Although global bond returns were positive in 2010, this year could prove challenging. Bond yields have been on an upward trend lately and uncertainty prevails in Europe. Going into 2011, global fixed-income fund managers are either more defensive or very selective about portfolio positioning.

One of those in the latter camp is Dan Janis III, senior vice president in Boston with Manu-life Asset Management, an arm of Manulife Financial Corp. of Toronto, and lead manager of Manulife Strategic Income Fund.

“We don’t think it’s time to get defensive,” says Janis. “There are other opportunities in the bond market that have less sensitivity to a duration-type hiccup.”

High-yield bonds and emerging-markets bonds, he notes, are less affected by rising government bond yields in developed countries — as has occurred in Europe and parts of Asia.

“We think the glass is half-full,” he says. “In an environment like that, we will take on situations in riskier assets, but prudently and make sure there is liquidity to get out. We can still make money if rates do go up.”

From a top-down perspective, Janis notes, the U.S. fiscal situation is a concern because the government might not adopt the necessary discipline to rein in massive deficit spending: “The bond vigilantes might come in and say, ‘We don’t believe you will control this.’ That’s in two or three years from now. If that goes unchecked, we could have a problem.”

As well, Europe’s continued fiscal strains and restructuring efforts might lose credibility in the markets. “We could get some surprises there, although maybe not as big as last year,” says Janis. “Our view is that we don’t have to be there, so we don’t own [bonds issued by] the peripheral countries, such as Ireland and Portugal. I don’t feel confident we have the proper risk/reward in buying those bonds right now.”

Working closely with portfolio manager Thomas Goggins, Janis has organized the Manulife fund into three so-called “buckets” that contain about 350 securities in total. The first is composed of foreign bonds — AAA-rated sovereign bonds from countries such as Germany and Sweden, which represent 30% of the fund’s assets under management, plus emerging-markets bonds (18% of AUM).

“There is some risk that rates could go up,” he says. “But this is the high-quality bucket to offset going into high-yield bonds.”

On the emerging-markets side, Janis likes bonds from countries such as Singapore, South Korea and Brazil.

The second bucket consists of corporate bonds — investment-grade U.S. corporate bonds (4% of AUM) and U.S. high-yield bonds (30%). The latter is distributed across 36 industries for risk-control purposes.

The third bucket is Canadian government bond and mortgages (18% of AUM).

The Manulife fund’s average duration is slightly less than five years, vs 5.6 years for the benchmark Barclays Capital multiverse total return index (C$). About 80% of the fund’s foreign currency exposure is hedged back into Canadian dollars. Looking ahead, Janis says, annual returns could range from 4.8% to 8% before fees.

“We might clip coupons, plus see some capital appreciation,” he says, adding that interest coupons will be around 5%-6.5%.



There Are Many Risks To be weathered this year, says David McCulla, vice president with Toronto-based TD Asset Management Inc. and lead manager of TD Global Bond Fund.

“One of the biggest risks is the sovereign debt crisis in peripheral Europe,” says McCulla. “There is a lot of concern about funding and confidence in those markets. It’s not a 2011 story as much as the continuation of the 2010 story.”

Last summer, there was a pronounced increase in bond yields for the PIIGS (Portugal, Ireland, Italy, Greece and Spain).

“There was also a flight to quality, and Germany’s 10-year bond yields dropped to 2.86% compared with 12% for Greece,” says McCulla. “Maybe the PIIGS can fund their debt. But the market has lost confidence in their ability to fund, thus driving rates up even higher. So, as long as markets are confident that you will be paid back, then yields will remain where they are, or even come in.

“Right now, there is a notion there could be a default. That’s what has driven some yields substantially higher,” says McCulla, adding that long bond yields have been edging higher in the U.S., thanks to its improving economy.

Measures are in place to stabilize bond yields, such as the European stability mechanism, and Japan also has stepped in with a promise to provide support.

“You need a collaborative effort,” says McCulla. “It is all interconnected, after all. If you get a crisis of confidence, it spirals upward; the cost of funding keeps rising to the point it can’t be funded.”

