Satish Rai laughs when asked the secret to the success of the $6.9-billion TD Canadian Bond Fund, the flagship fixed-income fund in TD Asset Management Inc.’s mutual fund family. In 2005, the fund returned 6.4%, easily beating the median bond fund’s 5% return.
Was it luck? Good timing? Special insights into the bond market?
“To be honest, in 2005 everything worked perfectly for us. There’s no luck involved,” chuckles Rai, 42, vice chairman of portfolio management and research at Toronto-based TDAM. “We have had this view for many years on certain structural aspects of the economy and bond market, and they all came to pass.”
As Rai and his team had expected, the yield curve began to flatten and the spreads between corporate and government bonds tightened. At the same time, the TD fund benefited from a 10% weighting in real-return bonds, whose prices shot up in 2005. “Those were the main drivers, and every one hit perfectly — all at the same time,” says Rai, who works closely with co-managers Geoff Wilson, vice president, and Ken Miner, vice chairman of fixed-income at TDAM. “That’s a pretty impressive one-year return —140 basis points over our competitors. It’s not anything to be laughed at.”
Competitors have been left behind since the fund began in 1988. For the three years ended Feb. 28, TD Canadian Bond posted an average annual compound return of 6.8%, vs 5.3% for the median bond fund. Over the past five years, it averaged 6.9%, vs a median 5.8%. For the most recent 10-year period, it averaged 7.9%, vs a median 6.4%. And over 15 years, it averaged 8.7%, vs 7.3%.
That outperformance is largely attributable to the consistently applied blend of top-down and bottom-up investment styles, as well as an attractive 1.07% management expense ratio. (The same methodology lies behind its sister fund, the $2.7-billion TD Real-Return Bond Fund, which Rai has managed since its inception in November 1994. Both funds have a five-star rating from Morningstar Canada.)
However, after years of generating superior returns, Rai says, high single-digit returns are a thing of the past: “It’s a fact of life with which we have to deal. On a go-forward basis, the reality is that fixed-income is not for wealth creation. It’s for wealth preservation. We have to come to grips with this change.”
Rai cautions that all fixed-income funds — not only his firm’s — will have some difficulty generating annual returns of more than 5% in the future. “Fifteen years ago, the savers benefited because they enjoyed very high rates. Borrowers were punished. Today, we have the opposite environment, and borrowers are benefiting.”
Rai would not be surprised if the yield curve in the U.S. becomes negative. He attributes this to the Federal Reserve Board’s determination to slow growth to prevent inflation from becoming a threat. “The Fed wants to see the whites of a slower economy’s eyes. To me, that means the risk of inflation getting out of hand is reduced,” says Rai, adding that the yield curve could invert. But he doubts the Fed will raise short-term rates above 5%.
The Bank of Canada may also raise its short-term rates to 4%. “But I am not concerned about a meaningful rise in 30-year rates. We know there is a lack of bonds out there. Pension funds are looking for yield,” Rai says. “I am comfortable with coupon-like returns. As long as the federal debt/gross domestic product ratio keeps improving, we have room for modest capital gains. But it won’t be like the past few years.”
Strong commodity prices, low inflation and demographic changes are key factors — in addition to the debt/GDP ratio — that guide Rai and his 11-person team in shaping the TD fund’s portfolio as it looks ahead three to five years.
The Canadian debt/GDP ratio of 38%, vs the peak 70% in the early 1990s, implies that Ottawa is not issuing many bonds. “There is a case to be made for real borrowing rates to drop even further on a secular basis,” he says.
Second, the strong appetite for Canadian resources, he adds, is supportive of the Canadian dollar, whose strength keeps inflation at bay.
Third, an aging population creates strong demand for income, which also keeps pressure on rates.
@page_break@As a result of these factors, Rai is bullish on the long term: “Even if short-term rates were to rise, we think 30-year bonds will be more stable than people expect.”
