“This is a reprint of The Globe and Mail article published on January 29, 2020."
With Canadians facing slow growth in the economy at home, mild economic growth globally and continued low interest rates, it will be a challenge for financial advisors and investors alike to eke out decent fixed-income returns in their portfolios, investment experts warns.
In fact, Franklin Templeton Investments Corp.’s 2020 Capital Market Expectations report predicts that fixed-income returns on global government and corporate bonds will lag past rates of return.
That means advisors and investors will have to get creative when it comes to fixed-income investing and consider how to use active and passive investing strategies to make up the difference.
Darcy Briggs, senior vice-president, portfolio manager with Franklin Bissett Investment Management in Calgary, says the best strategy is to be nimble and cast a wide net for returns.
“Going into 2020, [interest] rates are relatively low, credit spreads are pretty tight and we are in a low-volatility environment,” he says. “This is a very unusual environment, it doesn’t happen very often.”
Dan Hallett, vice-president and principal at Oakville, Ont.-based Highview Financial Group worries that the extended bull market has “blinded investors to the risks they’re taking” when they allocate more of their investments to higher-returning equities and away from fixed-income.
Thus, he suggests investors stick with a traditional portfolio mix of 60 per cent equities and 40 per cent fixed income rather than abandoning the latter, which is risky. “Generally speaking, investors’ bond allocations should largely stay intact,” Mr. Hallett argues. “Emphasizing high-quality corporate bonds can add a bit of extra yield [and] any reduction of bonds to redirect money to higher-returning assets should be done modestly.” Yet, Mr. Briggs says his firm is cautious when approaching fixed-income investments in the current environment. Rather than looking for home runs or taking bold positioning, he says Franklin Bissett is “looking to play a little more defense and hit singles.”
That includes using multiple levers to generate returns in the current environment, one of which is investing in selective “fallen angels” – or using extensive credit analysis to buy debt opportunistically in companies that have been downgraded due to a weakened financial position.
Mr. Briggs provides the example of Cenovus Energy Inc., which lost its investment-grade status for a time in 2016.
“A number of investors can’t hold subinvestment-grade [debt],” he says. “So, we are monitoring these types of securities for potential opportunities”
Mr. Briggs expects similar buying opportunities may arise this year as the trend among public companies of late has been to increase leverage for numerous reasons, one of which was for share repurchases. The current environment has created conditions for overall credit ratings to migrate downward, generally, given company fundamentals at the current stage of the credit cycle.
“There comes a time that if global economic activity doesn’t pick up, some of these companies actually trip, which may create conditions leading to a credit rating downgrade to junk,” he says
The dividing line between “junk” and investment-grade bonds can create the potential of superior returns, he notes. One recent example he cites is supermarket operator Sobeys Inc., which dipped below investment-grade status before improving its operations.
Mr. Briggs also looks beyond Canada’s narrow fixed-income market as 85 per cent of it comprises of government bonds and debt issued by financial service firms. He believes that investors have no choice but to embrace an active investment strategy to generate fixed-income returns in a low interest rate environment.
“We can dissect the multiple risks that we see, selecting those with better risk-return potential and move portfolio positioning to capitalize in order to generate excess benchmark returns,” he says. “With a passive strategy, you don’t even get benchmark returns. You get benchmark minus [management expense ratio] returns.”
The risks associated with a passive approach to fixed-income investing “have gone way up,” says Yves Rebetez, an exchange-traded fund (ETF) analyst and chief investment officer at Pascal Financial in Toronto.
That’s in large part because investors are assuming more duration risk as the average term periods of debt held within fixed-income ETFs is lengthening and making investors potentially more vulnerable to interest-rate changes.
Mr. Rebetez sees the appeal for investors to have a fund manager adjusting for credit and duration risk rather than taking a passive approach to fixed-income investing. “The problem is I am not sure I even want to be in that space because of low returns.”
However, lower bond returns are still better than returns generated by holding cash or cash equivalents, Mr. Briggs says.
While some wary investors have retreated to holding more cash in money market funds or ultra-safe, locked-in investments, such as guaranteed investment certificates (GICs), he worries that strategy is setting them up for disappointment.
“In 2018, cash was the best performing asset, but it was the best performing asset for the first time in 20 years. In 2019, it was the worst performing asset. It lagged fixed income and it really lagged equities,” he says.
As for holding GICs, except for those that are cashable, “you’re locked in with zero liquidity. It is a trade-off for safety but if it allows some investors to sleep better it is understandable,” he adds.
For investors looking for better fixed-income returns and liquidity than those offered by GICs but with more safety than a pure fixed-income fund, a short-duration bond fund, which invests in debt of two to three years, on average, is a good option, Mr. Briggs suggests.
“You are able to get better than cash returns,” he says. “It kind of wedges in between a pure no-risk GIC and a bond fund return. You don’t have a lot of volatility, generally, with a short duration bond fund.”