Don’t forget the NAV when chasing yield

“I think five of every six dollars that is coming out of money market funds is going into bond funds, [which is] perhaps a contrarian indicator,” she said. “Is everybody heading into bonds at the very inflection point for yield? We have had significant spread compression that’s what’s been driving a lot of that performance in the corporate bond sector.

“Investors need to ask: what is the new normal in a world of less leverage and regulation? Do spreads compress a lot further? It seems the majority of that theme has played out.”

She adds, “If you’re a bond fund investor you better be very aware of the underlying position of that fund — if it’s got significant corporate exposure, what is the duration of the holding etc. — especially if we are just at the inflection points for longer bond yields, where fears of inflation take hold next year and bond yields begin to climb.”

Advisors need to determine why clients should allocate capital to corporate bonds. For many investors, the issue is about yield. Investors need a higher income stream then what GICs and government bonds are yielding, says Stephen Geist, the president of CIBC Asset Management.

“You’ve got clients and investors who have traditionally been able to earn more investment income on relatively safe vehicles that are not able to produce income at that same level today. Investors are being forced to seek other alternatives,” he says. “In many cases, you have individuals who are considering bond funds, because the yields are higher than the returns you might receive in some other alternative products.”

Earlier this week, CIBC launched the Renaissance Corporate Bond Capital Yield Fund, which will focus on delivering tax-efficient corporate yields.

The fund seeks to generate tax-efficient returns primarily through exposure to its reference fund, the Renaissance Corporate Bond Fund, and the returns will be distributed as capital gains to reduce taxes for the end-investor.

“We expect the initial gross yield on the portfolio, gross fees of any management or expense ratio, will be 5%-plus on the portfolio. Fairly competitive, it’s very focused on providing yield,” Geist says. “On October 31, the government bond index was yielding 2.39%, the DEX corporate bond index was yielding 3.89%. It will be a mixture of different terms, they are actively managing the portfolio to deliver above average yield.

Protecting downside risk on bond funds
Bond funds have done fantastically well in capital growth as risk came out of the market in the past few months. Investors now entering the space have missed out much of that.

Investors looking to park assets in corporate bond funds until they’re more certain about equities need to understand the risk. Fixed income manager, Jean Charbonneau, the senior vice-president at AGF Investments, says much of the capital growth in corporate bonds has played out, although corporate spreads are still attractive by historical standards.

“In the Canadian corporate market, the average spread for the corporate index is just below around 140 [basis points] depending on what index you take,” Charbonneau says. “We’re still above the long-term average, but we reached a peak north of 400 basis points during the worst of the crisis last year, so we’ve had this tremendous spread compression since then.”

Most top-down analysts expect yields to start rising around the middle of next year, meaning bond prices will be in decline. Charbonneau says the team at AGF is already preparing contingencies for this.

“We call next year the year of normalization. That implies central banks around the world will start normalizing their monetary policy, which means at some point in time, the Bank of Canada may slightly increase their short term rates. That would have consequences on interest rate curves; the long end suffers more than the front end,” he says. “We have started adding some real return bonds and we have also fairly good floating rate notes that we will be adding as the more normal monetary policy returns. We have a bias for shorter duration in our overall bond mandates.”

He says investors looking for capital preservation in addition to yield, should consider mandates with a higher level of inflation protection.

Fundamental remain important
Investors need to remember that fixed income teams can use fundamental analysis to diminish the downside risks experienced by rising rates down the line.

“Right now the Fed Funds contracts are calling for a 25 basis point increase in the Fed Funds rate over the course of the second quarter of next year,” says Michael Reed, vice-president and portfolio specialist with Franklin Templeton’s fixed income team in San Mateo, California. “It’s something we’re monitoring pretty carefully because we’re not 100% certain the market’s assumptions are going to prove to be correct.”

Rather than fiddle with the duration and maturities of the portfolio, his team is more likely to offset inflation risk by selecting currencies and bonds in countries that would benefit from an inflationary cycle.

“If you know inflation is causing that rise in interest rates, you may want to make bets on currencies of commodity producing countries. They’ll benefit from a rise in inflation. Independent of that, they may also provide good growth fundamentals,” he says. “For us the yield target of the portfolio is going to be the residual of the underlying fundamental approach, rather than trying to put a top-down yield bogey on and try to find credits that meet it.

“We talk about things like shifting up in quality or down in quality, we talk about that from a top down portfolio perspective when were talking to clients, but ultimately our selection is all a function of how that bottom up process plays out.”

(11/20/09)