Case believes that interest rates will remain very low for a prolonged period of time, even though the tapering program inevitably will put pressure on the long end of the yield curve. “But at the front end of the curve, we see central banks remaining on hold for a long time. This will see steepening of the curve,” says Case, who shares portfolio-management duties with David McCulla and Geoff Wilson, vice president and managing director, respectively, of TDAM.
Case and his colleagues have reduced the emphasis on corporate bonds, in anticipation of increased volatility.
“North American companies are flush with cash and they have high levels of liquidity. There is still strong demand for corporate bonds,” Case says. “But with the tightening of corporate credit spreads and the Fed expressing a desire to taper its buying program, which will increase volatility, we have introduced some defensiveness and reduced our corporate weighting.” The fund’s duration is 6.5 years.
About 70% of the TD fund’s AUM is in corporate bonds, including 10% in high-yield bonds. (The latter is regarded as the “plus” component of the fund.) Case notes that his team uses a tactical component within the fund that allows managers to invest in global investment-grade corporate and sovereign bonds, global real-return bonds, emerging-market debt and global high-yield bonds. Of the four categories, global high-yield bonds offer the best valuations versus risk, says Case, adding that the remaining 30% of the fund’s AUM is in federal and provincial government bonds, along with a small cash component.
On the investment-grade side, there are about 50 names, with an emphasis on Canadian banks and telecom providers such as Rogers Communications Inc. and Shaw Communications Inc.
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