Fixed-income funds face headwinds

Greece’s government bonds, for instance, are trading at about one-third of their par value. “There are significant unrealized losses,” says Charbonneau. “That’s one of the big issues facing the eurozone. There is a big challenge because of the high level of indebtedness and the lack of growth.”

Still, he agrees, the launch in December of a program known as Longer-Term Refinancing Operations is a step in the right direction. Under the LTRO, banks can borrow from the European Central Bank at the rock-bottom interest rate of 1% for three years. This move is part of the 489 billion euro ($625 billion) that the ECB has pumped into the European financial system.

“[The LTRO] is a type of quantitative easing and will extend funding for the banking sector,” says Charbonneau, who works alongside AGF vice presidents Tristan Sones and Tom Nakamura. “At the same time, we had a co-ordinated response last autumn by the central banks, such as the U.S. Federal Reserve Board, to lower funding costs. That was worth US$500 billion. In total, that’s more than US$1 trillion to smooth out banking costs. And coincidentally, the bond market started improving.”

Although these measures will bolster confidence, it will take a long time for economies to turn around, he adds. “That’s what [Federal Reserve chairman] Ben Bernanke has said: ‘Expect subpar growth because we’re in a deleveraging process and it will take time to resolve’,” says Charbonneau, referring to statements Bernanke had made in late January regarding interest rates possibly staying low until late 2014.

From a strategic perspective, Charbonneau is focusing on the long end of the bond market, largely because interest rates could go lower. “I’m very cautious on the economy,” he says. “If we are now at 2% yields on U.S. or Canadian 10-year bonds, they could go lower in the second half [of 2012]. We could touch 1.75%.”

The AGF fund’s average bond duration is 7.25 years, vs 6.7 years for the benchmark Citi-group world government bond index. “You have to be long government bonds,” says Charbonneau, “more than spread products [such as high-yield or emerging-market bonds].”

About 48% of the AGF fund’s assets under management are in so-called “dollar bloc” countries (those with dollars for currencies), with the bulk in U.S. government bonds. There also is 23% in Europe, 12% in Japan, 4% in Britain and about 12% in a mix of emerging markets. With an active hedging program in place, about 37% of AUM is hedged back into the Canadian dollar, with the balance in currencies such as
the euro and the U.S. dollar.

As for returns in 2012, Char-bonneau is cautious: “The first half could be positive. But we face a lot of headwinds and uncertainty. Rates could see a small increase, which could erase any gains even if the increase is small. There could be flat returns for the year.”

 

Investors should lower their expectations regarding returns, says David McCulla, director and vice president with Toronto-based TD Asset Management Inc. and lead portfolio manager of TD Global Bond Fund.

“We are expect-ing modest, coupon-like returns,” says McCulla, who works closely with Christopher Case, TDAM vice president and director, and Trevor Forbes, TDAM vice president. “We are taking a somewhat defensive stance, similar to what we did in 2011. We’re looking for incremental yield. That’s reflected in our exposure to investment-grade corporate bonds and high-yield bonds. We hope to continue to add value on the currency side.”

The TD fund has a gross running yield of about 3.5%. McCulla believes that yields will continue to be low for some time. “We are in an environment [in which] there are incredible tail risks,” he says. “There is a low probability of them happening, but you need to acknowledge that they do exist. With those tail risks, you could get more extreme outcomes.”

Europe poses significant challenges, McCulla adds, as it is trying to implement austerity measures, with mixed results. “The challenge is that if you push too hard, you create a negative impact on growth. But our base case is that Europe will muddle along and you will see subpar [gross domestic product] growth,” says McCulla, adding that it is nigh impossible to predict how long the subpar situation may continue because of the complexity of the situation and the large numbers of key players.

“Whether we see a technical recession or not,” McCulla says, “growth will be disappointing.”

