George Young is vice-president and portfolio manager at Gluskin Sheff + Associates Inc.
One of the more vexing questions facing investors in 2014 is what to do with the fixed-income portion of their portfolios. After enjoying decades of stable and consistent returns, the traditional fixed-income landscape no longer offers many attractive opportunities. Despite the strong rally in bonds to start this year, there is real concern that 2014 may produce negative returns, echoing last year’s. For bond investors, it is a case of fool me once, shame on you, but fool me twice – shame on me.
There is no such thing as a free lunch, and fixed income is no exception. Investors get paid for the willingness to take on exposure to risk. The key is to make sure that the expected outcome is attractive enough to compensate for the risk. In fixed income, there are really only two risk factors: credit risk (default) and interest-rate risk (duration). Credit risk refers to whether you are going to get paid back or not, and interest-rate risk refers to the way that bond prices drop when rates rise. The most important component of the interest-rate factor is the direction of future interest rates. It is very easy to lose money in fixed-income investing in a rising interest rate environment, and investors should understand what downside protection is afforded them through their coupon payments.
Let’s use the DEX Universe Bond index as an example. Its current income yield is approximately 2.50 per cent, and its one-year break-even is 42 basis points. This means that if medium-term interest rates rise more than 42 basis points in the next year, the DEX will produce a negative return. It is a very thin margin of protection from rising rates, at a time when the DEX is also generating a low return from its income stream.
Credit risk is measured by credit spreads, the difference in yields between corporate fixed-income instruments and benchmark government bonds. The higher the spread, the higher the compensation for future default, and vice versa. Utilizing the worst-case scenarios from the past 50 years, and making a conservative assumption in terms of losses due to forced selling upon downgrade, the amount of excess spread required per year to compensate for taking on investment-grade corporate credit risk is about 20 basis points.
However, one can put together a diversified portfolio of Canadian investment-grade corporate bonds today and achieve a weighted-average excess spread of approximately 120 basis points – which implies an excess credit premium in the market of around 1 per cent.
One major problem that exists today is that traditional fixed-income management techniques make it difficult to separate the interest-rate risk factor from the credit-spread risk factor. However, they can be separated, and in a way that allows for an evaluation of the merits of each risk factor on its own. The strategy is to pair each corporate bond position with the sale of a government bond position. This effectively removes the interest-rate risk, leaving us solely exposed to the credit-spread risk, which is much more appealing in today’s environment. The strategy entails applying a modest amount of leverage. We buy and then borrow against short-term corporate bonds and use the funds to buy longer-term corporate bonds that typically carry a higher rate of interest. At the same time, we sell government bonds. If only interest rates change, causing the government bond to rise or fall, we are unaffected because the corporate bond should rise or fall by same amount. What remains is a pure exposure to credit spreads.
At Gluskin Sheff, we used this strategy to generate returns of 6 per cent to 9 per cent in 2013, across our various portfolios, at a time when the DEX posted a negative return of 1.2 per cent – representing its first negative annual return in 12 years.
The past 30-plus years of declining interest rates produced a generational bull market in fixed-income assets, with stable high returns and attractive portfolio risk characteristics. We believe that tailwind is now over, and investors need to reassess the role that fixed income plays within their asset-allocation process and reconsider the types of fixed-income strategies they allocate money to. We often hear in financial markets that “past performance is not indicative of the future results,” and nowhere is this truer than in today’s fixed-income market. Successful investing will require a new approach that recognizes the market’s new paradigm of rising interest rates.