High-yield bonds were side-swiped last year, victims of the strong Canadian dollar and the liquidity crisis that ensued from the U.S. subprime mortgage mess. As a result, spreads widened dramatically: today they are about 600 basis points more than 10-year U.S. treasuries, compared with about 240 bps in May 2007.

Although the C$ has settled into a trading range close to par with the U.S. dollar, volatility in fixed-income markets may linger for some time. Although some managers are being defensive, they are also looking for buying opportunities in the near-term.

“The subprime issue emerged in June,” says Dan Bastasic, manager of Mackenzie Sentinel Corporate Bond Fund and vice president of investments at Toronto-based Mackenzie Financial Corp. “But we didn’t see the effects until three months later, when there was evidence it would seriously affect lending conditions. The market realized this could lead to an overall economic contraction.”

Moreover, many Canadian high-yield bonds are denominated in US$. Those that were unhedged were hit by the US$’s decline against the C$. “Most of our fund is hedged,” Bastasic says. “But the move was so strong, it still had a fairly negative impact. Combined with what happened in the credit markets, this became an issue.” About 40% of the Mackenzie fund is in US$-denominated bonds.

Bastasic expects markets to remain challenging. Although he does not anticipate a full-blown recession in the U.S. or Canada, the market is expecting the worst. “The market is pricing in a 6% default rate. Compare that to the end of 2007, when there was 1.5% default rate,” he says. “Part of that will come true. Given that year-over-year corporate earnings growth in the U.S. will contract in the first part of 2008, I expect to see a two-percentage-point increase in defaults. At the end of the day, though, the market is actually fairly cheap. There’s going to be a pretty good buying opportunity of high-yield bonds.”

Bastasic became defensive in the spring of 2007, when he began increasing the credit quality of his fund’s bond holdings, moving to higher-rated securities. “When we don’t see these opportunities from a risk/reward perspective,” he says, “we either raise cash or boost the credit quality of the portfolio.”

In effect, he began adding BBB- and BB-rated bonds and reducing the B-rated bonds. The average rating is BB, or one rating below BBB-minus (investment-grade).

In the first quarter of 2007, the Mackenzie fund had 17% of its assets under management in cash, but, in August, took advantage of market turmoil to add to existing names or acquire new ones. Cash is now down to 11%. From a sectoral viewpoint, there is 13% in telecommunications and cable, 10% in retail, 7% in utilities, 6% in auto parts, with smaller holdings in areas such as agriculture.

Higher Credit Quality

Among the 50 positions in the fund, Bastasic has added to Fairfax Financial Holdings Ltd. “There is a lot of value in the company,” he says. “It has a strong investment portfolio and insurance losses are at historical lows.” The firm’s combined ratio, which measures the difference between premium income and insurance claims, is solid, thanks to the dearth of natural disasters. The bond, which matures in 2017, has an 8% yield.

Another favourite is Viterra Inc., (formerly Saskatchewan Wheat Pool). The bond matures in 2013, and yields 7.65%.

“For the next quarter or two,” Bastasic says, “we’ll maintain the higher credit quality and focus on names that are not so economically sensitive, such as the Viterras of the world.”

He expects the economy will improve around the third quarter: “We’ll get less defensive as [a turnaround] starts to occur.”



Defensiveness is also the focus for Jerry Domanus, manager of Standard Life Corporate High Yield Bond Fund and vice president of corporate bonds and private placements at Montreal-based Standard Life Investments Inc. He is concerned about the wider economic ramifications of the subprime mortgage crisis.

“Even though corporate profits are still strong, they are starting to slow down,” he says. “And the financial services sector is taking it on the chin with lots of write-downs. Corporate profits will not be as strong in 2008.”

One early indicator on the direction of the high-yield bond sector is the ratio of downgrades to upgrades by rating agencies. In late 2006 and early 2007, Domanus saw that spreads narrowed appreciably and there were more upgrades than downgrades. “Now it’s reversed,” he says. “There are more downgrades. Not big time, but the trend will continue, and there will be more downgrades than upgrades.”

@page_break@In a way, the market is going through the same process that occurred in 1996-97, when corporate spreads were narrow and then rapidly widened in 1998-99, with the Russian debt default and Long-Term Capital Management LP crisis.

“History repeats itself every 10 years or so,” Domanus says. “Today, we have the subprime crisis and loose lending standards that came back to bite the banks.”

