Canadian bond funds have reaped the rewards of the central banks’ strategy to ease interest rates as part of a worldwide stimulus package to keep economies afloat. And although there is a risk of inflation down the road, bond-fund managers maintain that conditions are still positive.

“We’re into a benign environment for bonds,” says Bruce Corneil, lead manager of Beutel Goodman Income Fund and senior vice president and chief operating officer with Toronto-based Beutel Goodman & Co. Ltd. “You can’t raise interest rates unless you get a liftoff [in the economy] and sustainable releveraging. So far, the jury is out as to whether that’s happening.”

Corneil argues that last autumn’s credit crunch and ensuing recession has been the most severe in three decades. “Take the recession in 1991,” he says. “We had a wholesale shakeup of some of our largest companies, such as Royal Trust, Algoma Steel and Olympia & York. Many had to be restructured or went into bankruptcy. This [recession] has been much worse.”

It could take 24 months, or more, before we will know if all the financial stimuli have worked, Corneil maintains. “Normally, when you get into a credit crunch, you end up with releveraging,” he says. “Lower interest rates foster loan growth, and off the economy goes again. But with the economy being so overleveraged to begin with, how can you releverage it?”

Corneil notes that total leverage, or borrowing, peaked in 2007, when it was more than five times the value of gross domestic product.

“We do know that we are in a process of deleveraging, but don’t know what the recovery will be like,” Corneil says. “A normal recovery would mean releveraging, in which we get a V-shaped recovery. That’s why everyone is talking about whether this will be a long, sustained U-shaped recovery or a W-shaped recovery.

“If you throw $50 billion at the economy,” he adds, “you will get a bounce. But until we see a rebound in the private side of the economy, interest rates will stay low. You have to releverage the economy to get a rebound in rates.”

In Corneil’s view, the economic recovery will be anemic, resulting in continuing low interest rates. “We will have housing starts going up,” he says, “and we will probably start to trough out and get a recovery — we’re right in the throes of it. Future fund returns are likely to be coupon-like.”

A top-down investor, Corneil shares fund-management duties with Beutel Goodman vice president David Gregoris. Beutel Income Fund has almost 50% of its assets under management in high-quality corporate bonds, the maximum that is allowed, and the rest in Government of Canada and provincial bonds. Corneil and Gregoris also co-manage Beutel Goodman Corp./Prov. Active Bond Fund, which is currently almost exclusively composed of corporate bonds. The duration in both funds is 6.9 years, vs 5.9 years for their benchmark, the DEX bond universe index.

On the corporate side, the Beutel managers favour pipelines and utilities, such as Transcanada Pipelines Ltd., Hydro One Inc., Nova Gas Transmission Corp. and Westcoast Energy Ltd.

“The majority of the move in interest rates is behind us,” says Corneil, who believes there is little prospect for inflation for about 18 months. “Dropping short-term rates to almost zero was the gain. Going out from here, until you see the private side rebound dramatically, you won’t have a huge increase in interest rates.”



Markets have definitely stabilized, says Suzanne Gaynor, manager of RBC Advisor Canadian Bond Index Fund and vice president, fixed income and securities, with Toronto-based RBC Asset Management Inc. “Last fall, [markets] were clearly in risk-aversion mode. Investors were flocking to safe-haven securities,” she says. “Ironically, you wouldn’t think the U.S., with its big printing presses, was a safe haven. But in that environment, the best liquidity was in the U.S. market.”

Last March, Gaynor notes, was a key turning point, when investors became more positive about central bank efforts; equities markets rallied and spreads between corporate and government bond issues began to narrow. For instance, Hydro One Inc. issued a five-year bond last autumn that yielded 222 basis points over Canadian treasuries — today, the spread has narrowed to 60 bps.

“We are back to pre-Lehman Brothers levels,” says Gaynor. “So, the market seems fairly valued. We have come a long way, from pricing in Armageddon to something that is normalized.”

@page_break@She points out, for instance, that the London interbank offered rate (the short-term interbank lending rate in the eurodollar market) has gone from 360 bps over U.S. treasuries to around 30 bps, the pre-Lehman Brothers level. Similarly, investment-grade Canadian corporate bonds have narrowed from a high of 400 bps over treasuries down to around 160 bps. Part of this, says Gaynor, is attributable to strong demand by foreign investors.

Is the market getting complacent? Not quite, says Gaynor: “We’re not going to have a recovery that is V- or W-shaped. We know that we’re in a period of slow growth, for both the U.S. and Canada. It’s going to take a while to get back [to full growth potential]. That’s why officials in the U.S. and Canada are leaving administered rates at low levels.”

Gaynor notes that Bank of Canada officials have said they will leave rates alone until around mid-2010, barring a spike in inflation.

Given how far spreads have narrowed, they are not likely to narrow much more. “We could probably trade in a sideways range, until we see the next catalyst for signs of sustainable growth in the economy,” says Gaynor. “The market has confidence that the officials are in control. There were a few stutters, but credit should be given to the officials for doing what it took to fix the problem — [although] it will cost a lot of money.”

