With economies slowing in the U.S. and Europe, the Bank of Canada has held off on raising interest rates in response to global conditions. But Canadian bond fund managers are bullish, focusing their attention on the corporate-bond sector, in which fundamentals remain strong and yields are higher than those in the government-bond sector.

“Markets are concerned about the growth prospects or lack thereof in the developed world, and primarily the U.S.,” says Greg Nott, chief investment officer with Toronto-based Russell Investments Canada Ltd. and manager of Russell Fixed Income Pool Series A. “We’ve had a fair bit of negative news — on the employment front, gross domestic product numbers, housing and manufacturing. Couple this with the political uncertainty about the debt-ceiling debate [in the US. in early August], and there is a significant lack of confidence in U.S. economic prospects.”

Despite this gloomy environment, Nott says, economic recovery will continue, although it will be modest by historical standards. “By and large that’s what we’ve seen,” he says. “Right now, people are anticipating a move back into recession. But we think there won’t be a strong recovery, nor will we slip into recession, either. What we’re seeing is a deleveraging process at the corporate and consumer level. And these processes take a long time to play out — a four- to six-year cycle. Going through this deleveraging period constrains growth.”

Still, corporate balance sheets are strong and there is room for companies to grow, hire workers and invest in new plants. As a result, says Nott, “We expect a modest increase in bond yields from these levels. Nothing dramatic. But with a change in sentiment and a more positive outlook, you could see much of this recent rally reversed. U.S. 10-year bond yields could go back to 3%-3.25%.”

Given the stronger Canadian economy, Nott expects that the BofC will raise rates by the end of the year: “[Overnight] rates could rise by 50 to 100 basis points over the next 12 months.”

Russell Fixed Income Pool has three subadvisors: Toronto-based Beutel Goodman & Co. Ltd. oversees about 50% of its assets under management; Pacific Investment Management Co. LLC of Newport Beach, Calif., manages 25%; and Richmond Hill, Ont.-based Canso Investment Counsel Ltd. oversees the remaining 25%.

The bulk of the Russell fund’s AUM is in Canadian bonds. About 12% of AUM is outside of Canada, most of that in the U.S. About 30% of total AUM is in Government of Canada bonds (vs 45% in the DEX universe bond index), 27% is in provincials (27%) and 42% is in investment-grade corporate bonds (28%). “We still like corporate bonds over government bonds,” says Nott. “Since we expect the economy to start to firm up, the duration is shorter than the benchmark.” The fund’s average duration is 5.4 years, compared with 6.4 years for the index.

“We expect a flattening of the yield curve,” adds Nott. “We’re underweight [in] the middle part — from three to five years — and overweight [at] the longer end and the very short end.”

If rates do rise down the road, Nott believes it will occur to a greater extent in the one- to five-year portion of the yield curve. “That will have the most negative impact,” he says, “if and when the curve flattens as expected.”



economic activity in the U.S. has been disappointing this year, notes Marc Goldfried, senior vice president with Toronto-based AEGON Capital Management Inc. and manager of imaxx Canadian Bond Fund. “We have not had any kind of momentum in economic indicators. Most releases out of the U.S. have been below consensus and disappointing.”

To add to the misery, the problems in the eurozone have widened, from Greece to Italy and Spain: “Over the course of this year,” Goldfried says, “policy-makers have realized that they need to keep monetary policy easy. In the U.S., there was no question an easy money policy will remain through 2011. There was no expectation of tightening until there was real confirmation of growth, and that was not expected until at least 2012.”

Even though Canada is a beneficiary of the strong demand for commodities from Asia, our economy has softened because of poor trade volume with the U.S.

“There is also so much uncertainty with respect to Europe,” says Goldfried. “And since our core inflation is within an acceptable range, a rate increase is probably off the table in Canada for the foreseeable future.”

At the same time, with the appetite for risk diminished, inves-tors have fled into safer instruments such as Treasury bonds.

