Sector Watch: Fixed-income funds face headwinds

As a result, portfolio managers of Canadian fixed-income funds have been employing a mixed bag of strategies to diversify portfolios and maximize returns in a difficult environment.

For example, many fund portfolio managers in the fixed-income category are allowed to hold some foreign content by their mandate, and have been sifting through the bigger and broader corporate bond market in the U.S. to diversify portfolios by currency and by issuer.

The Fed has raised its key lending rate three times so far in 2018, reaching 2.25% on Sept. 26, and has indicated the rate could be raised one more time before yearend. This year’s increases follow three implemented last year.

A strong U.S. economy, along with robust job numbers and wage growth, means the Fed is likely to remain committed to its policy of gradual interest rate hikes. Inflation remains close to the target of 2%, which translates into little pressure for more drastic increases.

A buoyant U.S. dollar (US$) may mean some caution could enter the Fed’s approach to raising interest rates. The US$ has been rising strongly against most other world currencies, which could be destabilizing for the global financial system if other countries run into trouble repaying their US$-denominated debt.

Collectively, some emerging markets’ borrowers are on the hook to repay or refinance a massive US$1.5 trillion in debt in 2019 and a similar amount in 2020. However, many of those borrowers are not generating enough revenue to meet their obligations. There already was a sell-off in emerging-market debt this year.

The value of the Canadian dollar (C$) is down sharply against the US$ this year, while the value of some emerging markets’ currencies, such as Turkey’s lira and Argentina’s peso, have declined by more than 40% vs the greenback. A weaker C$ gives the BoC some room to raise interest rates.

The BoC, after tightening interest rates in January and July, delayed raising rates again in September, leaving the trend- setting rate at 1.5%. Raising interest rates could slow Canada’s economy at a vulnerable time, when the housing market remains touchy, consumer debt is at record-high levels and households are sensitive to interest rate increases.

“Canada is a bit beholden to the Fed and U.S. economic policy, but the more we hike [interest rates], the stronger our dollar, and that’s not necessarily good for the rest of the economy,” says Tom O’Gorman, senior vice president and director of fixed-income at Franklin Bissett Investment Management (a unit of Toronto-based Franklin Templeton Investments Corp.) in Calgary and portfolio co-manager of Franklin Bissett Core Plus Bond Fund.

Although there has been meaningful tightening of U.S. interest rates, economic strength in the U.S. has been boosted by tax cuts, O’Gorman says, a measure that can’t be repeated every year. Thus, he anticipates the pace of U.S. growth will moderate in 2019 and there will be less upward pressure on interest rates.

“The big issue is whether wages, especially in the U.S., will grow enough to filter through to inflation, and we don’t foresee that happening,” O’Gorman says. “We don’t foresee this year’s pace of economic growth being repeatable in the U.S. next year. There also are some headwinds out there, including trade, as well as demographic factors and the erosion of some jobs by technology and artificial intelligence. At some point, the Fed will temper its expectations, and Canada will follow suit.”

The Bissett fund holds 70%-80% of its assets under management (AUM) in Canadian fixed-income, including federal, provincial and municipal bonds and investment-grade corporate bonds, as well as debentures and short-term notes.

The remainder of AUM is held in non-core or “plus” strategies for added potential, O’Gorman says. These securities can include high-yield bonds, foreign currency bonds, emerging-market debt, mortgage-based and asset-backed securities, preferred shares and bank loans. Foreign content can be as high as 30%.

“The Canadian market is smaller than [that of] the U.S., and half the corporates [in Canada] are issued by banks,” he says. “When we diversify, we’re looking for non-correlated investments that complement our Canadian core portfolio.”

The most recent Canadian energy crisis, triggered by plunging oil prices in 2015 and 2016, caused a sharp drop in the value of corporate debt across the board in Canada, O’Gorman says. The Bissett team was able to buy some attractive issues at low prices as the spread widened dramatically between corporate and government bonds, and these holdings subsequently boosted returns as the market recovered.

“It was a ‘pound the table’ moment for us,” O’Gorman says. “The baby was being thrown out with the bathwater, and we were aggressive. We’ve since had two-plus years of outperformance by corporate [debt].”

O’Gorman says the spread since has narrowed and corporates are “still attractive, but not as attractive.”

Corporate bonds now account for about 60% of the Bissett fund’s AUM, while government bonds make up about 33%. U.S. high-yield bonds have had a positive return this year even though U.S. interest rates have been rising, but the fund currently has no exposure to emerging markets.

“When the economy is good,” he says, “high-yield bond prices can go up even as rates rise.”

With short-term interest rates still heading upward, O’Gorman has been taking steps to invest a portion of the Bissett fund’s AUM in floating-rate securities and to upgrade quality to include more bonds with higher ratings – Triple B or better.

As well, the Bissett fund has sold off lower-quality, securitized bank loans and traded them for “investment-grade slices.”

Says O’Gorman: “On the corporate side, we’ve shifted away from consumer industries and [reduced] our exposure to the riskier energy stuff. We still [invest in] high-quality energy names, such as Suncor [Energy Inc.] and Canadian Natural Resources [Ltd.], and now hold more of the highly regulated and defensive issues, such as utilities and pipelines.”

mackenzie Strategic Bond Fund is another strong performer in the Canadian fixed-income category. The fund has achieved superior returns by maximizing diversification outside traditional government bonds. The fund holds about 55% of its AUM in corporate issues, with a strong emphasis on U.S. companies’ debt issues.

Felix Wong, vice president and portfolio co-manager with the fixed-income team at Toronto-based Mackenzie Investments, says the team also takes advantage of opportunities in other income-producing securities that offer higher yields than traditional bonds do.

Those higher-yield securities include preferred shares, real estate investment trusts, asset-backed securities such as credit-card receivables, and Maple bonds. (The last category is issued by foreign borrowers in C$).

Although Wong is cautious about exposure to emerging markets, he says, there are opportunities in some of the more stable issues, and the Mackenzie fund holds some Caribbean bonds.

As with the Bissett fund, the portfolio managers of the Mackenzie fund took advantage of opportunities in the Canadian corporate bond market when valuations dropped and spreads widened in 2015-16. But as spreads began to narrow earlier this year, the Mackenzie team cut back on the “high beta” corporate issues for which valuations appeared to be unsustainable.

The Mackenzie fund’s exposure to provincial bonds also was reduced, as some of the valuations appeared to be expensive, Wong says. However, the team added to holdings in some of the energy-related provinces, thanks to a positive outlook for oil prices.

Investment-grade corporate bonds in Canada are highly correlated and they often move in tandem, Wong says. That is why he looks to the U.S. for exposure to sectors that are minuscule in Canada, such as pharmaceuticals, telecommunications and industrials.

“At this point, we’re going for higher-quality issues,” Wong says, “as the valuations [in lower-rated bonds] are such that we were not getting paid to take risk.”

With the U.S. economy growing at an annual rate of 4%, the Mackenzie fund is being positioned for higher interest rates, Wong says. It has a slightly shorter average duration than its benchmark index, for which the average duration is about 7.5 years.

Wong anticipates the Fed will continue its pace of raising its trend-setting interest rate by one increase per quarter into 2019, and that Canada, where annual economic growth is about 2% nationally, will raise interest rates once every six months.