Despite low yields on longer bond maturities, active fund managers aren’t shy about venturing further along the yield curve. Though prices of long-dated bonds are vulnerable to rising interest rates, this risk must be weighed against sluggish global growth and potential easing of monetary policy by central banks.
Paul Sandhu, for one, says the prevailing trend is for lower interest rates, an environment in which bonds can thrive. “We have been bullish on global interest rates since about this time last year,” says the president and CEO of Marret Asset Management Inc., a subsidiary of Toronto-based CI Financial Corp. Specializing in fixed-income, Marret’s mandates include the $740-million CI First Asset Investment Grade Bond ETF and the $704-million CI First Asset Enhanced Government Bond ETF.
Marret’s interest-rate calls are based largely on its analysis of economic data in the developed markets, as well as China, that make up about 70% of global GDP. Another other key consideration is the monetary policies of the central banks in these countries.
Thirdly, the firm assesses current valuations in the bond market. “It’s about pricing and understanding, looking at forward markets, what is actually priced into the market with respect to either rate hikes or rate cuts,” says Sandhu. “We are making short-term adjustments to our duration on an actively managed basis in order to generate additional interest rate alpha for our clients.”
Duration, which is expressed in number of years, is a measure of the sensitivity of bond prices to changes in interest rates. All other things being equal, a one-percentage-point increase in interest rates will cause the price of a bond to drop one percentage point for each year of duration. For example, the benchmark FTSE Canada Universe Bond Index currently has a duration of roughly eight years, which implies that a one-point hike in market rates would cause the index to plunge eight percentage points.
Conversely, falling interest rates are bullish for bonds. Marret forecasts that the 10-year yield of U.S. Treasuries — a bellwether of long-term rates — will decline to about 1.25% over the next 12 months, down from its current trading range of 1.65% to 1.95%. Marret expects global growth will continue to slow to below 3%, led by Asia and Europe and spreading to North America.
Amid this macroeconomic backdrop, Sandhu says there will be “accommodative” monetary policies. “Central banks will have to keep rates where they are, or in some jurisdictions potentially continue to lower them,” he says, “if our growth forecast or our outlook for growth plays out the way that we think it will.”
Even so, Marret lowered the durations of the two First Asset ETFs at the end of October to roughly six years, well below the FTSE Canada index. “We hit our short-term target on where we felt interest rates could go in the short term,” Sandhu says.
Another prominent fixed-income manager that employs the concept of a trading range in bond duration is Montreal-based Fiera Capital Corp., which manages the $68-million Horizons Active Cdn Bond ETF. Fiera’s tactical fixed-income strategy team, led by senior portfolio manager Christopher Laurie, employs a proprietary model that incorporates fundamental and technical indicators to evaluate trends in interest rates. For the Horizons Canadian bond ETF, Fiera will vary the duration between plus or minus three years versus the benchmark.
As of Oct. 31, duration was a fairly aggressive 9.5 years, or a year and a half higher than the FTSE Canada index, and up from 8.9 years at the end of September. In between, opportunistic trades had briefly taken the duration down to close to neutral versus the index, says Jane-Marie Rocca, fixed-income product specialist with Fiera in Toronto. “We’re always actively looking at the market and trading it,” she says. “Even when our thesis might be going one way, we’re looking at other opportunities.”
Since the Horizons ETF’s largest allocation is to Government of Canada bonds, anticipating interest-rate trends and making profitable duration calls are the most important parts of its strategy. Other elements include the positioning along the yield curve, along with picking up yield by holding provincial, municipal and corporate issues.
Not all duration is created equal, says Tom O’Gorman, senior vice president and director of fixed-income at Franklin Bissett Investment Management in Calgary, part of Toronto-based Franklin Templeton Investments Corp. Among his mandates is the $29-million Franklin Liberty Core Plus Bond ETF, whose strategy is identical to the similarly named $2-billion mutual fund whose units the ETF holds.
While high-quality government bonds are largely interest rate plays, that’s not necessarily true for other issues such as investment-grade corporate bonds or high-yield issues, O’Gorman says. “The duration may not tell the whole story, because there’s a risk spread that those bonds trade at which can move in the opposite direction of say, where interest rates are going.”
Though O’Gorman expects the Bank of Canada to follow the U.S. lead in lowering short-term interest rates, the Franklin ETF headed into November with a duration slightly less than the FTSE Canada index. “We want to be defensive,” says O’Gorman, noting that the fund also seeks to generate returns through credit strategies and yield curve positioning. As of Oct. 31, 45% of the portfolio was in corporate bonds, including a small portion of high-yield issues, versus only 24% in Canadas. “Credit spreads are a cushion against changes in interest rates,” says O’Gorman.
He adds that duration remains important from a diversification perspective, even at today’s low yields. “It is the one true factor negatively correlated to the equity markets,” he says. “So if equity markets are at an all-time high, it’s probably a good thing to have some duration to protect you if you do have a selloff.”
Sandhu underlines the importance of duration management, estimating that two-thirds of the volatility of an investment-grade corporate bond portfolio is attributable to duration. “We have substituted credit risk for duration risk in our portfolios because we felt that [in] 2019, duration would be more additive to returns than would be credit in investment grade mandates,” he says. He calls corporate credit “a little expensive,” adding that late in the economic cycle, “corporate bonds become vulnerable to a downturn in the economy.”
Rocca observes that while 30-year Canada bonds recently yielded a mere 1.75%, the low payout for going long on duration should be viewed in a global context. “When you compare it to global rates, it’s huge,” she says, referring to countries such as Germany and Japan with negative long-term yields.
“It’s very hard to have an income off of a 1.75% Government of Canada bond. But we aren’t dealing with the negative rates like they are in other parts of the world,” says Rocca, adding that bonds should always be a core position in anybody’s asset allocation. “Just make sure you have good diversification between all your strategies.”