Says Goldfried: “We’ve had three ‘evils’: disappointing growth; continued volatility in Europe; and the U.S. debt-ceiling debate resolved, but not in a way that was satisfactory to Standard & Poor’s [Corp.].@page_break@“But the biggest evil,” he continues, “is that we cannot seem to produce GDP growth consistent with a recovery. I am not saying that we are going to make material changes to our portfolio. But it’s difficult in this environment, with one disappointing [news] release after another, to envision a situation in which the Bank of Canada has to raise rates.”

From a strategic viewpoint, Goldfried does not make duration bets, and the imaxx fund maintains the same duration as the benchmark index. “We don’t believe that the market pays us to take interest rate risks,” he says, “and we don’t want to add that kind of volatility to our portfolios.”

Goldfried also favours corporate bonds: they had made up about 90% of the imaxx fund’s AUM as of last February; the weighting is now 75%, with the remainder mainly in Government of Canada bonds.

“We pulled back in anticipation of volatility in the summer,” says Goldfried, “and expected softness in the economy. We took some risk off the table. But if I told you in April these events would happen, I would have pulled back more.”

Goldfried still likes corporate bonds: “We think there will continue to be reasonably good cash flows and earnings, based on reduced cost structures. Companies have taken advantage of very low interest rates to finance their business models.”

Among the 25 corporate bonds (there also are about 15 asset-backed securities) that the imaxx fund holds is a 2019-dated bond from Cameco Corp. that is yielding 4.04% and a 2021-dated bond from Rogers Communications Inc. that is yielding 4.6%.



Three years after the 2008 crisis, the global economy now has to digest a second round of financial crises, says Geoff Wilson, managing director with Toronto-based TD Asset Man-agement Inc. and lead manager of TD Canadian Core Plus Bond Fund.

“The emerging markets are doing quite well,” says Wilson, who shares portfolio-management duties with Nicholas Leach and David McCulla, both TDAM vice presidents. “But the developed markets are looking at their debt loads and future obligations, and trying to make sure that their budgets are balanced, longer term. This inherently means a fiscal drag on developed markets, while emerging markets continue to be quite strong.”

Canada is in better economic shape than the U.S. But if demand for commodities and goods from emerging markets slows, that will have an impact, not only on Canada but also globally.

“My view is that we are going to have very modest growth over the next five years,” says Wilson, adding that Canada’s GDP may grow by around 2.5% annually compared with 2% in the U.S. “Going beyond that depends on the ability of the U.S. economy to reinvent itself and continue to find ways to innovate.”

Strategically, the TD fund has the flexibility to invest in other markets besides Canada. The so-called “core” component currently accounts for 85% of the fund’s AUM and resembles TD Canadian Bond Fund (the flagship Canadian bond fund managed by TDAM). The “plus” component accounts for about 15% (but can go as high as 25%, depending on the attraction of riskier assets) and is largely weighted toward U.S. high-yield bonds.

“There is a lot more risk today,” says Wilson, “although some securities are still attractively priced — if you get the right ones.”

From an overall asset-allocation perspective, 22% of the TD fund’s AUM is in Canadian federal and provincial government bonds, 63% is in Canadian corporate bonds (mostly investment-grade) and 13% is in U.S. corporate bonds. Currency exposure is hedged back into Canadian dollars. The fund has an average duration of 6.2 years.

Corporate bonds have become more attractive as spreads vs benchmark U.S. treasuries have widened to about 710 bps. “There’s been no change in the companies we invest in,” says Leach. “Many of them are industrial and materials companies.”

Among the 60 or so high-yield names is Ford Motor Co., a leading U.S. automaker. “It’s sitting on US$22 billion in cash,” says Leach, “and is generating US$7 billion to US$10 billion in free cash flow annually. The 2014-dated bond, issued in C$, is yielding about 4.5%.

“We’re trying to identify those ‘crossover’ situations that are rated between BBB and BB. I’d put Ford in that category,” Leach adds, noting that the market is expecting that Ford will be upgraded from high-yield to investment-grade within 12 months. That could result, he notes, in some capital gains.

In a similar vein, Leach also likes CF Industries Holdings Inc., a fertilizer maker, whose bonds are rated between BBB and BB. The 2018-dated bond is yielding 4.8%, or 340 bps over U.S. treasuries. “When it gets upgraded,” says Leach, “we expect the spread could narrow to about 250 bps.”

IE