Hanif Mamdani, who oversees the five-star rated, $4.2-billion PH&N High Yield Bond, says the global economy has been picking up for some months and Donald Trump's U.S. election win has simply accelerated a change in market dynamics.
"You can't ignore the possibility of a more normal yield curve in the future," says Mamdani, head of alternative investments at Vancouver-based Phillips Hager & North Investment Management, a unit of Toronto-based RBC Global Asset Management Inc.
"Whether that's in six months or 18 months is unknown," Mamdani says. "But Trump's plans to change fiscal policy, bring in trade restrictions and tighten the labour market are all pro-cyclical and will nudge rates higher, not lower. You have to respect that the regime is changing."
Mamdani doesn't expect interest rates to climb too high, however, mostly due to a combination of underlying demographic trends, the global debt overhang and the impact of technology. "There is a tug-of-war between these pro-cyclical post-election events and over-arching reasons why rates cannot go enormously higher."
Primarily a bottom-up investor, Mamdani closely follows the high-yield bond market and notes that the impact of the "Trump factor" has not been as bad as expected. Spreads over comparable government bonds have widened to about 500 basis points (bps), or about 40 bps higher than last fall.
A 29-year veteran of corporate finance and fixed-income markets, Mamdani focuses on higher-quality securities within the high-yield market and doesn't see enough compelling bargains. "I don't see a lot of value in the 'go-go' BB-rated names. If the average spread is 500 bps, that includes CCC-rated bonds and distressed names. We focus on the high-quality segment where spreads are 300 to 350 bps," says Mamdani, who is backed by two analysts, Emil Khimji and Justin Jacobsen.
"That spread is fair, but not excessively cheap," Mamdani adds. "It's too early for bottom-fishing. But if we get a spike in Treasury yields maybe we'll see a pronounced selloff. That will be the time to buy." He adds that if benchmark 10-year U.S. Treasuries spike to 3%, that could spark a selloff in high yield and consequently whet his appetite.
Currently, Mamdani is holding about 8% cash, down from 12% last fall. Some holdings that he acquired recently include a Telesat B-rated bond, and new BBB-rated bonds issued by Granite Real Estate Investment Trust (GRT.UN) and Morguard REIT (MRT.UN).
"Technically, we're a high-yield bond fund in that we focus on BB and below, but our approach is a little different," says Mamdani. "We do use some BBBs where it makes sense."
Mamdani has been heavily invested in the energy production and services sector, which accounts for 35% of the fund. That was largely driven by attractive values that emerged when the crude-oil price fell dramatically last winter. "My interest in the oil sector is not because I grew up in the oil patch and my uncle was a roughneck on an oil platform. We go where the value is. We saw a great opportunity in some of these Canadian companies over the last year and a half."
Mamdani was skeptical that oil would stay at US$25 a barrel for a long time, when production costs were double that. "Yet these credits were being priced as if the oil price would never rebound from US$25 or US$35. We're not energy investors per se, but we saw tremendous value."
Industrials account for 12% of the fund, followed by 11% in media and telecommunications. There is also 16% in the major Canadian banks. The latter is composed largely of subordinated debt with four- to five-year maturities that pay around 3%.
"There was a supply-demand imbalance and we took advantage of that," Mamdani says. "There is no issue with credit quality and the duration is short since many instruments will be refinanced or called in 2019, 2020 and 2021." The fund's duration is four years, making it less interest-sensitive than the four-year duration for the benchmark BofAML Master High Yield Index.
The bank-debt yields sound modest, yet Mamdani argues the risk-return dynamics tilt in their favour. "You could buy what are perceived to be the best high-yield credits and earn 3.5% to 4%, but you take on below-investment-grade risk, duration risk and liquidity risk. We don't think you are being compensated in the BB segment for these three primary risks. Instead you can own Canadian bank subordinated debt, get 3.25% yields and have way better credit quality, shorter duration and infinitely better liquidity."
Mamdani's large stake in energy names hurt the fund in 2015, when it lost 2.97%, compared to the average fund in the High Yield Fixed Income category, which returned 0.48%. In the year to date to mid-December, the bet has paid off as the fund's Series D is up 17%, more than seven percentage points ahead of the category average.
Don't expect a repeat of that performance in 2017 for the Morningstar silver-medallist fund. "The valuations suggest that returns of that magnitude are not realistic," Mamdani says, noting the fund has just under a 6% running yield. "If interest rates spike up, there could be some modest capital losses, which will be offset by the coupons. If, however, rates don't go up a lot, and we execute some good relative-value trades, and are tactical, then maybe we can do better than the coupon. Four to seven percentage points is a reasonable expectation of returns."