How to adjust credit quality and term to preserve yield in a landscape of rising credit costs and stable inflation

By Andrew Allentuck | November 2017

With interest rates rising slowly in the U.S. and Canada, the negative pressure on bond prices is undeniable. For financial advisors, the usual advice to match bond holdings to age - for 65-year-olds, hold 65% bonds - needs to be refined. With interest rates still in a low band, a vanilla-style bond portfolio is going to bleed red ink in the short run. Maybe longer.

Current Government of Canada bond rates tell the story. For a 21-month bond due Aug. 1, 2019, with a 0.75% coupon, the payoff is a modest 1.54%. Go out five years for a 1% bond due Sept. 1, 2022, and the yield to maturity is 1.77%. At 10 years, the 1% bond due June 1, 2027, pays 2.12%. At about 30 years, the 2.75% Canada bond due Dec. 1, 2048, pays 2.49%. Provincials and investment-grade corporate bonds add perhaps 100 basis points (bps) to the yield, but the problem remains: after accounting for inflation at the 2% centre point of the Bank of Canada's (BoC) target inflation rate range of 1%-3%, how do you generate income from investment-grade bonds?

Clearly, generating income from Canadian bonds now entails either the stretching of terms and duration, or cutting government bonds in favour of corporates. There's more risk in going long, of course, but as an announcement in September from Richmond Hill, Ont.-based Canso Investment Counsel Ltd. noted, the yield boosts from taking on duration and default risk compensate for that risk.

The Canso announcement uses a dramatic example. The Canada 3.5% issue due Dec. 1, 2045, posted a yield to maturity of 2.48% as of Oct. 11, 2017, while the Telus Corp. issue due Jan. 17, 2045, posted a yield to maturity of 4.66% as of the same date. That yield spread is 218 bps.

Bonds with default risk carry a handsome premium over federal bonds. The question for you and your clients: "How much risk to take on?"

In Canada, an A-rated corporate bond has a yield spread of 113 bps, on average, over federal bonds of the equivalent term. Drop to 10-year, BBB-rated corporates and the spread rises to 183 bps. A longer-term, BBB-rated corporate has a 240-bps spread. And high-yield corporates, on average, have spreads of between 200 bps and 1,554 bps over federal debt.

For sheer speculation, U.S.-listed CCC-rated bonds on the edge of default have an average spread of 522 bps over U.S. treasuries of the same term and, for those clients who want to bet on workouts, defaulted bonds in the distressed category had an average spread of 1,794 bps over U.S. treasuries of similar maturity as of Sept. 30.

"The new story is that the yield curve has been flattening as the Fed[eral Reserve Board] and the Bank of Canada tighten short-term interest rates while long-term interest rates don't budge much," says Edward Jong, vice president, fixed-income, with TriDelta Investment Counsel Inc. in Toronto. "If growth slows, credit spreads should widen. So, staying in investment-grade corporates will be a play on widening spreads. After all, if central banks cut the rate, corporate rates would decline; but, given the credit spread, not by as much."

The hunt for yield will mean accepting more risk. Says Jack Ablin, executive vice president and chief investment officer with BMO Harris Bank N.A. in Chicago: "The U.S. yield curve has been flattening and is, in fact, flatter than it was in November 2016, on [the U.S.] election day. So, for more yield, you have to go to lower credit quality."

Any play on the broad spread between Government of Canada or U.S. Treasury debt and corporate debt is a bet that business conditions will not worsen a great deal. Part of the risk of going long or taking on default risk, which tends to rise over time, is to rationalize term by investing purpose. So, if the money is invested for a child likely to start university in 12 or so years, the term can be set for 12 to 15 years. The longer the term, the higher the quality of the bonds should be to reduce cumulative default risk.

One can step aside from the interest/default risk estimation process and, instead, select inflation-linked bonds such as Canadian real-return bonds (RRBs). The recent picture, however, is not pretty. For the 12 months ended Sept. 30, the RRB index lost 7.4%. For the five years ended Sept. 30, the index showed a 0.2% average annual return. For the decade, the index gained 4.89% a year, but that period is anchored in the debacle of the global financial crisis of 2008-09.

Investing in bonds in a period of slowly rising interest rates and inflation that's well contained by the BoC and the U.S. Federal Reserve Board requires a move to more risk or a longer term. In corporates, they're co-variant. Laddered portfolios or laddered funds and ETFs are a bet on rising interest rates to replace lower-rate bonds. But in this world, higher inflation and higher interest rates are as speculative as the chance of default.

How far down the ladder of term and bond quality to go is the issue.

"You can forget about daily price moves if your target is a specific liability you want to cover," says Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto. "We are late in the credit cycle, so credit is expensive. On long bonds, don't go below BBB."

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