In one of the worst stretches for fixed-income securities in history, rising interest rates and stubbornly high inflation are hitting the returns of bonds. As yields rise and prices fall, recipients of the 2022 Lipper Awards in the category say the challenging climate has required keen strategies, clear outlooks – and a sobering sense of the past.
“These adjustment processes are quite normal in the history of financial markets,” says Jim Gilliland, head of fixed income and president and chief executive officer of Leith Wheeler Investment Counsel Ltd. in Vancouver.
The company’s Leith Wheeler Corporate Advantage Fund Series F, which won the award in the Canadian Corporate Fixed Income category, has assets of $138-million and a management expense ratio (MER) of 0.53 per cent. The fund’s performance was down 9.6 per cent over the past year, as of Sept. 30, and was flat each year over the past three years. That compares with a drop of 8.5 per cent and decrease of 0.4 per cent over the same two time periods for its benchmark, a 50/50 blend of FTSE Canada indices tracking short-term and medium-term corporate bonds. (All performance data are based on total returns and net of fees).
Mr. Gilliland has a lot of experience in fixed-income investing. His career began in May 1993, as the economy was coming out of a severe recession in the early 90s. He saw the U.S. Federal Reserve increase rates from 3 per cent to 6 per cent throughout 1994, “very similar to what we’re seeing right now.” Bond yields rose significantly, he recalls, while prices suffered the largest declines in many years.
Mr. Gilliland notes the full impact of rate increases in 1994 wasn’t felt until 1995, “and there was a lot of dialogue, as you have currently; people asking, ‘Are we going to see a hard landing? Is it a recession again?’” The result was more of an industrial slowdown, he says, but the larger point of his example is that the nominal interest rates we have experienced since the 2008-2009 financial crisis couldn’t last.
“I see the current environment as going back to the types of adjustments you would normally see,” he says. “It’s really the last 14 years that have been the unique time period.”
Mr. Gilliland says the Corporate Advantage fund is oriented toward investors looking for income and less sensitivity to interest rates, with little exposure to longer-term securities.
“[It] has preserved the capital of our clients better than a typical bond fund,” he says.
The fund is primarily focused on corporate credit, with about 80 per cent in short- and medium-term investment-grade bonds. Another 10 per cent is invested in preferred shares and 10 per cent in high-yield bonds, both of which are inherently more volatile but provide greater yield, he notes.
Another Lipper recipient in the fixed-income category, Lysander Funds Ltd. of Toronto, received six individual fund awards and two group awards. Tim Hicks, chief investment officer of Lysander and portfolio manager at fund portfolio manager Canso Investment Counsel Ltd., says the company’s bond funds are all focused on credit, with different durations and risk profiles.
One example is the Lysander-Canso Short Term and Floating Rate Fund Series F, winner of the Lipper Award in the Canadian Short Term Fixed Income category, which has an MER of 0.84 per cent and $407-million in assets. The fund has seen a drop of 4.5 per cent over the past 12 months, as of Sept. 30, and an annualized return of 1.4 per cent over three years. The fund’s benchmark is the FTSE Canada Short Term Overall Bond Index, which has fallen 5.2 per cent over the past year and is down 0.1 per cent on an annualized basis over the past three years.
The fund invests in high-quality, short-term securities, reducing investors’ duration risk so they’re not as affected by big changes in interest rates, Mr. Hicks notes. When the COVID-19 pandemic hit and bond prices of blue-chip companies like Exxon and Procter & Gamble tumbled, Canso was able to sell its relatively liquid, high-quality assets and “buy other things that were much more attractively priced,” he recalls. “We moved extremely rapidly and in a fairly big way to take advantage of opportunities.”
This included travel companies like Air Canada and Hertz, which were down but not out. The fund invested heavily in their debt “at very attractive levels” and did the same with energy companies such as Occidental Petroleum and Continental Resources. It also invested in Pacific Life, a U.S.-based life insurance company, buying its floating-rate debt when the coupon was less than 1 per cent and riding it up to 4.5 per cent.
What’s ahead? While things have been rocky in fixed-income markets, “the thing you have to do when investing is not get overly affected by the water under the bridge,” Mr. Hicks says. Interest rates have been falling since 1980, “and that’s been a tailwind, if you will, for bond prices,” he points out. “We believe that whole era is over now.”
While it will be “tougher to make the kinds of returns in bonds that you have for the last many years, there’s always money to be made in lending,” he notes, especially with higher interest rates.
Mr. Gilliland says the Bank of Canada’s tightening cycle is expected to be complete by January, with suggestions rates might remain high. For fixed-income investors, “that gives you the ability to reinvest your capital and to continue to deliver some pretty attractive yields.”
The extent of the slowdown won’t be known until next summer. Higher-yielding bonds and preferred shares are more vulnerable in this period of uncertainty than the investment-grade securities in which the Leith Wheeler fund is largely invested. “You want to have that ballast or that balance in your portfolio,” Mr. Gilliland says.