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David Stonehouse, vice president and member of the fixed-income team at AGF Investments Inc. He is responsible for a wide range of income-generating mandates including AGF Fixed Income Plus, AGF Diversified Income and AGF Global Convertible Bond.
Q: Is there anything more we need to add to our discussion about the Canadian fixed-income benchmark index?
McHugh: The duration of the FTSE TMX Canada Universe Bond Index keeps going up. As I mentioned, this is a general trend in fixed-income markets. It reflects the impact of low interest rates and the issuances of longer-term debt by a range of issuers. (Duration, expressed as a number of years, measures the sensitivity of the price of a fixed-income security to a change in interest rates). At the end of August, the duration for the benchmark was 7.7 years versus 7.4 at the end of February. This 7.7 is a historic high for Canada and I think that it is true for all the major bond universe indexes in the developed countries.
Q: How have Canadian real-return bonds performed in the 12 months to the end of August? (Real-return bonds are those bonds where principal and interest payments are adjusted for inflation using the consumer price index).
McHugh: The real-return bond index includes mainly longer-term bonds and as a result has a long duration. In the FTSE TMX data at the end of August, the duration on real-return bonds was 15.66 years and these bonds produced a total nominal return of 9.16% for the 12 months to the end of August.
Gregoris: The return on real-return bonds is always expressed in nominal terms; it includes any inflation compensation. Compare the return from real- return bonds to Government of Canada long-term nominal bonds, which have a maturity of 10 years or more. In the FTSE TMX Long Term Bond Index, the duration on Government of Canada bonds was 15.57 years at the end of August, a similar duration to that of real-return bonds. These federal government nominal bonds had a total return of 11.32% for the 12 months to the end of August.
Q: What about the Canadian high-yield market?
Gregoris: The Canadian high-yield market is heavily weighted in energy. As the oil price rebounded and stabilized, some of those issues that were unduly depressed, prior to the commodity move, have rebounded strongly.
Stonehouse: With high-yield securities, you have to be concerned about defaults. The default levels have gone up. But the worst pressure on the oil patch has subsided. Default rates in energy are anticipated to peak in the latter part of this year into the early part of next year.
Q: It is time to talk about your portfolios. Let us start with David Gregoris and Beutel Goodman Income. This fund invests only in investment-grade securities, those with at least a BBB credit rating.
Gregoris: The duration of this portfolio is 7.6 years, which is similar to that of the FTSE TMX Canada Universe Bond Index, the benchmark of this fund. We have an underweight in Government of Canada or Government of Canada guaranteed securities at 22.1% versus the benchmark 36.1% weighting. We are market weight in provincial bonds at 33.5% versus 34.7% and overweight corporate securities at 42.8% versus 27.3%. The emphasis in our corporate holdings is on financials and utilities. Some of the utilities are energy-related.
Q: How did financials perform over the last year?
Gregoris: Looking at the FTSE TMX mid-term index, so as to avoid the influence of duration, financials produced a total return of 5.85% in the 12 months to the end of August versus 6.46% for energy.
Q: What about the positioning of Beutel Goodman Income along the yield curve?
Gregoris: Going into the year, we were focused on the middle part of the curve. At the beginning of the summer, in recognition of the flattening of the yield curve, we sold some mid-term holdings and bought both shorter-term and longer-term bonds. We run a conservative portfolio. We are looking for opportunities to become even more conservative on the credit spectrum. To Michael’s point, we see the overall credit cycle as being an issue for the bond market.
Q: Michael, can you please discuss Dynamic Canadian Bond, which focuses on investment-grade securities, and Dynamic Advantage Bond. The latter can include a wider range of investments, including high-yield bonds.
McHugh: We are defensive with respect to both interest-rate risk and credit risk. That is the framework for both portfolios. Our duration in both mandates is three years. Like David Gregoris, we have a bias towards higher credit quality within both portfolios. This is linked to our perception that we are in the late stages of the credit cycle and that corporate-bond valuations are vulnerable. Dynamic Canadian Bond has roughly 35% in investment-grade corporate bonds, 35% in provincial bonds, 15% in federal government bonds and 5% in real-return bonds. Floating-rate notes, which are mostly provincial, are 10%. The biggest weighting in the corporate sector is financials, in the form of deposit notes. (These are short-term securities issued by Canadian banks.) We look at these as being the relatively safe, liquid part of the corporate bond market. Our second largest weighting is utilities and our third largest is telecom, followed very closely by energy, mainly pipelines.
Dynamic Advantage Bond has roughly 50% in investment-grade corporate bonds, 3.5% in high-quality high-yield bonds, which is at the very low end of our mandated maximum weighting in these bonds, reflecting our view on the credit cycle. We have 18% in real-return bonds with a view that this asset class has become inexpensive. We have 6.5% in federal government securities and 22% in provincials.
Q: David Stonehouse, can you please discuss AGF Fixed Income Plus?
Stonehouse: We are running this portfolio with federal government bonds in the upper 20%. The fund has a small exposure to real-return bonds and floating-rate notes, which together with federal government bonds would total 32% of the fund. Provincial bonds constitute 23%. Investment-grade corporate bonds are around 34% and other holdings would be around 11%. This category includes 2% in emerging-market debt, 4% convertible debentures and 5% in higher-quality, high-yield bonds. This fund is positioned somewhat conservatively in the current environment. Valuations are not cheap and this point in the credit cycle is not the most attractive to us. We are overweight BBBs in our investment-grade corporate bond holdings. We view our holdings in the triple-B category as being of higher credit quality. The duration of this fund is 7.4 years, which is similar to David Gregoris’s fund.
Q: Time to sum up and talk about the outlook for the fixed-income market.
McHugh: The valuations and liquidity challenges are likely to create volatile investment returns going forward. Also, the price sensitivity of the fixed-income securities at these low levels of interest rates to even small changes in these rates makes for greater volatility. We are looking at an environment of higher volatility, low income and the prospect of capital losses. My challenge as an active manager is to mitigate this. It is important not to extrapolate a significant positive return profile from fixed-income securities going forward, given how low yields are and how much credit spreads have compressed.
Stonehouse: We are talking about a more sober outlook for bonds. Return prospects are lower because yields are lower. But there is still a case for owning bonds. They do give you better capital-preservation characteristics than equities. Diversification is important for investors too. There are low correlations with other asset classes. The correlation between bonds and equities has been lower than historically, in the last decade plus. Even if return prospects from bonds are in the low single-digits, the risk-adjusted return prospects still look good relative to equities.
Gregoris: We are mindful of the prospect of rising interest rates. Participants in the bond market have this expectation that central banks will continue to come to the fore, but central banks do have a limited tool set. I would like to make a case for active management of fixed-income portfolios versus passive investing. Active management at this point in the cycle is beneficial. If you do your credit work, you can avoid defaults and add returns.