Austerity measures introduced in several European countries are a positive development, he adds, although there are concerns about the impact to economic growth.@page_break@From a strategic viewpoint, McCulla likes corporate bonds, both investment-grade and high-yield: “They will cushion inves-tors in a rising rate environment. And in the government bond space, we are avoiding the long end globally. We’re concerned about rising rates, which will be felt more at the long end. We’re defensively positioned.”

About 16% of the TD fund’s AUM is in mostly U.S.-based high-yield bonds, 20% in Canadian investment-grade corporate bonds. The remainder is in sovereign debt, primarily of developed countries such as Australia and Germany.

“Canada is materially overweighted in the fund,” says McCulla, noting that Canada accounts for less than 4% of the benchmark Citigroup world government bond index.

Striking a cautious tone, McCulla says: “Our bias is to rising rates over the medium term. So, we ask ourselves, ‘How can we protect investors, should interest rates rise?’ There is no reason to be in a market if it is not providing attractive risk-adjusted returns. The most attractive returns are in U.S. high-yield, Canadian investment-grade and core European bonds.”

He adds that the TD fund’s average duration is five years, vs 6.3 years for the benchmark.



But Michael Hasenstab, senior vice president and co-director of international fixed-income in San Mateo, Calif.-based Franklin Resources Inc. , as well as lead manager of Templeton Global Bond Fund, does not believe that rising bond yields should worry investors.

“If you have the flexibility to move between different maturities and countries,” Hasenstab says, “there are a lot of opportunities.”

South Korea, for instance, raised its interest rates by 25 basis points in mid-January, driving its currency to a recent high. “One of our large positions is in South Korea,” says Hasenstab, referring to the almost 5% weighting for the country in the Templeton fund. “We’re buying short-dated government bonds that have a 3.5% yield. We’re not taking interest rate risk, but earning the yield as well as positioning the fund for currency [appreciation]. If you can go global, there are ways to get the yield without taking interest rate risk.”

Hasenstab argues that holding government bonds issued by Canada and other developed countries means taking interest rate risk, especially at the long end of the curve. “Going global offers a different opportunity set,” he says, “which allows you to navigate a little better.”

Still, there are countries to be wary of, such as Japan and its ongoing deflation. Like other fund managers, Hasenstab acknowledges the risks in Europe. He also is avoiding the peripheral countries, such as Ireland and Greece, and the Templeton fund has no exposure to the euro. “Sweden is doing well and brought its budget back into balance,” he says. “Norway has huge oil wealth. There are problem countries, but it’s not uniform.”

From a strategic viewpoint, Hasenstab is defensive. The portfolio has an average duration of 2.5 years, vs six years for the benchmark J.P. Morgan global government bond total return index. “In many parts of the world,” Hasenstab says, “we’re going to have upward pressure on rates. For some countries, possibly in the U.S. and Japan, it will be due to fiscal problems. For others, it will caused by strong growth and inflationary pressures. By and large, interest rates are trending higher.”

Backed by a 40-person team and shunning the index, Hasenstab blends top-down macroeconomic views with bottom-up analysis. In each of the 30 or so countries he studies, he looks for opportunities in either interest rates or currencies. Hasenstab tends to take a three-year horizon and the Templeton fund is highly diversified, holding about 135 bonds from 20 countries in 15 currencies. The fund owns only government bonds, with about 85% of its AUM in investment-grade bonds, and the balance in high-yield bonds.

Among the top 10 holdings are bonds from South Korea, Mexico, Poland, Malaysia and Indonesia. “Indonesia has been a strategic position for us for [more than] five years,” says Hasenstab, adding that the long-dated Indonesian bonds have grown in value, thanks to government initiatives that have improved the country’s creditworthiness. “In Indonesia’s case, we’re comfortable taking a little bit longer interest rate exposure because the yield curve is pretty steep and there is a lot of credit risk premium priced into the longer-term interest rates.

“We believe that Indonesia is on track over the next three years to become investment-grade rated,” he adds. “As a result, that credit risk premium will come down. Even if [Indonesia] raises interest rates, we believe that longer-term rates will remain anchored because of improving credit fundamentals.” IE