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Low rates change investors' fixed-income strategies

Facing rock-bottom interest rates and a sputtering North American economy, fixed-income investors are being forced to alter their portfolio strategies.

Since the European debt crisis rattled the market in April, investors redeploying cash from maturing debt have faced yields that continue to plummet. The situation turned even more grim after the Federal Reserve admitted last Tuesday that the U.S. economic recovery has been worse than expected.

It's an environment that's worrisome for even the most sophisticated managers, but many are navigating through it all by leaning on tactics that include looking further out the yield curve, moving down the capital structure into high-yield debt, and buying provincial and corporate issues.

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Finicky two-year yields have been the hardest for investors to reconcile, said Mohammed Ahmed, rates strategist at CIBC World Markets. In the U.S., the two-year rate now hovers around 0.5 per cent, offering almost no return, while Canada's is suppressed by foreign investor demand.

"Investors seeking yield find themselves in a very challenging situation," he said.

Challenges Going Forward

In Canada, the situation is not dire at the moment, but it could worsen if the Bank of Canada raises the overnight target rate in September, which most banks predict it will do. If that happens, two year yields should theoretically rise in tandem because a healthy yield curve is upward sloping - the danger is that the curve could flatten out, pinch the available returns on offer and take some of the shine off the Canadian market.

To this point, Canada has been a good place for central banks and sovereign wealth funds to park shorter-term money, Mr. Ahmed said, because Canadian government bonds pay more than their U.S. counterparts. Currently, there is a 0.90-percentage-point difference between the countries' two year yields. However, foreign demand has kept Canada's yields low. (Strong demand means higher prices and therefore lower yields.)

If Canada's overnight target rate increases in September but two-year rates do not budge, investors could earn a comparable return by simply rolling safer, short-term treasury bills. "You wouldn't want to own the two-year bonds because the yield ... does not compensate for the risk," Mr. Ahmed said.

Except many investors need a decent return. For them, the smarter option has been to either extend their preferred maturities or look to more speculative issues. Choosing between the two often depends on the account type. Pension funds with long-term mind frames may extend, while retail investors might look for riskier securities.

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What to Buy

Rémi Roger, head of fixed income at Seamark Asset Management Ltd., concurs. The current environment is "tricky," he said, but "you need to live with it." To do just that, he is looking at corporate and provincial bonds.

"Select the right names that you feel most comfortable with" in these spaces, Mr. Roger said, "and that brings some decent yield to your portfolio." At the moment, he likes Enbridge for its stable revenues, Sun Life because he doesn't think it is in as bad shape as some people predict and the Canadian banks because they have been touted around the world.

Other investors have turned to high-yield debt, said Adrian Prenc at Marrett Asset Management Inc., which specializes in these riskier securities.

If the economy grows slowly, he said, default rates will continue to drop - yet high-yield securities will continue to offer generous spreads until investors are fully confident again. Currently, the Bank of America Merrill Lynch high-yield index, which has an average maturity of just under six years, pegs high-yield spreads at around 6.78 percentage points above U.S. Treasuries - an average yield of around 8.27 per cent.

Investors have plunged back into this market. Last week, there were 26 new high-yield issues around the world, totalling $14.3-billion (U.S.), according to Thomson Reuters. That set new records for both total value and number of issues in a single week.

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Issuers responded quickly to the new investor appetite. In the high-yield space, Air Canada raised $1.1-billion by selling debt yielding an average of 10.4 per cent in both Canadian and U.S. dollars late in July, and a week ago Tembec Inc. sold $255-million of 11.25 per cent senior notes.

Provincial issuers also flooded the market last month, raising a record $6.9-billion (Canadian). After a quiet August, they came back this week with new issues by the provinces of British Columbia, Quebec and New Brunswick, which raised $1.3-billion collectively. Both B.C. and Quebec targeted investors at the 10-year mark.

Canada Housing Trust also came to market this week, raising a total of $3.55-billion in 10-year fixed-rate bonds and five-year floating-rate notes. The 10-year portion was priced at 3.376 per cent, offering investors 0.46 percentage points more than the Canada benchmark bond.

Asset-backed issuers have also put their foot in the ring. Canadian Imperial Bank of Commerce's CARDS II Trust, which securitizes credit card receivables, sold $600-million of new debt on Tuesday. Just a few months ago, this asset class could not get sold. But since the market got choppier, CIBC has sold $1.75-billion of the product, which most recently priced at 0.85 percentage points above the Canada curve.

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About the Author
Reporter and Streetwise columnist

Tim Kiladze is a business reporter with The Globe and Mail. Before crossing over to journalism, he worked in equity capital markets at National Bank Financial and in fixed-income sales and trading at RBC Dominion Securities. Tim graduated from Columbia University's Graduate School of Journalism and also earned a Bachelor in Commerce in finance from McGill University. More

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