Fixing income

“The risk-offset qualities of fixed-income [investments] haven’t changed – they still provide a valuable buffer to the volatility of equities, for which the drawdowns can be violent,” says Shailesh Kshatriya, associate director of client investment strategies at Russell Investments Canada Ltd. in Toronto. “But it’s a more challenging environment, and investors can no longer think of fixed-income as providing the same kind of safety as in the past.”

Portfolio managers of balanced mutual funds, and the majority of clients who adhere to a diversified investment approach, are inclined to hold a slice of fixed-income within their asset mix.

And that’s not a bad thing. Fixed-income securities have a low correlation to equities, act as ballast in offsetting equities market downturns and enhance a portfolio’s overall risk-adjusted return.

But managing the fixed-income component of a portfolio has become a more complex undertaking than simply parking money in government bonds and collecting a healthy rate of interest and a dollop of capital gains. This low-maintenance strategy serves investors well in a bullish bond market but can be ineffectual when interest rates start to rise.

If rates rise, as they are likely to do with the winding down of government economic stimulus programs, income-paying securities issued at the low rates in place previously will become less attractive and their market valuations will suffer.

“There are red flags in the fixed-income market that were not there before,” says Frank Mullen, portfolio manager with EdgePoint Wealth Management Inc. of Toronto. “If you’re investing in a balanced fund, it’s important to look at the way the fund manager is handling the fixed-income component and minimizing risk.”

Fund portfolio managers and investors with fixed-income portfolios now are including a range of sophisticated strategies to manage risks attributable to interest rates and credit quality in an effort to minimize capital erosion within the “safe” corner of their portfolios.

“Fixed-income has gone from being one of the easier decisions in a portfolio to something much more complex,” says Roger Mortimer, senior vice president of investments at CI Investments Inc. of Toronto. “The risk of capital loss is higher than ever before, and that raises the question of ‘What is an effective balanced strategy?'”

For Mortimer, who oversees two balanced funds – Harbour Growth and Income Fund and Harbour Global Growth and Income Fund – such a strategy involves broadening the number of asset classes he uses to derive income. The four “income” asset classes he defines include cash, government bonds, investment-grade corporate bonds and what he calls “equity yield.” This equity yield category includes common shares with dividend yields comparable to bond yields, he says, but all the companies selected must have a low dividend payout ratio. This means these companies pay out only a portion of their free cash flow in dividends and reinvest the rest in growth.

As an example of a company in this category, he cites Toronto-Dominion Bank, which pays out 47% of its cash flow in dividends and has a 3.5% dividend yield. By comparison, a 10-year Government of Canada bond has a yield of slightly more than 2%.

However, Mortimer adds, the Harbour funds still hold a portion of government bonds for the stability they provide in bad economic times. Within the funds’ corporate bond allocations, Mortimer ladders maturities to protect against future interest rate increases, and the maximum duration is five years.

“The goal is to hold multiple asset classes that will behave differently in times of duress and offset each other,” Mortimer says.

There are many uncertainties in the global outlook, Mortimer says, and the most prudent course is to design a portfolio to withstand a range of scenarios, including the possibility of external shocks. If economic growth turns out to be strong and rates rise, government bonds will not perform well while growth-sensitive components of the portfolio should do better, he says. However, he adds, with equities more expensive than a year ago, there is less potential return in any asset class.

“There is no single asset class that offers low volatility and high returns,” Mortimer says. “A balanced fund [portfolio] manager must be increasingly flexible with regard to the fixed-income universe, and sometimes that means buying income-paying equities as bond proxies.”

Stephen Lingard, director of Franklin Templeton Solutions, a division of Toronto-based Franklin Templeton Investments Corp., says his “best guess” is that interest rates will move up by the middle to the end of 2015. If the yield on 10-year Canadian government bonds rises to 3%, he says, the value of today’s bonds could drop by 5%.

“Many clients could be surprised by falling bond prices,” he says.

