Fixed-income roundtable: How high will rates go?

Steve Locke, senior vice-president and head of the fixed-income team at Mackenzie Investments. Locke and his team manage a wide range of mandates including Mackenzie Canadian Bond and Mackenzie Strategic Bond.

Brian Miron, portfolio manager for Fidelity Investments in the fixed-income division of Fidelity Management & Research Co. Based in Merrimack, N.H., Miron manages a large number of mandates including Fidelity Canadian Bond, Fidelity Corporate Bond and Fidelity Tactical Fixed Income.

Michael McHugh, vice-president and head of fixed-income at 1832 Asset Management L.P. His responsibilities include Dynamic Canadian Bond and Dynamic Advantage Bond, as well as the fixed-income components of the balanced offerings.

Q: What will be the impact of the expected U.S. monetary-policy changes on the bond market? What does it mean for bond investors? Rising interest rates are clearly a headwind for the bond market.

Locke: If the Fed pursues a tightening policy and raises its policy rate in 2015, it will have to factor in the level of the U.S. yield curve and manage that curve, as it pursues a tighter policy. This, therefore, does not presuppose a dramatic shift to a higher-yield environment immediately. We must be mindful that we are starting from low bond yields. The overall yield environment will continue to remain quite low, by historic standards, for the next few years, at the very least.

McHugh: The move by the Fed to begin raising the Fed funds rate will likely result in bond yields rising to a higher plateau. The Bank of Canada has the latitude to delay the process. This will help Canadian long-term bond yields to remain below those in the United States. But Canadian bond yields are likely to be dragged higher as U.S. yields inevitably and gradually rise. Bond investors may react negatively to the prospects of capital losses in bond portfolios as a result of higher yields, by selling their bonds. A plus for the Canadian bond market is that there is a global scarcity of high-quality government bonds including Canadian government bonds.

Q: Brian, what has been the foreign appetite for Canadian bonds so far this year?

Miron: Statistics Canada publishes monthly data on foreign flows. For the first half of 2014, foreigners purchased roughly $18 billion in Canadian bonds across the issuer board versus $16 billion in the first half of 2013. Overall, foreigners hold roughly $700 billion in Canadian bonds. That is up from $400 billion in 2007, prior to the global financial crisis. Foreigners find Canada an attractive market to invest in. It is part of that global asset-allocation shift that we have discussed.

The federal government is actually paying down debt. Canada is a major triple-A government bond market. The foreign-flow data for the second half of 2014 will likely show signs of continued foreign purchases of Canadian bonds, in part because of the yield advantage that Canada has. From the perspective of the euro or the yen, the Canadian dollar might be considered to have some potential upside, not so against the U.S. dollar. In all, the Canadian investment-grade universe has $1.3 trillion in bonds outstanding, and of that amount just under $400 billion are corporate bonds.

Q: The Canadian investment-grade bond market, as captured in the benchmark FTSE TMX Canada Universe Bond Index, produced a total return from the start of 2014 to the end of August of 6.6%. For the 12 months to the end of August this return was 7.6%, which is comfortably above the five-year number of 5.2% and the 10-year number of 5.5%.

Miron: Bonds have done reasonably well as an asset class.

McHugh: The strong Canadian bond performance this year has been driven by a decline in long-term yields and a decline in corporate credit spreads over the Government of Canada yield to what are arguably expensive valuation levels. There are headwinds for the bond market going into the end of the year.

Locke: Yes there are. There will be pressure on yields to rise. In the 12-month period to the end of August, yields declined and bond prices went up in all categories. Most of the decline in credit-yield spreads was in respect of corporate debt and less so provincial debt. Provincial bonds lagged in the past year on a duration-neutral basis.

It is important to look at the performance for each of the categories on a duration-neutral basis. The benchmark index’s duration is 7.27 years. Within that index, each category has a different duration, which influences the relative performance. I suggest then that we look at the Canadian Mid-Term Bond Index for five to 10 years. This will allow us to better compare the performance of the different categories of issuers over the past 12 months to the end of August. This index’s duration is 6.43 years and all the categories are fairly close to that.

Miron: You are comparing apples to apples.

Locke: In the 12 months to the end of August, the total return on federal debt was 7.4% versus 8.4% for provincial bonds and 9.3% for corporate bonds. The overall return on that index was 8.3%. In looking at corporate debt, we do not find that every area is expensive. But with the narrower spreads that we have today, the opportunities for outperformance versus provincial, municipal or even Government of Canada bonds are going to diminish.

Miron: Corporate spreads are on average some 112 basis points above Government of Canada bonds. The long-term average is under 100 basis points.

McHugh: You can see the impact of duration on Canadian bond performance for the 12 months to August. The duration of Canada’s Long-Term Bond Index (10 years plus) was 14.38 years and it produced a total return for the period of 13.6%. The Short-Term Bond Index, with its duration of 2.77 years, produced a total return of 3.3%.

Locke: This is telling us that when you have a decline in yield, with a portfolio that has more duration, you get more price performance from those bonds.

Q: The reverse is true in a rising interest-rate environment?

Miron: Investors should expect lower returns from fixed income as an asset class, as interest rates move higher from here. The impact on the bond market will depend on the magnitude and speed of the change in interest rates.

McHugh: Active management of a bond portfolio can enhance returns.

Q: Will investors move out of bonds into equities?

Miron: This is dubbed: The Great Rotation. Investors might have a sense that the secular bull market in bonds is over and decide to reallocate assets out of fixed income into other asset classes such as equities. This is a concern that I have. But I do not see it as an imminent threat because of where bond valuations are relative to those in other asset classes.

Locke: The Great Rotation into equities is something that has been dangled as a fear in front of the bond market for the last few years. If you look back 15 to 20 years, you do not typically see it. The flow is usually from cash to either asset class. It does not usually happen from bonds to equities or vice-versa. Institutional investors are constrained as to how much they can use equity risk in a portfolio.

McHugh: Fixed income remains an important asset class. Investor demand for income remains a durable theme.

Miron: Looking at valuations in other asset classes, equities are stretched on many measures. There are loftier valuations in other bond markets than the Canadian and U.S. bond markets. Bonds serve a role in a portfolio.

Locke: They are a stabilizing factor.

This three-part series concludes on Friday.