Even investment-grade bank bonds have been hit hard, with spreads over government bonds widening to 160 bps from 60 bps.

Is the worst behind us? Although liquidity was slowly improving in late December, Domanus says, there is still a lot of volatility: “Any new issuance or negative news causes wild swings in spreads, which are often disproportionate to the importance of the news.”

For instance, rumours in January that TD Bank Financial Group was about to make writedowns caused a widening of spreads, despite the bank’s denials. And issuers of the highest-rated investment-grade bonds have also been hit.

The malaise may persist for some time, as thousands of homeowners in the U.S. will be unable to finance their mortgages when they come up for renewal. “There could be another couple of waves of problems,” Domanus says. “Companies and credits that have nothing to do with subprime will get hurt. We see a very turbulent year, in terms of spreads and credits.”

As a result, he is sticking to the higher-quality bonds and occasionally buying those that are being hit for no real reason.

Domanus focuses on higher-grade issues than most competing high-yield bond funds. The fund’s average rating is BBB, or investment-grade. About 60% is in BBB bonds, 15% in BB and 25% in A or higher. The BB portion has been as high as 30% but has declined lately because of upgrades of some bonds and Domanus’s caution about exposure in this area.

On a sectoral basis, about 25% of the fund’s AUM are in telecommunications and media (names such as Rogers Wireless Communications Inc., Shaw Communications Inc. and Bell Canada), 25% in pipelines and utilities (Alliance Pipelines Ltd., Enbridge Inc. and TransCanada Pipelines), 15% in consumer products and retailing (Sears Canada, Loblaw Cos. Ltd. and MolsonCoors Canada) and the balance in a diverse mix of infrastructure (Greater Toronto Airport Authority) and real estate (RioCan Real Estate Investment Trust).

Running a 25-name fund, Domanus took advantage of last fall’s volatility to buy bonds that had been downgraded. For instance, he acquired a Bell Canada bond maturing in 2029, which yields 7.7%. But he also maintained holdings in several bonds issued by Rogers Wireless that had been upgraded to investment-grade.

Reflecting his bias toward longer-term bonds, the fund’s duration is eight years, compared with 6.5 years for the DEX universe bond index.



Volatility is expected to continue, given the uncertainty surrounding the U.S. economy, agrees Tom Nakamura, co-manager of the AGF Canadian and global high-yield bond funds and portfolio manager at Toronto-based AGF Funds Inc.

“The big question is: how will the U.S. economy perform this year? How much of an economic slowdown will there be? Will growth pick up later in the year?” Nakamura asks. “As we have companies such as Berkshire Hathaway or BankAmerica picking up distressed assets, that will create a lot of volatility until there is some conviction about the economic cycle. We may not see low volatility for a while. And that goes for all asset classes — not just high-yield.”

This presents buying opportunities for active managers, adds Nakamura, noting the AGF Canadian fund has a 6% cash weighting. “We’re in a fortunate situation to take advantage of sell-offs, and we have enough exposure to participate in a rally,” he says. “We look forward to the next couple of quarters and refining the positioning of the fund.”

Like other managers, Nakamura and Tristan Sones, lead manager and vice president at AGF, started to become defensive in late 2006 and early 2007, and developed a bias toward investment-grade and government bonds and cash. At the end of 2007, there was only about 43% of the Canadian fund’s AUM in high-yield bonds.

“But valuations are now more attractive,” says Sones. “Even though we’re still a bit cautious, in light of the current environment, it’s definitely a buyer’s market.”

The 70-name fund is heavily weighted in large holdings in Rogers Wireless and Rogers Communications Inc., whose bonds have been upgraded to investment-grade.

“In the present environment, it’s advantageous to find companies that don’t have a lot of financing to do in the next 18 months or so,” says Sones. “Nor do we want to go too long, either.” The portfolio has a duration of 3.8 years.

As foreign content has been a key component in the AGF managers’ strategy, foreign bonds account for about 30% of the fund. About 17% is denominated in US$, hedged back into C$. There is also about 13% in emerging markets, through government bonds in countries such as Vietnam, Indonesia and Brazil.

The Brazil-based holdings, whose national currency has appreciated against the C$, include some mid-term corporate bonds issued by Banco Brasil and Companhia Siderurgica Nacional SA, a major steel manufacturer. IE