Fixed-income inves–tors flocked to the safety of government treasuries as the financial crisis deepened last fall, and high-yield bonds (rated BB and lower) and even investment-grade corporate bonds (BBB and higher) saw their prices plummet and spreads over treasuries widen dramatically. Although spreads have narrowed somewhat, fund managers are cautiously picking through the debris for opportunities.

“It wasn’t just a high-yield story,” says Tristan Sones, lead manager of both AGF Canadian High Yield Bond Fund and AGF Global High Yield Bond Fund and vice president of AGF Funds Inc. in Toronto. “It was a credit story, in terms of credit being very weak — particularly toward the end of the year.”

As liquidity dried up, he notes, spreads priced in fears of a potential system-wide collapse: “Some of that has subsided recently, as performance over the past few weeks has actually started to improve.”

The crisis was rooted in the collapse of Lehman Brothers Holdings Inc. in mid-September. “Clients were left holding the bag,” says Tom Nakamura, co-manager of the AGF funds and portfolio manager at AGF. “With growing concerns about the worsening economic picture, a lot of people became very sensitive to counterparty risk. Markets seized up. No one was lending and no one knew who was going to be next. Without government support, or firms buying failing companies, you could be left with very serious losses.”

Market fears peaked in Decem-ber, when spreads for high-yield bonds over U.S. treasuries skyrocketed to about 2,200 basis points, according to the benchmark Merrill Lynch master high-yield II index. Today, the spread is about 1,700 bps, but still much higher than 300 bps at the start of 2008. Meanwhile, spreads for investment-grade corporate bonds have also widened considerably to 750 bps, compared with 100 bps-110 bps before the crisis. Today, the spread has slipped to about 600 bps.

Markets now are less on edge, says Sones. Governments have brought in fiscal stimulus and bailout packages; liquidity has slowly improved. “But we’re still living with fundamentals that will be poor this year,” he says. “Yet, the levels [of spreads] that we are seeing are extremely attractive on an historical basis. There are great opportunities, although you have to be cautious.”

Strategically, Sones and Naka-mura have been risk-averse since mid-2007, focusing on federal government bonds (or sovereign debt, in the AGF global bond fund) at the expense of corporate debt.

“We have been gradually rotating out of names that have done well, and into names that have weakened,” says Sones. He and Nakamura will be looking at new high-yield or investment-grade issues that will be coming out with higher yields than existing bonds. “The big theme this year is having the flexibility to be able to capitalize on what the market presents.”

The 90-name AGF Canadian high-yield fund is composed of 40% high-yield bonds, 20% investment-grade bonds, 30% government or A-rated bonds or better, and 10% cash. Lately, some of the cash has gone into so-called Tier 1 bank paper issued by Bank of Montreal and Toronto-Dominion Bank. The AGF fund’s average rating is BBB, or investment-grade.

Within the AGF global bond fund, which also has 90 names, about 33% is in government bonds from countries such as Brazil and New Zealand; 62% is split between U.S. and European investment-grade and high-yield bonds, and 5% is in cash. Sones and Nakamura have added some names in the U.S. health-care sector because its fundamentals are stronger than most.



Last year saw a massive flight to quality, says Frank Gambino, lead manager of RBC Global Cor-porate Bond Fund, co-manager of RBC Global High Yield Bond Fund and vice president with Toronto-based RBC Asset Management Inc. “We had Lehman Brothers go bankrupt, and Fannie Mae and Freddie Mac were taken over by the government,” he says. “There were a lot of stresses in the financial system, which was brought to its knees. That morphed into concerns about a synchronized global recession.”

Gambino works with a 12-person team that includes co-manager Jane Lesslie, vice president and senior portfolio manager with RBCAM.

Gambino is cautious about the next three to six months. “There are concerns about the global economic slowdown,” he says. “Credit conditions remain quite tight for many companies and consumers alike. Banks are not lending like they used to, and capital markets are not open for many corporations. Defaults are expected to pick up.”

@page_break@Still, the bond market has shown signs of a turnaround, he adds, as there has been a brief rally in corporate bonds: “It got oversold in mid-December.”