Overall, Lingard has reduced the fixed-income exposure by about 10% in all the balanced portfolios he manages. For example, Franklin Templeton Solutions’ “balanced income” portfolio previously had a 60% fixed-income weighting and 40% equities, but Lingard has changed the mix to 50/50. He is decreasing interest rate sensitivity by shortening the average duration in bond portfolios, and he also has juiced up the income by adding higher-yielding, investment-grade corporate bonds, global government bonds and some emerging-markets bonds. He is cautious about taking credit risk and is highly selective in choosing issuers.

Daniel Solomon, chief investment officer at NEI Investments, a division of Northwest and Ethical Investments LP of Toronto, says Canadians could reap better fixed-income returns by taking advantage of opportunities in global bonds: “A truly active, unconstrained global bond manager can exploit market inefficiencies and find value wherever it exists. By venturing outside Canada, investors can find better yield for the same or lower risk level.”

Although Canada represents only 2.7% of the global fixed-income market, Canadian investors have 75% of their fixed-income investments allocated to Canadian fixed-income mutual funds, Solomon says. By contrast, on the equities side, in which Canada accounts for 4% of the world market, Canadians hold about a 50/50 split between Canadian and global equities mutual funds.

NEI offers NEI Global Total Return Bond Fund, managed through a subadvisory relationship with Amundi Asset Management Group of Paris. Solomon cautions against passive investing in the bond market through strategies that mimic bond indices. Not only are there liquidity issues for some of the bonds listed in a index, Solomon says, but indices are weighted by market capitalization and thus are dominated by corporations and governments that have conducted the biggest bond issues and, therefore, carry the most debt. Broad global indices also have exposure to bonds he considers to be unattractive, such as low-yielding Japanese bonds.

Russell Investments Canada also recommends that Canadians add global spice. In addition to the firm’s core Russell Fixed Income Pool, Russell Canada also offers Russell Global Unconstrained Bond Pool, an actively managed strategy that includes exposure to such worldwide assets as high-yield bonds, mortgage-backed securities and other asset-backed securities, floating-rate notes and emerging markets debt.

“The global portfolio is not tied to the domestic opportunity set, and is likely to do relatively better when yields normalize,” says Kshatriya. “It’s not a question of if bond yields will rise, it’s when. Global diversification is not a market-timing tool; it’s a nice complement, as it adds strategic value.”

The ETF alternative

For some clients, exchange-traded funds (ETFs) are a convenient way to access a variety of fixed-income strategies, and the lower management fees on ETFs relative to mutual funds can make a noticeable impact on a portfolio’s return in a low-yield environment.

Daniel Straus, director of ETF research and strategy for National Bank Financial Ltd. in Toronto, recommends that the underlying bond portfolio of an ETF have a shorter average duration than broad market indices do. He also favours a tilt away from government bonds and toward corporates.

“It is important to remember the role of bonds in anchoring a portfolio, but if bonds are not short duration, you can get hurt if interest rates rise,” Strauss says.

ETF flows in 2014 indicate client preference for shorter-term, higher-yield corporate bonds. For the 10 months ended Oct. 31, the most popular ETFs in Canada were BMO High Yield U.S. Corporate Bond CAD Hedged, BMO Short-Term U.S. Investment Grade Corporate Bond CAD Hedged, BMO Floating Rate High Yield, (all sponsored by Bank of Montreal of Toronto), as well as iShares 1- to 5 Year Laddered Corporate Bond Index (sponsored by BlackRock Asset Management Canada Ltd. of Toronto) and PowerShares 1- to 5 Year Laddered Investment Grade Corporate Bond (sponsored by PowerShares Canada, a division of Toronto-based Invesco Canada Ltd.)

Toronto-based First Asset Management Inc. has developed a family of ETFs that offer a variety of specialized fixed-income strategies that differ from index-based ETFs and could enhance portfolio diversification in a rising interest rate environment. Strategies available through First Asset include one- to five-year laddered strip bonds, provincial bonds, emerging-markets bonds and convertible bonds.

“Whether it’s equities or fixed-income, our niche is to provide smart alternatives that can be added to enhance a core strategy,” says Barry Gordon, president of First Asset.

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