Special Feature

Outlook 2014: Superpowers lead the way

How the economy and investments will perform in the year ahead. From the Mid-January 2014 issue of Investment Executive newspaper.

A rise in long-term interest rates amid the end of the Fed's quantitative easing program will make it more difficult to find the point at which the reward for investing is sufficient to compensate for the duration and credit risks

By Andrew Allentuck | Mid-January 2014

Bond yields by category

In order to generate satisfactory returns with reasonable risk, it's useful to examine bond yields by category. Case in point: provincial bonds currently offer a 70- to 100-bps yield boost over federal bonds. For example, an Ontario 10-year 2.85% issue due June 2, 2012, was recently priced at $94.96 to yield 3.48% to maturity, as compared to a 1.5% Government of Canada bond due June 1, 2023, that was recently priced at $90.08 to yield 2.69% to maturity - meaning the Ontario issue carries a yield boost of 79 bps.

Going down the liquidity scale, a Prince Edward Island issue with an 8.5% coupon due Dec. 15, 2023, was recently priced at $140.14 to yield 3.67% to maturity - a pickup of 98 bps over a 10-year federal bond.

In addition, the P.E.I. issue totalled only $60 million, so this bond would be more difficult to trade than the Ontario issue, which totalled $10.85 billion and trades actively. Toronto-based credit-rating agency DBRS Ltd. rates Ontario as AA-low and P.E.I. as A-low, but Ontario is a big issuer and P.E.I. is the equivalent of a small-capitalization equities play.

"You get what you pay for," says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto and co-manager of TriDelta High Income Balanced Fund. "It's lack of liquidity more than a rating notch that pushes up the yield on the P.E.I. issue. It's unlikely that any dealer has the P.E.I. issue in inventory - or wants it, unless it's a big position of $2 million or more. And if you own 10% of the P.E.I. issue, you could have a problem selling it. The Ontario bond is a trader while the P.E.I. issue is a keeper."

For clients who want to set up their portfolios with bonds to backstop their stocks, you should mention the need to take on credit-sensitive corporate bonds. Provincial issues carry A or better ratings while corporate bonds' ratings range from AAA for chartered banks' covered bonds secured against specific assets to the lower end of investment-grade BBs and out to Bs (which indicate cyclical risk) and Cs (which suggest severe challenges to the ability to pay interest and redeem principal on time).

Liquidity can be an issue for corporate issues as well. For example, an A-rated Canadian Utilities Ltd. issue due November 2022 was recently priced to yield 3.67%, a 100-bps spread over a federal issue of similar term. And of that 100-bps point spread, no more than 20 bps can be attributed to default risk, says James Hymas, president of Hymas Investment Management Inc., a specialty fixed-income investment firm in Toronto. As the credit rating declines, he adds, default risk rises, but the largest premium remains the illiquidity premium.

In structuring a bond portfolio, you also should manage duration, which is the sensitivity of the bond portfolio to interest rate changes. The DEX universe bond index's duration currently is 6.6 years, which means that a rise of one percentage point in rates would cause a 6.6% drop in the market price of the portfolio. That duration goes along with an average term to maturity of about 7.5 years.

The other factor worth considering is minimizing the loss of purchasing power to inflation through holdings of inflation-indexed bonds. Inflation is expected to remain in the low single digits in both the U.S. and Canada, so Government of Canada real-return bonds and U.S. Treasury inflation-protected T-bills are unlikely to do as well as they did in previous periods, when inflation was higher. Indeed, for the 11 months ended Nov. 30, 2013, inflation-protected Canadas declined by 13.1% compared to conventional Canadas, which dropped by 1.2%.

In the end, the fixed-income components of a client's portfolio should reflect the client's need for liquidity, inflation protection and income, says Hymas. Canadas and provincial bonds offer liquidity; investment-grade corporate bonds provide a yield increase; and high-yield bonds provide an equities-like boost to bond returns.

However, as Caroline Nalbantoglu, president of Montreal-based CNal Financial Planning Inc., notes, some of your clients may be purists who believe in holding federal bonds as the bedrock of fixed-income portfolios because of these issues' absolute guarantee of payment - with provincials and high-grade corporates adding return, at the cost of diminishing liquidity.

The argument is that below investment grade, your clients are in a quasi-equities space in which the value of their holdings could plunge.

What bonds are yielding

A closer look at yield rates for some of the top-rated bonds in the market:





U.S. Treasury




Government of Canada




Province of Ontario




Investment-grade corporates




Source: Bloomberg LP




Investment Executive Chart




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