Manager Monitor: A buyer of oil-patch bonds

Before this, O’Gorman’s strategy for investing in energy-related fixed-income securities was to focus on less commodity-dependent pipeline companies in the investment-grade market, (where bonds are rated BBB and above) and on some Canadian high-yield energy-related bonds.

The drop in the oil price has, he says, prompted Canadian energy producers to make sizeable reductions in their capital expenditures and to cut their dividends. This, he adds, “is comforting to the lenders.”

On the macro level, O’Gorman notes that the oil-price decline and the accompanying reduction in capital expenditures by energy companies is negative for the Canadian economy. In “what was a surprise move” on Jan. 21, the Bank of Canada announced that it was lowering its target for the overnight rate by 25 basis points to 0.75%, “stating that this was in response to the recent sharp drop in oil prices.” (The overnight rate is the key policy rate and represents the interest rate at which the major financial institutions borrow and lend one-day funds among themselves.)

O’Gorman says that there is much discussion about whether the U.S. Federal Reserve Board will raise its trend-setting rate this year and, if so, by how much. “The Fed would like to increase the rate above zero and if and when it does, it is likely that it will raise rates at a slower pace than it has in the past,” says O’Gorman. “The front end of the U.S. yield curve continues to show that there is this debate on whether the Fed will raise its rate, but long yields have fallen dramatically.”

Turning to his fixed-income portfolio, O’Gorman says that he still favours corporate bonds over government bonds. Corporate bonds are still attractively priced, he says. “Corporate investment-grade bond spreads over risk-free government bond yields have widened marginally of late,” he notes. “But their fundamentals remain intact. New-issue supply seems fairly balanced against the substantial demand for corporate debt.”

The high-yield market has come under some pressure, he says, “mostly because of energy.” O’Gorman’s strategy is to invest in the higher-quality segment of this market, including in energy bonds, primarily targeting companies that carry a BB rating.

O’Gorman says that he remains unenthusiastic about federal government bonds. “They are expensive.” The 10-year Government of Canada bond, for example, had a recent yield of 1.48%, “which is not a lot of yield for the duration.”

Government fixed-income securities have benefitted from the risk-off investment environment as “investors have flocked to safety over the last few months,” he says. “Yields on these bonds have come down dramatically since the beginning of October.”

For example, O’Gorman says, yields on Government of Canada 10-year bonds, declined to a recent 1.48% from 2.07% in early October. There was, he says, a similar decline in U.S.-government bond yields. The yield on 10-year U.S. Treasuries was recently 1.84% versus 2.4% at the beginning of October.

Still, he says, the Canadian and U.S. 10-year yields remain markedly higher than the recent rate on 10-year German Bund at 44 basis points, while Japan’s 10-year bond was a “mere” 19 basis points.

Looking out over the next six to nine months, O’Gorman considers that bond yields “are unlikely to rise meaningfully,” given the outlook for modest global economic growth.

In all, the case for fixed income as an important source of diversification in an investment portfolio remains compelling, he says. “This is despite the generally low yields on bonds,” he adds. “Besides, who would have thought that the benchmark FTSE TMX Canada Universe Bond Index would produce a total return of 8.8% in 2014?”

At Franklin Bissett Investment Management, which is part of Franklin Templeton Investments Corp., O’Gorman and his team manage a wide range of mandates including Franklin Bissett Bond and the fixed-income component of the firm’s balanced offerings including Franklin Bissett Canadian Balanced.

The Canadian team, which works closely with Franklin Templeton’s global fixed-income team, develops big-picture themes for its Canadian-focused portfolios and employs extensive bottom-up analysis to select individual securities.

At the end of December, Franklin Bissett Bond, with 287 holdings, had 49.1% in corporate bonds, 29.6% in provincial loans and 12.1% in government bonds. Municipal loans constituted 4.8% and bank loans 4.2%. The latter are floating-rate U.S. corporate loans made by the banks, which they then package for sale to investors. “These are classified as high-yield securities, but they are secured against the borrowers’ assets, and are of a higher quality than many unsecured high-yield bonds,” O’Gorman says.

In all, the portfolio held 10.9% in high-yield securities, less than half of its mandated maximum of 25%. “There is insufficient compensation, by way of yield pick-up, for going further out on the credit-risk curve, at this point,” says O’Gorman.

Looking at the geographic weightings in Franklin Bissett Bond, Canadian issuers constituted 77.4% at the end of the year and U.S. securities were 15.1%. The remaining holdings include small weights in a number of European countries, for example 1% in France and 1% in the United Kingdom, as well as small weights in Australia and Mexico.

Duration (which measures bond-price sensitivity to changes in interest rates and is expressed in years) in the portfolio is 6.8 years, below the benchmark’s 7.5 years. The portfolio’s duration has been rising, along with that of the benchmark. O’Gorman says this reflects the fact that “corporations are issuing bonds with longer maturities to take advantage of the low interest-rate environment.”

By far the largest sector weight among corporate issuers in the benchmark index is financials. O’Gorman reports that he has an underweight position in the banks and is overweight in the insurers and non-bank financials. “The banks’ senior debt securities are on the expensive side,” he says.

In addition, O’Gorman notes, the banks’ new non-viability contingent capital debt needs to be carefully assessed. These securities, which are not part of the benchmark index, come with the risk of being converted into equity under certain circumstances, for example, if a bank’s capital falls below a certain level. “I do not think that investors are being adequately compensated for the risk attached to these securities.”

Finally, turning to Franklin Bissett Bond’s weighting in provincial government debt, O’Gorman notes that at 29.6% of the fund, it is clearly more favoured than federal government debt at 12.1%. He reports that he has not been adding to his overall weighting in provincial bonds, of late. His strategy in tackling this segment is to look for relative value among the provincial issuers and to trade the provincial bonds accordingly.

Alberta has, at this stage, retained its “enviable” AAA credit rating, says O’Gorman. The recent sharp decline in the price of oil will certainly affect the strength of its economy, though it is hard to forecast the extent of this, at this point, he says. “It is important to remember that Alberta has benefitted from years of high oil prices and its fiscal position remains strong compared to other provinces and jurisdictions.”