Canadian bond markets have recovered in the past year, thanks to central banks responding to the credit crunch and actions such as the Federal Reserve Board’s engineering of the US$30-billion rescue of Bear Stearns Cos. Inc. in March. Yet fund managers expect economic conditions to remain challenging for the near term, although they are divided over where the opportunities exist in the fixed-income market.

One of those who have a particularly bleak view of where global economies are headed is Bruce Corneil, co-manager of Beutel Goodman Income Fund and senior vice president with Toronto-based Beutel Goodman & Co. Ltd. “We think that the financial turmoil has further to run. The de-leveraging of the economy has further to go as lending standards continue to tighten. This means we will have sub-trend-line economic growth — and lower interest rates to stimulate economies.”

Corneil argues that until the summer of 2007, North American economies were leveraged at a ratio of about four to one (that is, US$40 trillion in public and private debt lent against US$12 trillion in economic output).

“Historically, we’ve stayed below a ratio of two,” he says. “This leveraging of our economy has occurred on the backs of the bond market and commercial-paper market.”

Last fall, however, the latter market questioned the sustainability of the underlying assets (mortgages, car loans and the like). Credit became far more expensive and more difficult to obtain, and the process of returning to historical levels of leverage was set into motion.

“Over time, the gross domestic product will grow, but the outstanding amount lent against it will shrink,” says Corneil, who shares money-managing duties with David Gregoris, Beutel’s vice-president, fixed-income. “That process should be deflationary.”

Corneil notes that the slowdown is evident in the 17% year-over-year drop in average home prices in the U.S., and the 20% fall in crude oil prices to around US$115 a barrel. “The Federal Reserve will counteract the slowdown by lowering short-term interest rates,” he says. “[The Fed] will keep them down until we get some sort of economic stabilization and a liftoff.”

Because Corneil believes that the de-leveraging process is happening on a huge scale and is leading to drastic losses mostly for the U.S. banks (but also for some Canadian banks), he expects that it could take another year or two to unwind: “We’re not done yet — not by a long shot.”

Top-down investors, Corneil and Gregoris are being cautious in terms of average duration in the Beutel Income Fund portfolio, which is 5.7 years — half a year shorter than the 6.2 years in the benchmark DEX universe bond index. The shorter duration is based on their belief that long-term rates are expected to stay at around 4%. Because they believe the opportunities are in the middle portion of the yield curve, the bulk of the fund’s exposure is between four and 12.5 years. There is also about 6% at the short end of the yield curve and 10% at the long end.

From an asset-allocation standpoint, 31% of the Beutel fund’s assets are in Government of Canada bonds, vs 41% in the index; 26% in provincials (27% in the index); and 43% in corporate bonds (30%).

This last category is concentrated in utilities and infrastructure plays such as Consumers Gas and the Greater Vancouver Airport Authority. The managers are wary of financial services firms, to which the fund has no exposure at all. “The banks are too non-transparent; they are opaque,” says Corneil. “We are not getting enough disclosure to meet our needs.”



It’s difficult to know where economies are going, judging by the actions of the Fed and the European Central Bank, which have declared themselves neutral by standing pat on rates, argues Suzanne Gaynor, manager of RBC Advisor Canadian Bond Fund and vice president, global fixed-income and currencies, with Toronto-based RBC Asset Management Inc. “Going forward, the central banks will all be looking for signs on what the play is going to be. Will inflation become a bigger problem, or is it all about stimulating growth?”

For now, the pendulum appears to have tilted toward stimulating growth, says Gaynor, noting that the decline in crude oil prices is one key factor behind the Fed’s neutral stance. “Our hope is that the U.S. manages to stave off a recession and goes into a period of extended slow growth,” says Gaynor.

@page_break@She adds that the recent U.S. government bailouts of mortgage insurers Freddie Mac and Fannie Mae are likely to impact taxpayers for years to come. “Housing is a huge worry, and will be for much of 2009,” she adds. “People are not buying homes — some are giving them up and holding on to their credit cards.”

Nevertheless, she notes, the U.S. economy showed surprising resilience in the second quarter, growing at a 3.3% annual pace.

The rescue of Freddie Mac and Fannie Mae has seen corporate bond spreads widen over U.S. government treasuries to levels last seen in March. It’s also put pressure on the banks. “It’s a big worry that banks have to pay more to recapitalize. They’re not getting as much as they used to,” Gaynor says, noting that conditions are challenging because so-called “sovereign wealth” funds are not as eager to invest in ailing financial services firms as they were last year.

