Manager Insight

Fixed income manager expects "normalization" to continue, but headwinds remain.
By Michael Ryval | 19/08/11

The Bank of Canada is likely to resume the process of "normalization" and boost its benchmark lending rate later this year or early next, says Jim Gilliland, head of fixed income at Vancouver-based Leith Wheeler Investment Counsel Ltd.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"Over the next several years, the bank will continue to normalize, although a few things are causing headwinds and giving the bank pause," says Gilliland, lead manager of Leith Wheeler Income Advantage  .

"There are questions about the continued restructuring in the U.S., the working through of the real-estate challenges, and the impact it has on consumer spending. We are not seeing a typical rebound." Unemployment in the U.S., he adds, is stubbornly high at 9.2%, 32 months into the recovery.

A top-down manager, Gilliland argues that the Bank of Canada will not move too aggressively on rate-setting because of the impact on the Canadian dollar. At the same time, "we don't anticipate the central bank will remain too far out of lock-step with the U.S. That will temper the pace of increases." He expects that short-term rates will increase another 150 basis points over the next two years. "The central bank can bide its time because of the restructuring process in the U.S."

Short-term government bonds are most vulnerable to rate hikes. "But if the rate increases are muted and well paced, the additional yield offered by four- to five-year corporate bonds will most likely compensate for the potential capital loss," says Gilliland, noting that investors are compensated as they move further up the yield curve. "At the short end, the curve is quite flat and there is potential for capital loss."

Gilliland takes a total-return approach in managing Leith Wheeler Income Advantage, which was launched in December 2010. There is about 48% in bonds, 36% in Canadian dividend-paying equities and 16% in preferred shares.

The fixed-income component is comprised exclusively of investment-grade corporate bonds, which tend to outperform in a rising rate environment. "It's an environment that is reasonably positive for corporate earnings -- and positive for corporate spreads."

The equity portion, which is held in Leith Wheeler Canadian Dividend, has a heavy concentration of banks and pipelines. But it also includes firms such as Saputo Inc. SAP, a dairy-products producer with a history of rising dividends.

"The most important aspect is the diversification between corporate bonds, preferred shares and dividend-paying stocks," says Gilliland, adding the fund has a running yield of about 3.6%, before fees. "It's the latter portion where we anticipate dividend increases, which will help the total return of the portfolio."

Equally important is a low volatility. "We're trying to deliver a strategy that has two-thirds the risk of a typical balanced fund, with a higher component of that return coming from dividends than capital appreciation," says Gilliland. "The combination of less volatility and a higher income component is attractive to some of our investors."

A Vancouver native, Gilliland has been in the industry since 1993, when he graduated from the University of British Columbia with a bachelor of commerce degree. He was hired as a fixed-income analyst by M.K. Wong & Associates. By 1996, he became a fixed-income manager.

"What appealed to me was the combination of top-down and bottom-up analysis," recalls Gilliland. "For most equity managers in Canada, it's 80% bottom-up, and 20% top-down. Fixed-income investing is more balanced, in terms of the macro and micro influences."

When the firm was acquired by HSBC, Gilliland became chief strategist and was later named co-head of the investment team in 1999. Two years later, he returned to school and earned a master of financial engineering degree at University of California at Berkeley in 2002.

Gilliland joined Barclays Global Investors in San Francisco. Over seven years he had a variety of roles, including head of the international fixed-income team.

In September 2009, Gilliland was hired by Leith Wheeler, which was looking to expand its fixed-income business. The firm, which manages money primarily for institutional accounts, has about $11 billion in assets under management, including $3 billion in fixed income.

In heading a six-person team, Gilliland also manages the flagship Leith Wheeler Fixed Income  . Currently, the fund's duration -- a measure of its sensitivity to changes in interest rates -- is 5.8 years. That compares with 6.3 years for the DEX Universe Bond Index. While there is an underweighted exposure to short-term bonds, there is bias to seven-to-10-year bonds that Gilliland believes should do better in a rising rate environment.

Gilliland does not expect long-term bonds to underperform, as they did in 1994. "As long as the Bank of Canada's moves are well telegraphed, and controlled, you might find that the longer-term securities are within a trading range."

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