With global economies caught in a weak recovery, interest rates are still at rock-bottom levels two years after the financial crisis. And although inflation remains a distant concern, Canadian bond fund managers are becoming a little more defensive and selective in their holdings.

“We’re right at the testing point,” 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. “From a U.S. perspective, we’ve had US$1.25 trillion in stimulus. Clearly, you should get a liftoff [in the economy] with massive capital works projects, such as repairing highways and bridges, and so on. Then you get an inventory rebound, which we’ve seen.”

Yet the U.S. economy is stalled he says: “With two years of oversupply, we’re not getting a housing rebound. That means you don’t get the ‘multiplier effect’ — people buying carpets and furniture and dishwashers.”

In fact, the U.S. economy has stubbornly remained in a subpar growth mode, despite the Federal Reserve Board’s low-interest rate policy. Says Corneil: “As Ben Bernanke [chairman of the Fed] pointed out to Congress, ‘This is the worst job-creation market post the Great Depression’.”

In Canada, thanks to a moderately better economic backdrop, short-term interest rates will creep upward very slowly from 0.75% to 2%, says Corneil, while long-term rates will stay down.

“In spite of large government deficits, we’re still in a deleveraging mode,” he adds. “The economy is not taking off and inflation is contained. The yield curve is flattening. Long-term rates will stay low because you’re not seeing a robust economy with excess demand. And you’re not seeing inflation because there is excess capacity. You also have a double-digit unemployment rate, if you include the millions of discouraged workers.”

Looking out by about one year, Corneil expects that inflation will stay at around 1.5%-2%, long-term government bond yields could be around 4%, while long-term corporate bond yields will be 5%.

A top-down investor, Corneil shares management duties with David Gregoris, vice president at Beutel. About 45% of Beutel Income Fund’s assets under management are in high-quality corporate bonds (vs 27% in the benchmark DEX bond universe index), as well as 40% in Government of Canada bonds (vs 48% in the index) and 15% (vs 25%) in provincial bonds.

Corneil and Gregoris also manage Beutel Goodman Corporate/Provincial Active Bond Fund, which is almost exclusively composed of corporate bonds.

The average duration in both funds is six years, equivalent to the duration in the benchmark index.

On the corporate side, Corneil and Gregoris favour infrastructure plays — pipelines and utilities such as Transcanada Pipelines Ltd., Nova Scotia Power and Hydro One Inc.

“We are not as bullish as we were,” says Corneil. “But we don’t see inflation, so we don’t see interest rates going up robustly.”

As a result, they concentrate on the yield curve and continue to emphasize quality in the corporate bond space.



With U.S. gross domestic product growth this year at around 1%-2%, says Michael McHugh, manager of Dynamic Canadian Bond Fund and vice president, fixed-income, with Goodman & Co. Investment Counsel Ltd. in Toronto, “It will certainly be much lower than a post-recession recovery. That’s a function of a financial crisis vs an inventory-induced recession. With low [GDP] growth, employment will be very slow to grow, fiscal balances will deteriorate as revenue declines and structural costs increase.”

On a positive note, McHugh says, credit markets have stabilized and companies are in better shape. “Earnings are improving, and companies have access to low-cost capital,” he says, adding that many companies are cash-rich and yet reluctant to invest. “There will be a very gradual process as companies releverage their balance sheets. We are in the midst of a slow, gradual recovery, in an environment of numerous risks and uncertainty that will contribute to bouts of volatility in the economy and capital markets.”


From a strategic viewpoint, Mc-Hugh has about 54% of the Dynamic fund’s AUM in Government of Canada bonds, 21% is in provincials and 27% is in corporate bonds. McHugh was far more bullish on corporate bonds in the spring of 2009, when they accounted for 55% of the fund.

“The reduction is based on two reasons,” he says. “First, we had the collapse in the corporate-bond spread premiums over government bonds. You were not getting paid to take the same type of risks. Second, in an environment with heightened uncertainty, there will be periods when we will see a decline in the value of risk assets over the course of this cycle. I have pulled back to neutral. It’s important not to lose sight of valuations.”

McHugh adds that he has avoided new issues that are higher-risk and have lower credit quality. He focuses on investment-grade corporate bonds and, as of late August, favoured telecommunication firms such as Shaw Communications Inc., Rogers Communications Inc. and BCE Inc.
@page_break@“We also like oil-focused energy companies,” says McHugh, referring to holdings in Canadian Natural Resources Ltd., Suncor Energy Inc. and Husky Energy Inc.

