Encounter

Corporate balance sheets are weaker, David Gregoris warns.
By Sonita Horvitch | 05/07/17

David Gregoris, managing director, fixed-income at Beutel, Goodman & Co. Ltd., says that at this later stage in the economic cycle and credit cycle the focus when investing in fixed-income securities should be on capital preservation.

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.

The Beutel Goodman fixed-income team's strategy is to increase the creditworthiness of its portfolios' holdings of provincial and corporate fixed-income securities and to reduce the duration of its portfolios. (Duration is a measure of the sensitivity of the price of a fixed-income security to a change in interest rates, expressed in a number of years.)

"On the macro front, we are at the beginning of the end of the expansion phase in the economic cycle and do not know, as is the case with any stage in the cycle, how long this phase will last," he says. Also, he adds, corporate balance sheets are weaker. Canadian corporations, for example, are increasing the debt on their balance sheets, in some instances, to finance takeovers.

Of late, says Gregoris, there has been a flattening of the yield curve on both sides of the border. "This is characteristic of the later stage in an economic cycle and is signaling the fixed-income market's concern about the longer-term outlook for economic growth."

In Canada, the 10-year Government of Canada bond yield has come down to a recent 1.57% from a 1.72% yield at the beginning of the year, he notes. At the same time, yields at the shorter end of the curve have gone up.

For example, the yield on Government of Canada bonds with a two-year maturity was recently 0.96% versus 0.76% at the start of the year. The same is true for the U.S. yield curve, Gregoris says. The yield on 10-year U.S. Treasuries was recently 2.21% versus 2.45% at the start of the year, whereas the yield on two-year Treasuries was recently 1.37% versus 1.2% at the beginning of 2017.

Gregoris says that there is concern among fixed-income investors about the possible negative impact on economic growth of a reduction in central-bank accommodation both in Canada and the United States. "The U.S. Federal Reserve Board has been in a tightening mode for some time." It is expected, he says, that the Bank of Canada's next move will be to raise its trend-setting overnight target rate. The rate is currently at 0.5%, where it has been since 2015, after two rate cuts in that year.

This expected change in Canadian monetary policy to a tightening stance, says Gregoris, reflects the fact that the country's recent economic growth rate has been exceeding the central bank's estimate.

There is speculation that a Bank of Canada rate-hike announcement could come as early as July 12, says Gregoris. The expectation is that such a hike, if it comes, could be in the order of 25 basis points, he says. (One basis point equals 0.01%).

David Gregoris
David Gregoris

With the proviso that Canada's economic growth rate continues, the increase, says Gregoris, is more likely to be at the Bank of Canada's next date for the announcement of its overnight rate target, which is Oct. 25.

In the United States, the U.S. Federal Reserve Board is continuing to tighten, says Gregoris. The Fed started to raise its policy rate in December 2015 and has continued to do so. In its latest move in mid-June of this year, the U.S. central bank raised its federal-funds target range to 1% to 1.25%. It is the second time so far this year that the Fed has increased this rate.

In addition, the Fed is beginning to gradually wind down its quantitative-easing program. It has stated that it will start allowing some of the securities that it bought during its stimulus program to mature, Gregoris says. "This less accommodative monetary policy is signaling the fact that the Fed is comfortable with the outlook for U.S. economic growth, but the fixed-income market is more skeptical about the U.S. economy's long-term prospects."

Canadian fixed-income securities have held their own in the first five months of 2017 versus the lacklustre performance of the Canadian equity market, says Gregoris.

The benchmark for Canadian investment-grade fixed-income securities, the FTSE TMX Canada Universe Bond Index, produced a total return of 3.57% from January until the end of May. By contrast, the S&P/TSX Composite Index had a total return of 1.5% in the first five months of 2017. Over the 12-month period to the end of May, the picture is quite different, he notes. The fixed-income benchmark's 2.99% total return is far lower than the 12.27% produced by the S&P/TSX Composite.

Looking more closely at the performance of the bond index for the first five months of 2017, provincial and corporate bonds outperformed their federal government counterparts, Gregoris notes.

Removing the impact of duration on performance by looking at the FTSE TMX mid-term bond index (five to 10 years), provincial bonds produced a total return of 3.64% for the first five months of 2017 and corporate bonds a total return of 4.58% versus the overall performance of the mid-term index of 3.7%. By contrast, federal government securities had a total return of 3.12%.

Gregoris reports that the relative performance of the different fixed-income issuers over this period reflects the fact that "the spread premium on the most volatile provincial and corporate issuers has been coming down." This yield spread has fallen to recent lows and "investors are not being compensated for the credit risks associated with lesser credit securities."

All these bigger-picture issues affecting the Canadian fixed-income market are shaping the Beutel Goodman fixed-income team's strategy. Included in this team's mandate is Beutel Goodman Income. This fund is benchmarked against the FTSE TMX Canada Universe Bond Index.

At the end of May, the fund held 16% in federal government securities -- less than half their 36.7% weighting in the index at that date. Provincial bonds were 40% (34.3% in the index) and corporate bonds 44% (27.0%). In all, the fund had a total of 129 holdings at the end of May, with the top-10 holdings accounting for 32% of the fund.

The Beutel Goodman fixed-income team has been concentrating on higher- quality provincial bonds and has been upgrading its corporate fixed-income holdings, says Gregoris. "The latter are of a higher quality and shorter duration than the index."

The overall duration of this fund at the end of May was 7.48 years versus that of the benchmark index at 7.49 years. "Since the end of May, we have been reducing the duration of the portfolio given the recent flattening of the Canadian yield curve," he says.

Within its corporate bond segment, the fund is overweight in financial issuers. These represent 10.7% of the benchmark and are the biggest corporate-sector weight in the index. The portfolio is also overweight infrastructure and utilities.

Gregoris says that the portfolio has holdings of Canadian bank-deposit notes. They are, he notes, a favoured security for fixed-income investors seeking exposure to financial-services issuers. These notes pay a fixed rate of interest and have an original maturity of three to five years. But he cautions that the Canadian regulators are looking to make changes to the rules surrounding these securities, which if they go through could make them more volatile.

The regulators' objective "is to require investors in these securities and some of the other securities issued by the banks to take on the risk of a bank failure, rather than letting the taxpayers pick up the tab." This approach is known as a "bail-in" rather than a "bailout regime." A bail-in regime, says Gregoris, "holds shareholders and bondholders responsible for the bank's risk, if there is a failure."

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