fortifying a fixed-income portfolio

The past year or so has been profitable for global fixed-income investments as the downward trend in global interest rates boosted bond prices.

The U.S. Federal Reserve Board set the tone by lowering rates three times in 2019, putting its trend-setting federal funds rate at 1.50%-1.75%. (Compare that with a peak of 3.25% in 2018.) Generally, monetary policy has been easing around the world.

Whether rates will continue to drop in 2020 is unknown. (See story on page 6.) The Fed has indicated it is in “pause” mode. If economic growth slows to levels at which recession becomes a worry, there is room for central banks’ decision-makers in the U.S. and Canada to lower rates by a notch, although countries such as Japan and several in Europe are in negative rate territory already and have less room to ease monetary policy.

Global economic growth continues to simmer and inflation is benign, keeping portfolio managers optimistic about the outlook for bonds — particularly carefully chosen corporate issues that can provide a little extra yield at a time when bond income is lean.

Mark Wisniewski, partner, senior portfolio manager and head of the fixed-income team at Toronto-based Ninepoint Partners LP, has consistently outperformed Morningstar Canada’s global fixed-income fund category by focusing on meticulous issue selection — especially when it comes to corporate debt.

Ninepoint Diversified Bond Fund Series F posted a three-year average annual compounded return of 3.28% as of Dec. 31, 2019, putting the fund in the top quartile of the category, according to Toronto-based Morningstar Canada. The fund’s one-year gain was a healthy 4.25% last year.

The Ninepoint fund, a global mutual fund, has about 62% of assets under management (AUM) in Canadian bonds, 24% in U.S. issuers and some European holdings. The fund currently has no holdings in emerging markets.

About 75% of the Ninepoint fund’s AUM is held in investment-grade corporate bonds, with a portion in lower-rated high-yield bonds. The balance of the portfolio is in government bonds, which tend to have lower yields than corporate debt.

“High-yield and investment-grade [debt is] starting to look more expensive, and we are being extremely selective,” says Wisniewski, who co-manages the Ninepoint fund with vice president and portfolio manager Etienne Bordeleau-Labrecque. “Spreads, relative to government bonds, are well below average, and the lower-rated stuff is becoming riskier. Investment-grade is not cheap, especially if you believe a recession could be a year away.”

Corporate bonds are viewed as being more vulnerable than government bonds to any downturn in the economy, due to business risk and potential disruption to interest payments.

Last year turned out to be a much better year for bond investors than anticipated at the outset, when markets were fretting about rising interest rates. Instead, the Fed applied monetary stimulus, chopping rates to keep economic growth on a positive course.

“Last year was a good year if you had any duration at all in your portfolio,” Wisniewski says. “Interest rates fell a lot lower over the course of the year and risky assets did particularly well. Normally, when interest rates fall, it’s because the economy is slowing. [Debt issues] don’t do well in that environment. But last year, [the result] was the exact opposite.”

Wisniewski expects 2020 will be more challenging, and says there is less room for rates to fall from current levels. Although he doesn’t expect an imminent recession, staying on a growth path could become harder for governments. The fallout from the unrest in Iran is unknown.

“This year will be trickier for bond investors,” Wisniewski says. “We think the global economy will continue to grow in 2020, but at a slow pace. There is some question of whether rates can fall much more. And could we get increased volatility in the bond market if a recession approaches in 2021?”

Wisniewski is taking a more conservative stance, moving toward higher quality debt and shorter duration to obtain more flexibility and liquidity. The duration of the Ninepoint fund’s portfolio is 6.5 years, which is less than the approximately eight years for the Bloomberg Barclays aggregate bond index.

“We are not being compensated to lend for longer, and there is less volatility with shorter-term securities,” Wisniewski says.

Top holdings in the Ninepoint fund include a smattering of financials, including issues from Mississauga, Ont.-based GE Capital Canada Funding Co. and Kingston, Ont.-based Empire Life Insurance Co. Wisniewski also likes Calgary-based Enbridge Inc.’s short-term commercial paper, describing the yield as “healthy.”

“Usually, we’re either in defensive mode or opportunistic mode,” Wisniewski says. “If volatility presents opportunities, we can re-cycle into longer-term [debt].”

With inflation low, Wisniewski doesn’t own inflation-protected or real-return bonds. However, as a hedge, he holds bonds of a few gold-producing firms, which could see increased investor interest if gold bullion appreciates.

Invesco Global Bond Fund Series F also had a stellar year in 2019, with a top-decile gain of 8.77%. The fund also did well for the three-year period ending Dec. 31, 2019, with a top-quartile average annual gain of 3.89%.

Avi Hooper, senior portfolio manager with Invesco Ltd. in Atlanta and a member of the fixed-income team managing the Invesco fund, expects a continuing favourable environment for bonds this year, particularly in the U.S. and Canada.

At the beginning of last year, the Invesco team anticipated that interest rate hikes had run their course. As a result, the Invesco fund’s portfolio was favourably positioned for an end to Fed tightening, with a tilt toward corporate bonds and extended maturities in government issues.

“We had been positioning for an easing of monetary policy, and what we actually got was rate cuts,” Hooper says.

Hooper describes the current bond environment as a “Goldilocks” scenario, characterized by slow but steady economic growth with room for interest rates to drop further if necessary for central banks to keep the economy on track.

“We are not in the recession camp,” Hooper says. “The U.S. and Canada have strong, service-driven economies and are less dependent on global trade than many countries. Mediocre growth will support the central banks’ accommodative policies, and could potentially lead to further interest rate cuts.”

The upcoming U.S. presidential election in November also will support a continuation of easy monetary policy, Hooper says, to keep the economy moving in a positive direction.

With Europe and Japan’s low to negative rates, their economies are weaker than those in North America. The Invesco fund is focused primarily on U.S. and Canadian bonds, with some European issues and a sprinkling of emerging markets’ bonds.

“The best way to capture extra return is through high-quality corporate debt,” Hooper says. “We are focused on credit, and do extensive research to build our portfolios bond by bond with the best ideas. This is where an active fixed-income manager can really add value.”

About one-third of Invesco Global Bond’s portfolio is in government issues and two-thirds is in corporate debt, Hooper says. In terms of quality, the focus is 75% in bonds with AAA to BBB ratings, which are the core of the portfolio and offer consistent income and capital preservation.

About 25% of the Invesco fund’s portfolio is held in higher-yielding bonds, such as emerging-market government issues and a handful of lower-rated corporate bonds. These securities provide an opportunity to enhance income, Hooper says.

He likes some emerging market government issues from Latin American and a couple of Eastern European countries, but invests only in bonds issued in U.S. dollars and usually hedges back to the Canadian dollar. “We normally take currency risk out of the equation by hedging back to the Canadian dollar,” Hooper says, “and we focus on exposing the portfolio only to credit risk.”

Emerging markets’ bonds offer extra yield relative to North American bonds, Hooper says. For example, some 10-year bonds issued by emerging-market governments have yields in the 4% range; in contrast, at yearend the U.S. 10-year T-bill yielded less than half that, at 1.88%.

“One of the drivers for emerging-markets bonds is that there is no yield these days on European and Japanese bonds,” Hooper says, “and investors are searching the globe for places to put money.”

Closer to home, Hooper adds, there can be opportunities to profit from upgrades in the credit ratings of corporate bonds.

“We are cautious and don’t want to expose clients to risk at this point in the cycle,” Hooper says. “But we look for opportunities to find those nuggets in the high-yield market where a bond may be upgraded and thereby attract new investors and offer capital gains.”