The Dynamic fund is underweighted in banks, largely because valuations are less attractive. “In an environment in which there are concerns about excessive debt, McHugh says, “the financial sector is most at risk.”

On the provincial side, the Dy-namic fund is underweighted vs the benchmark because of concerns of a deteriorating fiscal position in several provinces. “This [deterioration] could contribute to a widening of spreads over federal bonds,” says McHugh. “Second, there is a trend toward public/private partnership financing [that] is contributing to a significant increase in off-balance sheet financing by the provinces.”

McHugh has become defensive and has shortened the Dynamic portfolio’s average duration to 4.7 years. “Sentiment shifted recently to a bearish mood,” he says. “Investor focus and media coverage has been discussing deflation risks, although these risks are now fully discounted. As a manager focused on capital preservation, I believe there is growing principal risk within longer-duration bonds.”



Despite easing monetary policies, concurs Geoff Wilson, manager of TD Canadian Bond Fund and managing director of Toronto-based TD Asset Man-agement Inc.,economic growth in many economies has not reached a steady level.

“When we look at growth and break it down globally, you can really differentiate between emerging economies and developed economies,” he says. “Emerging markets have moved past the point they were at in 2008. But the developed countries are still working their way back to that level. The challenge we face is the debt overhang. We have to find our way through that.”

In the U.S., there is no sign of interest rate hikes. “In fact, we may see further evidence of quantitative easing,” says Wilson, referring to the practice of printing money. “In Canada, it would not surprise me if we saw one more increase, and then wait and see how the global economy performs. If we finish the year at 100 basis points, that would be a reasonable level.”

Canada is somewhat different from the U.S. because of its slightly stronger economy, which is due to demand for raw materials from emerging markets and a better housing market. “However, the evidence suggests that the Bank of Canada has it right,” says Wilson, “in that we’re looking at a slower period of growth in the second half of 2010.”

He adds that the first half was boosted by a rush to avoid the new harmonized sales taxes in Ontario and British Columbia that were introduced in July.

Although inflation has been pushed to the back burner, there are concerns that it will eventually emerge. “And with the growing debt in the U.S., supply/demand dynamics will cause some concern about the level of long-term interest rates,” says Wilson. “On the other side, the U.S. mortgage market has put a lot of downward pressure on interest rates as people prepay their mortgages. Once all the prepayment is done and the U.S. continues to issue bonds, there is a concern that bond yields will move back up.”

Running the largest bond fund in Canada, Wilson and co-manager Satish Rai, senior vice president and vice chairman at TDAM, have long emphasized corporate bonds.

Currently, that portion accounts for about 58% of the TD fund’s AUM. There is also about 20% in federal bonds and 15% in provincial bonds, and small holdings in commercial mortgage-backed securities, real-return bonds and cash. The average duration in the fund is 5.85 years, including the exposure to real-return bonds.

“We’ve seen spreads go from 50 bps over treasuries to more than 400 bps and fall back down to 150 bps,” says Wilson. “From here, 150 bps is not as good as 400 bps. But it’s a lot better than 50 bps. With very low interest rates, you get a significant increase on the margin by being in credit. The real question is: can we lend money to the right companies and still make that incremental income for the fund and also manage the credit exposure?”

Wilson favours investment-grade bonds, with a bias toward financial services companies. Among the 150 securities in the fund are holdings in Manulife Financial Corp., Royal Bank of Canada, Toronto-Dominion Bank and Wells Fargo Financial Corp.

“We look for a growth profile that is consistent with a stable balance sheet,” says Wilson. “We’re looking for the best companies in Canada.”

Like other fund managers, Wilson has become more defensive as of late: “Our focus is making sure we have the right risk profile, given that spreads have moved down to 150 bps. We have adjusted the portfolio, so there is less exposure to the credit market.”

Producing returns in future may be harder, he says: “The challenge is, even if you get a spread of 150 bps over Government of Canada yields of 1%, you’re only getting 2%-3% yield to maturity. That makes it difficult for all investors. There will continue to be a focus on getting that marginal income, which means there will be a continued focus on the credit space.” IE