ice freeze / Yevgeniy Drobotenko

The mainstream bond markets have fallen on bad times. Widespread expectations of higher inflation in a post-pandemic economic rebound are weighing on bonds, and they’ve taken a hit from rising yields.

Through the first five months of this year, the benchmark FTSE Canada Universe Bond Index is down more than 5%, an uncomfortably steep drawdown for what is supposed to be a less risky asset class.
Amid this depressing backdrop, some asset-allocation experts have advocated lowering bond allocations in portfolios or, more boldly, avoiding bonds altogether. But these approaches will increase investor exposure to equities at a time when valuations have become elevated and, some would argue, vulnerable to a correction.

Regardless of their low yields, bonds provide diversification and a source of liquidity whenever equities markets turn bearish. Financial advisors and their clients must consider how to structure their fixed income allocations in the current inhospitable environment.

“There are parts of the fixed income market and different strategies that actually can still perform and produce positive returns in fixed income,” said Paul Sandhu, president and CEO of Toronto-based Marret Asset Management Inc., which manages about $5.5 billion in mutual funds and ETFs for CI Investments Inc. “For instance, there are some fixed income strategies that don’t take any interest-rate risk. There are some fixed income strategies that focus more on yield with very limited duration.”

Even so, returns won’t come easily. On the whole, corporate bonds yield only about 100 basis points more than government bonds. “Investment-grade corporate credit is not overly attractive at current spreads,” said Sandhu, referring to the average yield pick-up over Government of Canada or U.S. government issues. “If you look at the Canadian market, we’re only five or 10 basis points away from the all-time tightness in credit spreads.”

Moreover, corporate balance sheets currently tend to be highly leveraged, with a greater proportion than in the past of credits that are rated BBB, the low end of investment grade. “We have almost the highest levels of corporate leverage in history, and we’re getting paid very little,” said Sandhu, whose largest ETF under management is the $880-million CI Investment Grade Bond ETF. “So from a credit fundamental point of view, your risk-reward here is not great.”

That said, Sandhu believes investing in corporate issues to pick up extra yield still makes sense, given an economic environment where businesses will be reopening as the Covid-19 pandemic eases and corporate cash flows will improve. But he doesn’t expect much in the way of capital gains — excess returns over and above the yields — from any further tightening of spreads.

When investing in corporate bonds, security selection is important, said Tom O’Gorman, director of fixed income with Franklin Bissett Investment Management, part of Toronto-based Franklin Templeton Investments Corp. “We’re very selective and very much doing bottom-up type research,” said O’Gorman, who heads a team in Calgary that manages more than $5 billion. “The easy money in just allocating to corporate bonds has been made. Now it becomes very much relative value.”

The same thinking applies to high-yield corporate bonds. As O’Gorman put it, high yield isn’t high any more, since some issues have coupon yields of 4% or lower. On the positive side, these bonds provide diversification to Canadian investors because of their lack of correlation with the broad Canadian market, he said.

Floating-rate bank loans are another source of higher fixed income yields, and one the Franklin Bissett team has been adding to holdings in modest amounts. Along with being positively correlated to economic growth, the loans can do well in a rising-rate environment, O’Gorman said. Because of their floating rates, their prices move in the same direction as interest rates.

Real-return bonds also provide protection against rising rates, because their payouts are tied to inflation. They’ve outperformed the broader Canadian market over the past 12 months but not more recently, as seen in year-to-date losses by the BMO Real Return Bond Index ETF and the iShares Canadian Real Return Bond Index ETF.

Marret holds real-return bonds in almost all of its mandates. Nearly all of these holdings are in U.S. Treasury Inflation Protected Securities, known as TIPS, which Sandhu prefers because they are much more liquid than Canadian government real-return bonds. ETF investors can obtain exposure to TIPS through the BMO Short-Term US TIPS Index ETF, launched in January.

Sandhu said that since real-return bonds already performed well last year while providing inflation protection, the time to buy has probably passed. “You would have to have a very hawkish view on inflation to buy more inflation-protected bonds from here,” he said. “You actually now might be looking for a place to start selling them.”

Among the more exotic fixed income investments are emerging market bonds. “It hasn’t been a huge part of what we do,” said O’Gorman, who favours U.S.-dollar issues rather than those denominated in local currencies. “But again, it’s another one of those areas that can offer some diversification.”

Sandhu said Marret generally avoids these securities because of the higher default risk, volatile local currencies, and difficulties in assessing the creditworthiness of sovereign or corporate issuers. “We’re not experts in emerging markets and we don’t claim to be.”

Led by the IA Clarington Emerging Markets Bond Fund, Canadian-listed fixed income ETFs specializing in emerging markets have outperformed their Canadian counterparts over the past 12 months. But Sandhu said the risk factors associated with these securities “are greater exposures than we really want to take for our clients.”

What Sandhu does support enthusiastically is global diversification in developed markets. In government bonds, diversification enables Marret to take advantage of different monetary policy regimes and differences in relative value across different countries. On the corporate side, issuers in the U.S. and elsewhere provide fixed income exposure in sectors and industries that aren’t available in Canada.

With multinational companies that issue bonds in various currencies, Marret looks to exploit pricing anomalies between countries. “You might be able to find bonds of an issuer that are cheaper in one market relative to another,” Sandhu said.

But Marret generally shuns foreign currency exposure by fully hedging back to the Canadian dollar. “Currency is in our view one of the most volatile asset classes,” said Sandhu. “Having unhedged currency in your fixed income portfolio generally gives you more volatility. What we’re trying to do is sell you fixed income products that lower volatility in your overall asset allocation.”

O’Gorman takes a contrasting view. Though the Franklin Bissett team’s scope for foreign currency exposure is limited in its Canadian-focused mandates such as the Franklin Liberty Core Plus Bond ETF, it currently has about 7% U.S. dollar exposure in its portfolios.

“We view the Canadian dollar to be extremely overvalued,” O’Gorman said, citing a domestic economy driven by consumer borrowing and government stimulus, and where the housing boom crowds out capital investment.

“We’ve seen these overshoots before where the pendulum goes way too bearish on the Canadian dollar and way too bullish,” he said. “And we think [the market is] in the way-too-bullish camp right now.”