Steve Locke, senior vice-president and head of the fixed-income team at Mackenzie Investments, says the recent move by the Bank of Canada and many other central banks to cut their key policy rates signals to investors to expect the low-yield environment to persist.
“Yields could go lower,” says Locke, as key central banks, including possibly the Bank of Canada, continue to cut rates, “thereby taking out what were previously considered to be new lows in bond yields.”
This trend represents a considerable challenge to those investors who are in search of yield. In Canada, the yield on the benchmark FTSE TMX Canada Universe Bond Index was 1.7% toward the end of January versus 2.2% at the end of December. “This is one of the biggest declines in one month in this benchmark’s yield that we have seen for some time,” says Locke. (The Canada Universe Bond Index represents Canadian investment-grade fixed-income securities, where bonds are rated BBB and above.)
Looking around the world, “central-bank policy rate cuts have become a pattern,” Locke says. In the last few months, “no fewer than 13 central banks” have reduced their rates. They include the Reserve Bank of India, the Central Reserve Bank of Peru and the Danish Central Bank, which recently cut its key interest rate for the third time in two weeks. Also part of this trend is the European Central Bank (ECB), which administers monetary policy for the eurozone.
The ECB is going one step further, says Locke. It is embarking on its “anticipated and ambitious” quantitative-easing program, whereby it will purchase a range of fixed-income securities amounting to 60 billion euros a month during the period from March 2015 to September 2016. “Furthermore, the ECB has hinted that it could extend this program, if necessary.”
These central banks, including Canada’s, are moving to address the challenges of slow or no economic growth and low inflation or, in some cases, deflation in their countries or regions, says Locke. In the case of the ECB, its moves are being driven by concerns about deflation and economic stagnation across the eurozone, he says.
“The U.S. economy is one of the few major economies globally to be experiencing strong growth,” says Locke. The U.S. Federal Reserve Board is “still signaling the possibility of a rate hike,” while acknowledging the economic challenges of other countries.
Even if the Fed does raise its policy rate in 2015, as is widely expected, “this move is likely to be slow and gradual,” says Locke. “We are still looking at a historically low global interest-rate environment.”
While the bond market is anticipating a “slightly tighter monetary policy” in the United States, it is starting to factor in the likelihood of a second rate cut by the Bank of Canada, says Locke. “Canada’s central bank might cut the overnight rate by a further 25 basis points at its meeting this March.” This would reduce its key policy rate, (which represents the interest rate at which the major financial institutions borrow and lend one-day funds among themselves), to 50 basis points.
On Jan. 21, Canada’s central bank surprised the market by lowering its target for the overnight rate by 25 basis points, bringing it down to 75 basis points. “This move had not been telegraphed by the Bank of Canada,” says Locke. “The bond market reacted quickly, lowering yields across the yield curve, with the biggest declines at the front end of the curve,” he says. “A second cut is likely to result in a less dramatic reaction.”
The Canadian bond market, in step with its global counterparts, has been rewarding the higher-quality investment-grade bonds, says Locke. He adds that this has been at the expense of higher-yield bonds, in what has been a flight to quality in the bond market.
At this stage, he says, “we consider that there is value to be had in the high-yield market and that both high-yield and investment-grade corporate bonds, as well as provincial bonds, offer a fair yield premium.” In 2015, “it is likely that the rewards will not go to (federal) government bonds.”
At Mackenzie Investments, Locke and his team manage a wide range of mandates including the fixed-income flagship Mackenzie Canadian Bond and Mackenzie Strategic Bond, which can hold up to 25% in high-yield bonds.
At the end of 2014, Mackenzie Canadian Bond, with 210 holdings, had 46% in corporate bonds, 31% in provincial and municipal bonds and 23% in federal government and National Housing Act mortgage-backed securities (MBSs), which represent distinct pools of insured mortgages.
Relative to its benchmark, the FTSE TMX Canada Universe Bond Index, Mackenzie Canadian Bond has an overweight position in corporate issuers, is almost index-weight in provincial bonds and significantly underweight in federal bonds. The fund’s duration, (which measures bond-price sensitivity to changes in interest rates and is measured in years) is 7.2 years versus the benchmark’s 7.5 years. “We have been increasing the duration of the fund for some time, in anticipation of the ongoing move to lower yields,” Locke says.
The Mackenzie fixed-income team has recently been adding to the provincial weighting in this fund. “The objective is to gain a pick-up in yield, add liquidity to the portfolio and increase its duration,” says Locke. The team has been finding relative value in Quebec and Ontario. The bulk of the provincial holdings have maturities of 10 years or longer, he adds.
Within its 46% corporate weighting, Mackenzie Canadian Bond has an overweight position in securities issued by the financial sector at 22.5% of the fund versus 13.4% in the benchmark index. “The banks are large issuers in this market and we have found relative value in Canadian bank senior notes,” says Locke, adding that these issues have also helped to increase the liquidity profile of the fund.
Energy issuers represent 6% of the fund versus 4.3% in the index. “We have not changed our energy holding, though spreads on these securities have been widening,” says Locke. He adds that the energy holdings in the fund “are of high quality and we are comfortable with them.”
Finally, turning to Mackenzie Strategic Bond, Locke notes that this “core plus” portfolio currently has 13.5% in high-yield bonds versus its mandated maximum of 25%. Last summer, the high-yield bond weighting in this fund was 21%, he notes, and “we reduced it in the third quarter of 2014.”
The team is now looking to selectively add to this fund’s holdings of high-yield securities, Locke says. “Some high-yield issuers represent relatively good value and remain an important means of diversifying a fixed-income portfolio.”