Over the next six to 12 months, Gambino is optimistic about corporate bonds, more so for investment-grade than high-yield issues: “The key for us is valuations. Credit spreads have reached historical levels. They bake in the worst news we’ve ever seen in the market. The market has discounted a Depression-like scenario in these credit spreads. But we’re positive about government and central bank actions. Eventually, there should be some traction.”

Lesslie, who specializes in emerging markets bonds, says that sector has suffered from the collapse of commodity prices and the dearth of liquidity resulting from the failure of Lehman Brothers. “We are somewhat more cautious in the near term,” she says, “partly because emerging markets are further behind in the economic cycle. Most of them will have entered into recession in the fourth quarter [of 2008].

“We are also separating the wheat from the chaff,” she adds, “keeping those countries that have made progress in reducing debt, increasing foreign currency reserves and improving public policy frameworks, vs those that have not.”

Moreover, she says, relative to U.S. investment-grade or high-yield corporate bonds, emerging markets bonds look expensive.

RBC Global High Yield Bond Fund has a split benchmark: 50% Citigroup high-yield index and 50% JPMorgan emerging markets bond index. (The latter includes about 38 countries, but the RBC fund owns only about 25.) In the current environment, says Lesslie, the fund is adopting a defensive posture; there is an overweighted 57% of assets under management in North American high-yield bonds, 38% in emerging markets, and 5% in cash.

There are about 125 holdings, including bonds issued by U.S.-based HCA Inc. and Qwest Corp. “In terms of compensation, emerging markets are not as generous as high-yield corporate bonds,” says Lesslie.

RBC Global Corporate Bond Fund is benchmarked against six indices, with the Lehman Brothers U.S. aggregate credit subindex C$ dominant. The fund is composed of 80% investment-grade corporates, 16% high-yield bonds and 4% cash. About 48% of AUM is in the U.S., 22% in Europe, 19% in Canada, 6.5% in emerging markets and 4% in Asia. The fund is highly diversified and holds more than 400 securities, with larger holdings in TD Bank and Bank of America Corp.

Gambino intends to increase the high-yield and investment-grade exposure gradually in the corporate bond fund. “Over time, we will increase the risk profile,” he says, “and capture the opportunities some time down the road.”



Is the worst behind us?

“In terms of credit, it’s a big step having governments recognize the seriousness of the situation,” says Jean-Pierre D’Agnillo, portfolio manager with Montreal-based Standard Life Investments Inc., who oversees Standard Life Corporate High Yield Bond Fund. “If the banks can’t fund themselves, there is no lending to non-financials. Everything is in suspension. So, if governments stand behind the banks, that’s a major step for credit markets.” Canadian banks have yet to tap a government program that guarantees short-term bank debt, he adds, choosing instead to launch new equity issues.

There are other signs that markets have stabilized, says D’Agnillo: “We’ve seen a pickup in primary issues since the start of the year, as opposed to last fall, when the market ground to a halt. And in terms of secondary market trading, traders are willing to give bid/asks, compared to last fall when dealers were going one way — selling. Liquidity has greatly improved.”

D’Agnillo manages a portfolio in which the average rating must be BBB, which is higher than most competing funds. He can own high-yield bonds, but only to a limited extent. Currently, 33% of the fund’s AUM is in A-rated bonds or higher, 47% in BBB, 18% in BB or lower, and the rest in cash.

Spreads were very tight during 2003 to 2007, says D’Agnillo: “The only way to add yield was to go out on the yield curve. We went into 2008 with about 50% long-dated corporates. But these are very high-quality utilities, such as Enbridge Inc., and infrastructure plays.”

The Standard Life fund was underweighted in the financial services sector because spreads were unattractively low. “We were defensive for two years before the crisis hit,” says D’Agnillo. “Spreads were too narrow. But after Bear Stearns [Cos. Inc. ] collapsed, we started slowly buying some financials — but never to put ourselves at risk.”

D’Agnillo favours industry leaders and sectors that tend to be monopolistic. From sector standpoint, there is 21% of AUM in telecommunications and media, 26.5% in energy (including pipelines), 19.5% in financial services, 12.3% in consumer staples, plus smaller holdings in infrastructure, real estate and cash.

The 50-name fund recently added a 10-year BMO Tier 1 issue, which has a 10.2% coupon — 720 bps over treasuries. Says D’Agnillo: “We had not seen that kind of coupon since the mid-1990s.” IE