The media noise surrounding interest rates and the bond market in the United States in general is sometimes deafening. After six years of record low interest rates, it's eye-opening how hyper sensitive the fixed-income landscape has become to even the slightest hint of Fed action, or inaction, over the federal funds rate.
(This matters whether you're an American investor who owns a domestic fixed-income offering or a Canadian investor who holds U.S. fixed-income products, because the United States is the largest bond market for corporate and government issuers in the world. This earns it exceptional financial and regulatory influence in other jurisdictions: inevitably, Canadian fixed-income issuers and investors are influenced by U.S. fixed-income markets.)
It wasn't always this way. Yet, things changed significantly over the last decade. The fund industry rapidly expanded its fixed-income offerings, and the individual and institutional world took a big liking to their convenience and diversification benefits in the constant stretch for yield.
Corporate bonds and some other fixed-income strategies today are hardly plain-vanilla, and can actually provide exciting insights into fundamentals. As I see it, whether you're looking at bonds or stocks, your compass should always point you in the direction of intrinsic value.
Value investing equally applies to the stock and bond worlds – and it makes no difference which side of the Canada-U.S. border you're on. As with equities, the direction of the overall fixed-income market will have little bearing on the value opportunities that present themselves on a company-by-company basis.
Bonds actually are what started it all for value investing; they are at its core alongside the principles of value-oriented equities in Ben Graham's Security Analysis of 1934. Mr. Graham devoted nine chapters to debt investing, arguing that a company's intrinsic value can separate from its bond pricing just as it could its share price.
The concept is relatively straightforward. Coupons are "fixed," but the businesses that issue them are not. The market's perception of a company can change, and this affects the perceived value (quality) of its bond issues, just like its stock. Investors who see when this happens – who examine the corporate balance sheet from all angles – can find opportunities. I believe the only discipline that can do this with any consistency and patience is value investing.
Today, the market struggles to find income in corporate bonds, but it doesn't mean long-term opportunities aren't out there. If you're going to find the hidden gems, however, you need to look beyond the index average. And, if you believe that lower credit quality always means higher return, then you're fishing in the wrong place.
Taking on more actual risk isn't always necessary for higher returns, especially in the non-investment grade bond pool. Whereas value stocks represent companies whose value is greater than their stock price suggests, value bonds represent companies whose quality is believed by the investor to be better than the higher interest rates they're forced to pay. It takes some searching to recognize these inefficiencies, but they do happen and sometimes in striking patterns. Value bond investors look for these "sweet spots" constantly.
Also helping patient U.S. bond investors were new rules starting in 2005. This is when the U.S. Financial Industry Regulatory Authority imposed requirements for bond trade reporting that evened the pricing playing field among the big and smaller players in the market. Called Trade Reporting and Compliance Engine (TRACE), it essentially required all bond dealers to report prices and whether they were buying or selling, which wasn't even required before. (The Ontario Securities Commission published a comprehensive report on the Canadian bond market in October, 2014. The Canadian Fixed Income Market identifies current transparency standards and pending changes by the Investment Industry Regulatory Organization of Canada, or IIROC, to support improvements.)
TRACE was a huge game changer for investors in U.S. bonds. It gave wider access to prices, which previously were privy only to the select few involved with the transactions. With price, you're on your way to determine value separation more effectively.
Another helping hand to value fixed-income investing was the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). As banks were forced to strengthen their capital requirements, many dealers reined in their risk profiles by divesting much of their corporate bond inventory. Inventories shrank dramatically, which flooded the market with corporate bonds. Yet, dealers didn't want them. Shrinking inventory creates pricing volatility. When prices dip and yields spike in the short term, it creates buying opportunities for long-term managers focused on fundamentals. Value bond pickers can take full advantage of that.
You won't see value bond investing everywhere. Although it dates back to 1930s Graham & Dodd principles, value fixed income is not your conventional bond fund strategy.
The value fixed income strategy is transparent, so investors typically know what they own. It's not an array of 5,000 bonds, swaps, currencies and other alternatives. Rather, it pursues its mandate with a select group of about 70-90 undervalued corporate bonds.
Value fixed income doesn't make macro calls or bets either. So, like its value equities cousin, value fixed income will take on its own appearance relative to the index. Moreover, the playing field is levelling through TRACE, while the banking industry's general abhorrence of risk under Dodd-Frank keeps most U.S. bonds (other than investment grade) off their books, so that they can get into the waiting hands of the market. That's great for value bond hunters in the United States, who are more than happy to take a look, and while they're at it, the other side of the issuer's balance sheet too.
Charles Brandes, CFA, is the founder and chairman of Brandes Investment Partners LP, and is also a member of the firm's Investment Oversight Committee.