Canada’s fixed-income markets were roiled in July and again in early September when the Bank of Canada (BoC) raised short-term interest rates, setting the stage for further interest rate hikes. Fund portfolio managers are cautious, given mixed signals on the strength of Canada’s and the U.S.’s economies, and are watchful for events that can put pressure on the asset class.

“There’s no denying that Canadian economic growth surprised in a good way,” observes Dagmara Fijalkowski, senior vice president, global fixed-income and currencies, with Toronto-based RBC Global Asset Management Inc. and lead portfolio manager of RBC Bond Fund. “The [BoC] took advantage of this window of opportunity and moved interest rates to a more normal level. That means taking back the so-called ‘insurance cuts’ made in 2015 and perhaps a bit more. That’s ambitious and dependent on a few things going right.”

In particular, the central bank’s assumption is that the slowdown in consumer spending will be only marginal and be “offset by exports picking up, thanks to stronger U.S. growth, but also stronger business investment domestically,” says Fijalkowski, “and that certain risks don’t materialize.”

Among the risks Fijalkowski identifies are that North American Free Trade Agreement (NAFTA) negotiations get off to a good start; Canada’s real estate market doesn’t topple under a mix of higher interest rates and anti-speculative measures; and the Canadian dollar (C$) doesn’t appreciate even more against the U.S. dollar, thus contributing to tightening of financial conditions. “If all of these things go as the [BoC] expects,” she says, “perhaps it will have this window of opportunity to normalize interest rates a bit more.”

Figuring out where bond yields are going is a challenge, especially when predictions have been notoriously wrong. Still, Fijalkowski notes, given BoC guidance and stronger economic growth, bond yields should move higher and the so-called “forward yield curve” is already pricing in interest rate hikes and higher bond yields.

“If you look at pricing of five-year bonds and expectations embedded in the forward curve, these expectations are adding 40 basis points to the five-year yield, pushing it to 2.15% in two years,” she says. “That assumes a gradual increase in yields and seems about right, given all these various risks still hanging over the market. We note the bias in the market and think it’s probably fair.”

However, Fijalkowski’s team doesn’t focus on a single scenario; rather, they use several based on several factors to shape and adjust the RBC fund’s portfolio. Other scenarios that may come up include the fixed-income market being too optimistic about the risks surrounding the NAFTA talks.

“Some of these risks are going to slow down the pace of growth, and five-year bond yields could be lower than 2.15% in two years,” says Fijalkowski. “The other risk is that yields could increase even faster than the market expects and, for that, we would have to see even more positive economic growth and inflation surprises.”

From a strategic viewpoint, Fijalkowski maintains a neutral portfolio duration in the RBC fund that matches the DEX universe bond index’s 7.35 years. Fijalkowski has become more cautious simply because she believes the RBC fund’s portfolio isn’t being compensated for taking risk.

“That [situation] has become much less attractive in the past six months, and especially when it comes to credit risk,” she says. “There is less margin for error. As we said before, there are a lot of potential risks.”

Fully invested, about 40% of the RBC fund’s assets under management (AUM) are allocated to investment-grade corporate bonds, 40% to provincial bonds, 12% to Government of Canada and Crown corporation bonds, with smaller holdings in categories such as high-yield bonds. Among the corporate bonds the RBC fund invests in is BCE Inc.’s 2035-dated bond yielding 4.2%.

Although interest rates are trending upward, the inflationary pressures that normally act as a driver are low, at around 1.5% a year, says Christine Horoyski, vice president with Toronto-based 1832 Asset Management Ltd. and portfolio manager of Dynamic Aurion Total Return Bond Fund: “Traditionally, inflation has been fed by supply shocks or wage demand, and we haven’t seen either.”

The so-called “commodities supercycle” seems to be fading, she adds, noting that emerging markets continue to see a growing middle class. “The demand for raw materials should stabilize and there won’t be the parabolic demand that we saw a decade ago. China’s investment in infrastructure is slowing and the [economy is] shifting to moderate consumption.”

Horoyski anticipates Canadian interest rates will move higher, but at a gradual pace as the BoC seeks to normalize interest rates.

“The long end of the bond market will anticipate this move. Bond yields at the long end, which have already risen by about 60 basis points, may move a little higher,” says Horoyski, who anticipates the overnight interest rate to rise to 1.25-1.5% in 2018.

“[Long bonds] are more impacted by growth and inflation, but inflation doesn’t look to be a problem and growth should continue to be modest. The increase at the long end of the market should be more modest in the next few months after a vicious sell-off in Canadian long bonds,” says Horoyski, adding that the bond market has priced in the next interest-rate hike already.

Ten-year Canada bonds now yield 2%, vs 1.4% in the spring. Although 2% still is a relatively low yield, Horoyski argues, comparing this yield to long bond yields a decade ago is unfair, mainly because today’s economic growth is slower.

The economic outlook for the U.S. is not as bad as some skeptics have expressed, Horoyski says: “The [U.S. has] full employment, reasonable growth and low inflation. So, the U.S. Federal Reserve Board will continue to increase interest rates in an effort to normalize the overnight rate.”

Horoyski expects the next U.S. rate hike will come at the end of the year, as the Fed will be preoccupied with unloading some of the trillions of dollars in bonds and mortgage-backed securities on its balance sheet this autumn. “The Fed will do it in a very measured way so as to not disrupt the markets too much,” she says.

Horoyski admits she turned bullish on U.S. bonds earlier this year, when the market was euphoric about the Trump administration’s fiscal plans: “Yields peaked last December and year-to-date U.S. bond yields are actually lower. Canada went the opposite way: yields began low and went higher. But the pendulum is going to be swinging toward the middle, and we don’t anticipate any fiscal boost coming in the near term. The market may be too downtrodden [based] on the U.S. economy.”

About 45% of the Dynamic fund’s AUM was held in foreign content (mostly U.S. bonds) in the first half of 2017, which was protected by a currency hedge. “We believed that U.S. yields were cheap and Canadian yields expensive,” Horoyski explains. “In May, the differential was 80 bps in the 10-year segment; that’s now fallen to 25 bps. And yields now are priced relatively the same, so we’re more comfortable coming back to Canada.”

The Dynamic fund now holds about 30% of AUM in foreign content, mostly hedged back to the C$. Horoyski reduced the fund’s U.S. investment-grade corporate bond holdings to 17% from 35% and focuses on U.S. short-term treasuries. The foreign content includes 5% New Zealandic and 5% Australian bonds. The remaining 60% is in a mixture of Canadian government and corporate bonds. There’s also 10% held in cash.

The Dynamic fund’s duration is around 6.5 years. Says Horoyski: “We have a barbell position, with a big weighting in 10-year and longer government bonds and short exposure in the credit market.”

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