In Canada, she says, spreads between corporate and government bonds are remaining wide because fixed-income investors are expecting a supply of new issues this fall. “Buyers are a lot more reticent because they know that the banks have [to raise] more funding. Issuers have to make more concessions to satisfy buyers.”

Although the RBC fund cleaves closely to the benchmark DEX universe bond index, Gaynor is allowed to adjust the duration by plus or minus one-quarter of a year. Currently, the fund’s duration is slightly longer than the index, at 6.33 years. She is also allowed to add or reduce the corporate bond weighting by 5%, and add or reduce the provincial bond exposure by 10%. “It’s an index fund with a kicker,” she says.

Gaynor began the year with corporate bonds underweighted by 4% less than the index but has gradually moved up to a 28.5% weighting (1.6 percentage points less than the benchmark). The provincial bond weighting is 29% (1.4% percentage points higher than the index). The RBC fund also holds 42% in federal government bonds.

“Last year, when spreads were 40 basis points [for corporate bonds] over treasuries, and Ontario was issuing at around 30 bps [over government of Canada bonds], it didn’t make a lot of sense to own [corporate bond] products,” says Gaynor, noting that spreads are not likely to narrow further. “It was fortuitous that we were underweighted when spreads widened. This year, [corporate bonds] offering spreads at 150 bps — or 180 bps for two-, three- and four-year product — will add incremental yield to the fund.”

Significantly, Gaynor has been selectively buying bonds issued by some financial services providers. “There’s great value in five-year bank bonds,” she says, “with [some] spreads 170 bps over treasuries.”

Among the additions to the RBC fund are Bank of Nova Scotia bonds maturing in 2011, HSBC Bank Canada bonds maturing in 2010, and TD Bank Group bonds maturing in 2013. Some existing holdings include bonds issued by Sun Life Financial Services Inc. and Telus Inc. “I have a fair amount of confidence in the Canadian banks. Would I buy Citibank? No. But the Canadian banks are in pretty good shape,” says Gaynor, noting that down the road, she may add bank bonds with terms longer than five years. “In the future, we’ll look back and say, ‘There were some great opportunities to buy credits’.”



The credit crunch is not behind us, says Michael Crofts, manager of Mawer Canadian Bond Fund and director with Calgary-based Mawer Investment Management Ltd.: “We have not seen all the bad news from structured products, or the bad news from mortgage delinquencies. The financial system in the U.S. is not as healthy as we’d like it to be. There is a lot of weakness in some of the regional banks. You could argue they are fairly small overall. Yet, we’re starting to see a relatively significant number that are in trouble, which you can see in the FDIC [Federal Deposit Insurance Corp.] numbers.”

Although central banks have lowered rates to stimulate growth, the corporate credit market is not reflecting those moves. “You can see it in spreads [among] corporate bonds in general, and in lending conditions. Mortgage rates have stayed [where they are] or have gone up,” says Crofts. “And you have the offset: central banks are trying to get the credit market moving, but they’re all talking about inflation concerns — which bonds don’t like. It’s a tug of war.”

For now, the bond market appears to be less concerned with inflation, as commodity prices have tumbled, economies are showing signs of weakness and central banks may lower rates. “You have a weakening economy and credit conditions are degrading. Those [investors] in corporate bonds won’t be enthusiastic about that,” says Crofts. “There’s a battle going on. Low yields are supportive for the economy. The problem is that credit conditions appear to be weak. Spreads are still quite wide, despite a friendly interest rate environment from the central banks.”

A year ago, Crofts was cautious on corporate and provincial bonds and reduced the Mawer fund’s exposure. “Spreads were too narrow for the risks in the market. When spreads got to some of their widest points last spring, we began to move back into corporate and provincial fixed-income,” says Crofts. “Bottom line: we feel we’re being compensated for the risks we’re taking.”

The corporate bond weighting in the Mawer fund has gone from 25% of fund assets to 35%, or about six percentage points over the index. Similarly, the 25% provincial bond weighting has been raised to 31%, just slightly more than the index. The balance of the fund — 34% — is in Canadas. The Mawer fund’s average duration is neutral relative to the index.

Running a concentrated fund with about 30 names and focusing on credit selection, Crofts favours bonds issued by Royal Bank of Canada, Scotiabank and TD. One top holding is a Royal Bank bond that has a so-called “fixed floating” rate until 2018 (the first five years are fixed, then rates float over the next five years; the bank is expected to call the bond after the first five-year period). The bond is yielding 4.98%.

Although Royal Rank has been tainted by its involvement in the U.S. auction rate securities market (it may have to buy back certain long-term bonds from clients), Crofts likes it: “Every bank has had its hiccups. but I like the way [Royal Bank is] structured. It has done well in the past and has the strength to get through these things.” IE