Encounter

Dynamic managers take cautious stance amid uncertainty over U.S. economic agenda.
By Sonita Horvitch | 15/02/17

Michael McHugh, vice-president and head of fixed income at 1832 Asset Management L.P., says that the global fixed-income market is likely witnessing the bottoming of interest rates, after their long secular decline, but there is still considerable uncertainty as to their outlook.

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

Since the end of September 2016, global bond yields have increased, says McHugh. This is, he says, based both on expectations of higher inflation rates in the developed world and of stronger U.S. economic growth after Donald Trump's election in November as U.S. president.

Canadian bond yields, he says, have largely followed U.S. bond yields higher, but to a lesser extent. "The Canadian economy has been weaker than its U.S. counterpart," says McHugh. "While valuations on bonds on both sides of the border have improved, they remain high from a historic perspective."

Further increases in fixed-income yields are predicated on continuing economic growth in the United States and the ongoing European economic revival, says McHugh and "there are many question marks."

Domenic Bellissimo, vice-president and portfolio manager who heads up corporate credit for the fixed-income team, says that the financial markets have already substantially priced in positive expectations about the outcome of Trump's commitment to stimulate U.S. economic growth.

Bellissimo says there is "considerable uncertainty surrounding the implementation of Trump's economic agenda." This includes, he says, the likely negative impact of Trump's protectionist approach to international trade and the negative fall-out of trade barriers on global economic growth. "The potential for a broader spectrum of possible outcomes from Trump's policies is greater than the financial markets are currently pricing in."

Michael McHugh
Michael McHugh

The expectation in financial markets is that the U.S. Federal Reserve Board will continue to increase its policy rate, says McHugh. This is predicated on the forecast that the U.S. economy will continue to gather steam in 2017 and will be assisted in this by the pro-U.S. economic growth policies of the new president.

The divergence between the monetary policies of the Fed and the Bank of Canada is likely to persist, says McHugh. The expectation is that the Fed will likely increase its policy rate two to three times in 2017, whereas the Bank of Canada is expected to "remain on hold in 2017," he says.

Foreign flows of funds into both the U.S. and Canadian bond markets are likely to continue in 2017, says McHugh, provided the Bank of Japan and the European Central Bank continue with their policies to stimulate their respective economies. At recent count, 10-year U.S. Treasury bonds had a yield of 2.42% while Government of Canada 10-year bonds yielded 1.7%. By contrast, 10-year German bonds yielded 0.37%, while those in Japan had a yield of only 0.09%. "There is a considerable yield pick-up in the United States and Canada."

Of the lacklustre performance of the Canadian bond market in the 12 months to the end of January, McHugh explains that rising interest rates have largely removed the capital-gain component of the investment and the returns on investment-grade Canadian bonds mainly reflect the low coupon rates.

The FTSE TMX Canada Universe Bond Index, the benchmark for Canadian investment-grade securities, produced a total return of 1.14% for the 12 months to the end of January. The corporate sector, which had a weight of 27.6% in the index at the end of January, outperformed the benchmark with a total return of 4.13% for the 12 months. While the federal sector (36.9% of the index) and the provincial sector (33.6%), both underperformed the index.

In the 12 months to the end of January 2017, Bellissimo notes that within the corporate sector of the bond index, those securities with a lower credit rating outperformed their counterparts that were rated higher. At the beginning of 2016, corporate debt with a lower credit rating in the investment-grade universe came under heavy pressure on concerns about the health of the global economy, including a possible slowdown in China. "As the year unfolded these concerns subsided, and this segment of the corporate investment-grade market rebounded sharply." There was a similar experience in the high-yield market, he says.

Domenic Bellissimo
Domenic Bellissimo

At present, says Bellissimo, the corporate credit market represents a challenge. Current valuations on corporate bonds are high, he says. Their yields versus government of Canada yields or credit spreads have declined to the point that they are now in line with the lows in the latter part of 2014. "During the course of 2016, investors became more comfortable with taking on greater risk."

Against these valuations, the fundamentals of the corporate-credit market continue to deteriorate, he says. "The current credit cycle is getting longer in the tooth." Although earnings grew in the second half of 2016 and this has continued into 2017, profit margins have peaked, he notes. Furthermore, leverage on the balance sheets "continues to climb."

Despite the challenges, Bellissimo believes investors should maintain an overweight position in corporate bonds to "capture the incremental income." In terms of credit ratings, investors should concentrate on higher-quality issuers, he adds.

At 1832 Asset Management, McHugh and his team manage a wide range of fixed-income mandates including Dynamic Canadian Bond and Dynamic Advantage Bond. The former is a predominantly Canadian portfolio of investment-grade securities. The latter is also a core Canadian bond fund, but it has more latitude.

At recent count, the principal weightings in Dynamic Canadian Bond were corporate bonds at 35.5%, provincial bonds at 37.8% and federal government bonds at 21%.

McHugh has increased the federal government weighting, he says, by both selling off the fund's holding in floating-rate notes and deploying the cash in the fund. "We put this money into federal government bonds at the shorter end of the yield curve on the expectation that this part of the yield curve will remain stable." The shorter-term yields are "influenced by changes in the Bank of Canada policy rate and this rate is likely to remain unchanged for some time."

This increased investment in Government of Canada short-term bonds plus the move by the team to close out their short positions in Government of Canada and U.S. Treasury bond futures (which were put on earlier to mitigate the risk of an increase in bond yields) raised the duration in the portfolio, says McHugh. This is now 4.3 years, "still a low level," versus the previous duration of three years. (Duration is a measure of the sensitivity of the price of a fixed-income security to a change in interest rates expressed as a number of years.)

The duration of Dynamic Advantage Bond, says McHugh, is four years. The composition of this portfolio is different to that of Dynamic Canadian Bond, he notes. Of the sector weights, Dynamic Advantage Bond has 55% in corporate bonds, 24% in provincial bonds and 2% in federal government bonds.

In addition, the fund has 15% in real-return bonds, which are bonds issued with a fixed coupon rate where the principal is indexed to the Consumer Price Index and each coupon payment is based on the original coupon rate and the indexed principal amount. Dynamic Advantage Bond holds only 3.7% in high-yield securities. "This is far lower than our mandate allows and is a reflection of where we think we are in this current credit cycle," says McHugh.

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