Like Charbonneau, McCulla hails the creation of the LTRO. But it will take more than that to boost investor confidence, he says: “You also have a situation in which European commercial banks are still deleveraging. That curtails lending and exerts a drag on the European economy. Sovereign bonds are still vulnerable to a loss of investor confidence.”

From a strategic viewpoint, McCulla and his portfolio co-managers are focusing on investment-grade corporate bonds and high-yield bonds. About 20% of the TD fund’s AUM is in the former asset class (weighted toward Canadian banks, media firms and telecom companies) and almost 19% in the latter, most of which are U.S.-based companies.

There also is 12.5% of the TD fund’s AUM in Government of Canada bonds, 16.5% in provincial bonds; 11% in U.S. treasuries; about 6.5% in Australia; 6% in Germany; and 5.5% in Britain.

From a currency perspective, about 36% of AUM is in US$, 32% in Japanese yen, 26% in euros, and modest exposures to the C$ and Mexican peso.

The portfolio-management team has set the TD fund’s average bond duration at six years, vs 6.7 years for the benchmark Citigroup world government bond index. Much of the reason for the fund’s shorter average duration is due to the composition of the fund and the almost 40% in combined exposure to shorter-dated, high-yield bonds and investment-grade bonds.

In addition, the TD fund’s exposure to very long-dated sovereign bonds is low, relative to the benchmark. “Given where yields are, and their sensitivity to changes in yield,” says McCulla, “we don’t feel it’s attractive from a risk/reward perspective. You can’t afford not to have any exposure. But you need to be selective where you are taking the exposure.”

 

dan janis iii, senior vice president with Manulife Asset Management (U.S.) LLC in Boston and lead portfolio manager of Manulife Strategic Income Fund, believes there is now greater certainty about Europe’s fiscal situation: “When it comes to Europe, we have more knowns than unknowns and can quantify some of the banks’ exposures [to sovereign debt], which before was more of a black hole. The surprise element, which caught us last year, is less of an issue. But it’s still there. What we need from Europe is a path to a solution.”

(Although the Manulife fund is not part of the global fixed-income category, it shares many common elements, such as sovereign debt from the developed world.)

Janis expects that by the end of the second quarter, Germany and France could reach a resolution regarding their sovereign debt that could take several years to implement. “If you put France, Germany and Italy together, that’s 70% of Europe’s GDP. You want those three as your ‘anchor tenants’ to set up the new rules,” says Janus, who works alongside portfolio manager Thomas Goggins. “[Those three countries] also want to avoid a situation in which one country has a vote that could disrupt the process. That was a very positive thing and a good provider of liquidity.”

But there are still concerns about the U.S.’s US$1.5-trillion deficit, which is not likely to be addressed in an election year. “After the election, we may get a path from elected officials on how they will cut the deficit,” Janis says. “But it won’t happen in one year. Both sides have to come together and get it done.”

On the whole, though, Janis is optimistic because he believes: Europe’s quandary is not a repeat of 2008; the U.S. will avoid a double-dip recession; and China is unlikely to experience a hard landing. “As such,” he says, “I still want to embrace risk — similar to what I did last year.”

Janis and Goggins have structured the Manulife fund’s portfolio into three “buckets”: the first, which accounts for 31% of the fund’s AUM, consists of AAA-rated sovereign bonds from developed markets, such as Australia; at 25% of AUM, the second bucket contains a mix of high-quality bonds issued by emerging-market countries such as Singapore and relatively lower-rated countries such as Brazil and Argentina; the third bucket, which accounts for 37% of AUM, holds U.S. investment-grade and high-yield corporate bonds. The balance is in cash.

The Manulife fund’s average bond duration is 4.7 years, vs 5.6 years for the benchmark Barclays Capital multiverse total return index (C$). About 71% of the foreign currency exposure in the fund is hedged back into C$, with about 22% in Asian and Latin American currencies and 7% in US$.

Looking ahead, Janis believes annual returns for the Manulife fund could range from 3% to 7%, before fees: “I’m still looking at the glass half-full, not half-empty.” IE