At the core of his philosophy, Rai is an optimist, maintaining the economy is doing much better than many critics have been saying. “The economy has been growing at 3% steadily for the past decade, and year-over-year changes have been very low,” he says. “Yet we continue to fear what is out there, instead of looking at the reality. There have been tiny moves compared with the 1980s and ’90s, when the economy was more volatile. That’s very important, because a stable economy means that interest rates will be stable, too.”
Because of their long-term focus, he and the team shun day-to-day speculation and forecasting of interest rate movements.
From a bottom-up standpoint, the team focuses on the structure of the yield curve and tries to identify the most advantageous areas. They also closely scrutinize companies that issue bonds. “That credit research has allowed us to have a track record in which we never had a default or a late interest rate payment,” Rai says.
Three analysts specialize in credit analysis on corporate bonds, which makes up about 55% of the portfolio. (The remainder is in a mix of real-return, federal and provincial bonds, and mortgage-backed securities.) Other team members provide mathematical modelling and other services to determine the best place to invest.
Collectively, the team tries to construct portfolios that utilize their best ideas but also limit downside risk. As the team takes buy-and-hold positions, portfolio turnover has been moderate at 25.1% in 2004 and 19.2% in 2003. Overall, there are about 250 positions in the fund, although there is some overlapping of issuers because some have differently dated bonds.
“We’re not a one-person shop just picking bonds and deciding the best place to be on the yield curve,” says Rai. “It’s a complex business, and we have a lot of expertise in bringing together the best ideas.”
Rai’s financial experience goes back more than 20 years, when he developed an interest in investing while attending the University of Waterloo. In his spare time, the native of Delhi, India, who grew up in Ottawa, traded stocks, options and futures. After graduating in 1986 with a bachelor of mathematics, he was hired by the former Toronto-Dominion Bank as a technology professional.
But Rai’s true calling was investing, and within 18 months he joined TDAM as a jack of all trades. “I did everything: stock trading, securities analysis — you name it — and ran a lot of spreadsheets.”
In 1988, he became part of the team managing what was then known as Green Line Canadian Bond Fund. The following year a fixed-income manager left and Rai was appointed manager of the fund. He became acquainted with much of corporate Canada because of the intense research into corporate credit; for example, he visited Suncor Energy Inc.’s oilsands project in Alberta and Dofasco Inc.’s steelworks in Hamilton, Ont.
By the end of the 1980s, Rai was head of fixed-income for TDAM and responsible for about $7 billion in assets. That figure grew to about $12 billion, after the bank’s February 2000 merger with Canada Trust.
In 2003, Rai was asked to head up all fixed-income and equity asset management at the bank, including its U.S. operations. “We have the same disciplined process on the portfolio-construction side and the same guiding principles,” he says.
In total, TDAM manages $135 billion in assets. About $75 billion is in active money management, including $57 billion in fixed-income. The remaining $60 billion relies on so-called “quantitative” solutions such as index futures.
From a portfolio standpoint, Rai still has a hands-on role. He acknowledges that there are fewer opportunities in the corporate bond market than a few years ago, when spreads were much wider. But that’s largely because balance sheets are generally in better shape and companies are less likely to borrow.
Rai earns accolades from Gordon Pape, Toronto-based fund commentator and publisher of Internet Wealth Builder. “He’s an excellent manager and doesn’t take a lot of risk,” says Pape, adding there is an almost even mix between corporate and government bonds in the flagship fund’s portfolio. “This reduces the chances of getting badly whip-sawed. As a result, the fund produces very nice returns.”
Pape also notes that it is a no-load fund with a 1.07% management expense ratio.
The competitive MER also appeals to Dan Hallett, head of Windsor, Ont.-based research firm Dan Hallett & Associates Inc. , who praises Rai and his team. As well, Hallett says, the TD fund provides investors with sold diversification because of its emphasis on corporate bonds. IE
Blend of styles propels TD Canadian Bond Fund
But fund manager Satish Rai says fixed-income funds will have difficulty generating annual returns higher than 5%
- By: Michael Ryval
- April 4, 2006 October 30, 2019
- 10:18