Slower growth for global bond funds

Charbonneau does not believe the rate increase will be significant, adding, “But normalization of monetary policy will exercise some pressure on the upside for interest rates – if not this year, then sometime next year.”

Another concern, he says, is a general complacency in the market: investors are taking on more risk and buying into corporate and high-yield bonds.

“The search for yield is increasing the risk for underlying portfolios,” says Charbonneau, who shares duties with AGF vice presidents Tristan Sones and Tom Nakamura. “These other instruments are fairly valued, but people are buying anything for a pickup in yield. You may be getting an additional 500 basis points, but are you being compensated for taking the risks?”

As government-bond yields have fallen to record lows, Charbonneau urges investors to lower their return expectations this year. “Three to four per cent is probably on the high side,” he says, adding that a major negative event could push yields lower still, although there is little likelihood of that. “Getting 2.5% could be good, if in fact we start seeing higher rates in the developed world.”

From a strategic standpoint, the AGF fund has an average duration of 6.2 years, vs 6.7 years for the benchmark Citigroup world government bond (unhedged) index.

“Most of my duration bet is in the ‘dollar bloc’ of countries and some eurozone bonds,” says Charbonneau, adding that the AGF fund holds government bonds only. “But, overall, some markets are much more stable, and duration management is not as important within the developed world or dollar bloc.”

On a country basis, about 30% of the AGF fund’s assets under management (AUM) are in U.S. government bonds, followed by 23% in eurozone countries, 18% in Japan, 14% in emerging markets and 8.5% in Canada, with smaller weightings in Australia and New Zealand. However, the currency exposure varies, as 70% of total AUM is hedged back into the Canadian dollar (C$). The fund holds about 40 securities.

equally cautious is paul Simon, vice president of Signature Global Advisors (SGA), a division of CI Financial Corp., in Toronto and co-manager of CI Signature Global Bond Fund.

“We will have a high hurdle to traverse to match last year’s returns,” says Simon, who shares duties with SGA vice president John Shaw. “The big issuers in global fixed-income markets have engineered lower rates through monetary easing and asset-purchase programs. It’s almost asymmetrical risk to the downside, in which the yield on your bonds will be very quickly eroded if we have any backup in rates whatsoever.”

Although policy-makers want to keep interest rates low, says Simon, “Any uptick in longer-term expectations for inflation and/or growth, given the current flat yield curve, could result in negative returns for the sovereign bond universe.”

Policy-makers can influence the short end of the sovereign yield curve, he points out, but the longer end is determined by a host of factors, including a country’s growth expectations and the strength of its currency: “The market can reprice all these things, irrespective of whether the central bank is raising rates. Higher rates are a definite risk, especially in Canada, where the central bank speaks more hawkishly than the economic data dictate. [Canada’s] bond market, the way it’s priced now, is susceptible to a number of shocks.”

Much like Charbonneau, Simon notes that long-term yields crept higher in reaction to the FOMC’s statement in January that it was less committed to QE now: “This kind of thing can happen, irrespective of the official policy rate. But it was a bit of an overreaction.”

As a result, Simon expects returns in 2013 might be in the neighbourhood of 3%-4%. “It’s not beyond the pale,” he says. “If it happens, it’s because we expect monetary authorities to continue to manage their interest rates regimes. We don’t see interest rates moving much higher, but [will] maintain their range.”

However, he admits, there is potential worry in the form of bond investors who decide to seek risk elsewhere and rotate out of bonds into stocks or real estate: “This may not do much [on] the front of the yield curve, but it could impact the long end of the curve.”

From a strategic viewpoint, Simon is being cautious, as the CI fund has an average duration of six years, vs seven years for the benchmark J.P. Morgan global government traded index. About 73% of the CI fund’s AUM is held in governments in developed markets, 10% in emerging markets, 15% in investment-grade corporate bonds from developed countries and 2% is in cash.

Although the U.S. and Japan each account for 30% of the benchmark, about 35% of the CI fund’s AUM is in U.S. bonds, but only 2% is in Japan. There also is 22% in the so-called “dollar bloc,” dominated by 15% of AUM held in Canada, as well as 8% in Britain, 14% in eurozone countries, 3% in Sweden and 15% in emerging markets.

Simon favours the U.S. dollar, which represents 33.6% of the CI fund’s currency exposure, followed by 33.3% in Canada, Australia and New Zealand, 13% in emerging markets and smaller weightings in the Japanese yen and British pound sterling.

Higher than expected economic growth is one of the main risks that face the global sovereign-bond market, says Dagmara Fijalkowski, vice president and head of global fixed-income with Toronto-based RBC Global Asset Management Inc. and co-manager of RBC Global Bond Fund. “The world went into 2013,” Fijalkowski says, “with many different outlooks from various economists and strategists that focused on downside risks to growth because of prevailing austerity measures implemented in Europe and the expectation that the need for fiscal restraint in the U.S. will be heeded. As a result, the world expects lower growth in 2013. But growth could be stronger than expectations – and push yields higher.”

This is not the base case at RBC, however, says Fijalkowski, who shares fund-management duties with Soo Boo Cheah, portfolio manager with London-based RBC Asset Management (U.K.) Ltd. “But I would not assign zero probability to it, either,” says Fijalkowski. “There is probably a 30% chance of stronger than expected growth. There are some factors working in favour of global growth. If fiscal restraint and austerity do not prevail, maybe that will be the surprise in 2013.”

Fijalkowski believes that the U.S. gross domestic product will grow by about 2%, while Europe’s economic growth will be flat to slightly negative.

As for the risk of inflation, she says, markets have been very watchful since central banks introduced a series of radical policy measures in 2009.

“These inflation expectations are at the top of the range, but they are still very subdued and have not broken out of the range,” says Fijalkowski, who anticipates global fixed-income returns in 2013 could be in the low single digits. “Because of the intense vigilance, it’s probably not the key risk. That gives the central banks the flexibility to continue to engage in unorthodox measures.”

Strategically, the RBC fund’s portfolio managers are being cautious, as the fund’s average duration of 5.7 years is below the benchmark Citigroup world government bond (C$ hedged) index’s 6.6 years. Adds Fijalkowski:”But we’d like to caution that one duration number is not reflective of our strategy.”

In other words, although Japan accounts for 30% of the index’s duration, by weight, the RBC fund is underweighted in Japan because of its extremely low government-bond yields.

“We may be defensive, by reducing duration, but we are not sacrificing yield because the fund’s yield is slightly higher than the benchmark,” says Fijalkowski. “And because of the global opportunities available to us, and the multiple levers we employ, such as buying some corporate bonds, we can find these opportunities.”

From a currency perspective, about 85% of the RBC fund’s AUM is hedged to the C$, mainly because the co-managers believe it will outperform. “This warrants putting some of the currency risk back into the portfolio,” says Fijalkowski. “That’s why we have 15% exposure to foreign currencies, mostly in the U.S. and Europe. There is less than 3% in emerging markets, so [the risk] is very limited.”

The RBC fund, with about 300 holdings, is dominated by its 30% weighting in the eurozone, with a 26% weighting in the U.S., 22% in Japan and smaller weightings in Britain and Canada.

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