She adds that the markets appear to be satisfied with the U.S. Federal Reserve Board’s exit strategy to unwind its economy-saving steps: “The recession is over. Now we need a recovery.”

From a strategic viewpoint, Gaynor had underweighted corporate bonds for most of 2008, but went to a neutral stance in the fourth quarter. “We got to neutral by increasing our defensive corporate bonds, such as shorter-term banks and utilities. The next step was to move into higher-yielding securities. But the market did not co-operate.”

To Gaynor’s surprise, spreads for riskier bonds, such as industrials and telecom firms, narrowed sooner than expected: “I thought we would be in a longer healing process.”

As a rule, the RBC fund stays close to its benchmark, the DEX universe bond index, and does not take large bets, says Gaynor. Although the fund’s federal bond exposure is about half a year longer than the index, the corporate bond exposure is half a year shorter than the index. Gaynor, who has become less defensive in the past few months, has extended duration to six years, slightly longer than the index. Currently, there is an underweight 37% of AUM in Government of Canada bonds, 31% in provincial bonds (5% overweight vs the index), and 32% in corporate bonds (5% overweight). “The added yield [by being in provincial and corporate issues],” she says, “still looks attractive.”

On the corporate side, Gaynor favours bonds issued by the Big Five banks, infrastructure names such as Highway 407 International and Greater Toronto Airports Authority, as well as consumer names such as Loblaw Cos. Ltd., and Canadian Tire Corp. Gaynor has underweighted the energy names, partly on concerns that they were risky. “What if China was not going to save the world and not need commodities?” she asks, adding that energy bonds were also in limited supply.

It is notable that the bond market hasn’t seen any further hiccups and seems to be taking the gradual recovery in stride. “There hasn’t been another widening of spreads,” Gaynor says. “It’s been pretty much a case of going from Armageddon to ‘It’s going to be OK’.”



The co-ordinated global efforts, in the forms of monetary and fiscal stimuli programs, have succeeded in stabilizing economies and markets, agrees Anthony Imbesi, a portfolio manager with Toronto-based Invesco Trimark Ltd. and a member of the team that oversees Trimark Canadian Bond Fund. “The world is a better, safer place today. There is a lot less fear. Liquidity is coming back into the market, and the banking system is working a lot better.”

Yet the trillions of dollars thrown at the problem raises the spectre of inflation, says Imbesi, who shares portfolio-management duties with Alfred Samson and Invesco Trimark vice president Rex Chong.

“It depends on how [the economy is] managed, and how quickly the stimuli are removed,” says Imbesi. “But there is a greater risk of inflation. We don’t know if it will be tomorrow or in six months or a year. It could stay low. But there is only one way it can go, if you think about it. Eventually, it will start to rise.”

As a result of that concern, the Trimark team has become more defensive. Given that benchmark 10-year Government of Canada bonds are yielding 3.5%, Imbesi argues, there are better opportunities elsewhere: “Would you be happy earning 3.5% in 10 years’ time? I’m not sure you would.”

And government bonds could come under pressure as investors demand higher yields from new debt. “Governments have moved into a large deficit position,” says Samson. “The interest rate risk is from both an increased inflation standpoint and additional supply of government debt.”

Because it is hard to predict when interest rates may rise again, the Trimark fund’s managers focus on the best risk/reward opportunities.

Of note, they have gradually emphasized investment-grade corporate bonds, which now account for 50% of the fund, compared with 34% in late 2007. There is also 22% in Government of Canada bonds, 7% in provincial bonds, 15% in mortgage-backed securities and 6% in cash. “The way we look at things is: relative value,” says Imbesi. “On a risk/reward basis, you are getting paid more to be in corporate bonds.”

The Trimark fund’s duration is about 4.8 years, or about 1.1 years shorter than the benchmark. “We are not trying to time the market, in terms of duration,” Imbesi says. “Our strength is on the credit side.”

Among the 50 corporate bonds in the fund, one larger position is in Rona Inc. The fund began with a small holding in the hardware and building materials supplier last winter, and has since added to it. The Rona bond, which matures in 2016, is yielding 6.8%, 380 bps above federal government bonds.

“We like the business and we feel it has the sustainability of cash-flow generation through the credit cycle. It is proving that right now,” Imbesi says. “It’s a name we felt comfortable with.”

One new name in the Trimark fund is Alliance Pipeline LP. This Calgary-based utility has contracts with natural gas customers in the U.S. Midwest that extend to 2015 and beyond. The holding is split between two bonds: one yielding 5.5% to maturity in 2015 and another yielding 6% to maturity in 2023.

“Energy infrastructure is an area that is attractive,” says Samson. “The contracts that underpin this pipeline system are with solid, investment-grade shippers. We are comfortable with that profile.” IE