Bond markets have been roiled by the credit crunch ensuing from the subprime mortgage crisis in the U.S. With central banks pumping liquidity into economies and the U.S. Federal Reserve Board responding to the potential of slowing growth by lowering interest rates, some fund managers are taking a cautious approach to market conditions.

“We’re in the middle of a ‘credit event’ and there’s is a lot of stress in the financial intermediaries, with the asset-backed commercial- paper market having an affect on all spreads,” says David Gregoris, co-manager of Beutel Goodman Income Fund and vice president of Toronto-based Beutel Goodman & Co. Ltd. “We’re seeing a re-pricing of credit risk. And it’s affecting all kinds of financial intermediaries — banks, brokerages, insurers and financing companies of any sort.”

There has been considerable volatility, adds Gregoris, as spreads have widened. For instance, the spread between bankers’ acceptance notes — used in short-term financings — and three-month government treasuries has gone to about 75 basis points from about 20 bps. Meanwhile, spreads on junk bonds in the U.S. over 10-year U.S. treasuries have jumped to about 475 to 500 points from 270 bps.

“Any type of financing company has been going through a re-pricing [of credit],” Gregoris says. “This is probably the hot bed right now.”

Nevertheless, the widening of spreads is a healthy development. “We’ve gone from an overly tight basis to a more normal situation,” says Gregoris, who works with lead manager Bruce Corneil, senior vice president and COO at Beutel Goodman.

Although central banks have pumped liquidity into the financial systems — the U.S. Federal Reserve, for instance, lowered the discount rate by 50 bps in August — the meltdown in the subprime mortgage market has affected a host of players who have lost billions because they bought commercial paper and leveraged it to maximize profits. “It doesn’t take much to start hurting profitability and ability to get funding,” he says.

The crisis could linger for some time because of its origins in the U.S. housing market, says Gregoris, And because housing is a significant part of the U.S. economy, the best outlook in that country is subpar economic growth rates of around 2%. “We think it will be lower than that,” he says. “If anything, there is a higher risk of recession than in the last few years.”

Gregoris admits he was surprised that Ben Bernanke, Fed chairman, lowered the federal funds rate and the discount rate in mid-September to 4.75% from 5.25%. “But three to six months from now, I would expect that Bernanke would have to lower rates further,” he says. “He may not have a choice. The economic numbers will show weakness and he will lower rates.”

Meanwhile, he notes, the Canadian bond market has already started to rally in anticipation of such a move. For instance, yields on benchmark Canadian 10-year treasuries have moved down to 4.3% from 4.6% .

“When it becomes apparent [that growth prospects are questionable], bond markets will rally. [They] always [have] in the past,” he adds.

Strategically, Gregoris is being moderately defensive. “We’re positioned in the middle part of the yield curve, and looking for a steepening of the curve.”

The fund’s duration is neutral relative to the benchmark Scotia Capital universe bond index, whose duration is 6.5 years. In terms of asset mix, there is a neutral 43% position in government of Canada bonds, an underweighted 23% in provincial bonds (vs 29% in the benchmark), and an overweighted 34% in corporate bonds (vs 29%).

Yet he is maintaining a conservative approach in terms of credits by emphasizing regulated utilities and pipelines, and underweighting financial services firms. The top 15 holdings, which account for 62% of the portfolio, are dominated by bonds issued by Westcoast Energy Inc., TransCanada PipeLines and Union Gas.

But even though spreads have widened, Gregoris is not rushing to snap up any potential bargains. “Bonds are still not overly cheap, at least from our point of view,” he says.



The credit crunch has the potential to escalate, warns Tom Czitron, manager of Sceptre Bond Fund and managing director and head of income and structured products at Toronto-based Sceptre Investment Counsel Ltd. “If things don’t settle down and liquidity is restricted, we could see a significant economic slowdown — although that’s not our call so far,” he says.

@page_break@The yield curve is fairly flat in the U.S., and the difference between short-term rates and so-called headline inflation is fairly high. “By itself, it’s not a big enough indicator of recession,” he says. “But, with the credit crunch, the chances are significantly higher.”

Czitron believes that the underlying problems behind the credit crunch may persist for some time, as many lenders should have not lent money. “At the fringe, there was a lot of imprudent lending going on,” Czitron says, adding that house prices may weaken or at best flatten, as families are finding it more difficult to buy homes. “This has to work its way through the system. I don’t think a small cut in rates will resolve these problems.”

The yield curve will start to steepen, he adds, as short-term rates decline within a year, while long-term rates remain where they are or move slightly lower. Yet the Fed is striking a delicate balance between controlling inflation and preventing a recession. “If it lowers rates too much, we could have an outbreak of inflation like we have not seen in a while. If it keeps rates the same, the credit crunch could worsen.

“Either way, there will be some difficult adjustments to the current situation,” he adds. “Our view is that rates will be a little lower, but we worry that in two or three years, we could have more inflation and bond yields could be even higher.”

Like Gregoris, he argues that the bond market is returning to more normal conditions. “In the worst part of the crisis, everything was being punished,” he says. “Now, we’re going through the carnage and seeing that there are probably some good values out there. There are still a lot of good corporate credits, but spreads are higher than they were a year ago.” The average spread is up around 30 bps.

“If you are patient, and buy good corporate credits, you will be well rewarded over the next few years,” Czitron says. “There may be better opportunities in a couple of months, but you should start looking at these issues now.”

Czitron is maintaining a duration of 6.3 years, which is slightly shorter than the benchmark Scotia bond index. Broadly speaking, he is underweighting long-term bonds, overweighting the mid-term and market-weighting short-term bonds. From a sector allocation viewpoint, there is an underweighted 22% position in provincial bonds, an overweighted 46% in corporate bonds (which are tilted toward short-term bonds) and an underweighted 32% in federal bonds.

“Even when we are bearish on corporate bonds, we will stay in the short end,” says Czitron, adding that he has observed that in any 12-month rolling period in the last 20 years, there is an 85% probability that short-term corporate bonds will outperform short-term Canada bonds.

At the same time, he has lately moved to better quality bonds, such as those issued by companies involved in infrastructure projects, as opposed to those geared to the economic cycle. Typical holdings in the 70-name fund include Greater Toronto Airport Authority, Caterpillar Co., TransCanada PipeLines and GE Capital Corp.



It could be some time for the re-pricing of credit to make its way through the system, argues Geoff Wilson, co-manager of TD Canadian Bond Fund and managing director of Toronto-based TD Asset Management Inc. “It could be here for the balance of the year. From there, we will set new levels. It could remain more volatile than it has been. And that creates opportunities.”

Wilson suggests that the credit crunch is largely concentrated in the U.S., and not in Canada, where the corporate sector has benefited from improved balance sheets.

“Underlying corporate Canada are some very strong companies — and their credit spreads have not moved a lot,” says Wilson. “In the U.S., credit spreads are considerably wider. It’s also focused in on the structured products that utilize the derivatives market to package some of the riskier assets and concentrate that risk profile on subprime mortgages, for example,”

As the markets have re-priced those assets, “there has been some dislocation that has spread to the general market, and credit spreads are wider,” Wilson says, adding that concerns about the subprime market were not new and had been raised before this past summer’s turmoil.

Should the U.S. economy show signs of slowing as a result of the subprime crisis, the Fed will cut rates, Wilson believes: “We need to see some economic data to reflect the weakness. It will be forthcoming. It’s only a matter of when.” As Canada’s economy is in better shape, however, the likelihood of a rate cut this year is much slimmer.

Running the largest bond fund in the country, Wilson, and lead manager Satish Rai, vice chairman of TDAM, have long emphasized corporate bonds. Corporate issues account for about 55% of the portfolio.

There is also about 20% in federal bonds and 15% provincial bonds, 5% commercial mortgage-backed securities and 5% real-return bonds. The duration of the entire fund is 6.45 years, excluding the real-return bonds. Viewed as one group, the corporate bonds have a shorter duration of four years.

Wilson and Rai have been adding selectively to existing holdings among Canadian banks and financial services firms, and mainly focusing on 10-year bonds for which spreads have widened about 30 bps over government treasuries.

“When we see some volatility in the market we’re likely to go back to the bonds we are comfortable with, as spreads widen out,” says Wilson.

Among the 150 names in the fund are holdings that include Manulife Financial Inc., TD Financial Group, GE Capital Corp. and Sun Life Financial Inc. IE