spoke to Mark Wisniewski, Sprott Asset Management's Senior Portfolio Manager, about the current and future environment for bonds, fixed income and alternatives and to ask how investors can go about tackling duration, yield, interest rate risk and capital preservation challenges.
Although the recovery from the financial crisis is now eight years in the making, interest rates remain relentlessly low. Late last year the Bank of Canada announced its decision to hold its benchmark interest rate at 0.5%, and the common consensus is that if interest rates are to be altered this year, the direction will be lower not higher.
While fixed income securities have had a great run in recent times, bonds and the traditional fixed income funds they populate have struggled to both preserve capital and generate sufficient income. The coupon on typical investment grade or government bonds is a fraction of what it once was.
“Back in 2008, a 10 year Canadian government bond had a coupon of 4.25% (today it’s around 1%) and investment grade corporate bonds had coupons in excess of 6%,” Wisniewski explains. “If you purchased a broad market index bond fund back then, which contained mostly governments and some credit, you were likely earning around 4.50%. Today, that type of yield or income isn’t available in that or any higher quality bond product.”
To illustrate his point, Wisniewski highlights the BOFA Merrill Lynch Canada Broad Market Index, which today has a yield of 1.8%, compared with 4.5% back in 2008.
“As interest and coupon rates decline, bond funds have endeavoured to stabilize their fund’s yield by increasing duration (a gauge of price volatility, expressed in years). The yield on a longer-term duration security is much more than its shorter dated duration maturity,” Wisniewski says. “For example, a Canadian 2 year government bond yields 0.55% while its 30 year bond yields 1.8%. In an effort to generate more income, bond funds have added a higher percentage of longer dated, higher duration bonds to their portfolios.”
In 2008, the BOFA Merrill Lynch Canada Broad Market Index had a duration of about 6.7 years, yet today the duration of that same fund is more than eight years, which increases both risk and the probability of an impairment of principal if interest rates begin to increase.
“Investing money in a fund with eight years of duration, earning 1.8% per annum at best, seems absurd. Why? Because interest rates don’t need to move that much higher before an investor loses money,” Wisniewski says. “By calculating the current breakeven (yield per unit of duration) on the BOFA Merrill Lynch Canada Broad Market Index, an investor today would lose money if rates moved more than 0.23%. That’s not much cushion considering how low interest rates are today.”
But what alternatives are available to an investor who isn’t willing to accept, at best, approximately 1.8% per annum? “A better alternative, in the current low rate environment, is to utilize higher yielding corporate bonds in lieu of duration: 5 year bonds issued by major Canadian banks, car companies, REITs, telecommunications and pipelines; names like Royal Bank, GM, Granite REIT, Shaw and Enbridge,” Wisniewski says. “These securities yield three to six times what a 5 year government bond yields, with a duration that’s closer to four years.”
For investors willing to embrace more credit risk, Wisniewski points to lower-rated credit, which, he says, has a yield that is as much as 20 times that of a similar duration government.
“On a risk-adjusted basis, you’re earning much more income for the risk you’re taking,” he says. “Finally, if and when interest rates do rise, an investor who owns short-dated, lower duration credit instead of longer duration government bonds has a much shorter investment time horizon. That provides them with the ability to redeploy their investment earlier, without a significant drawdown of their capital, because they aren’t invested in longer-dated securities.”
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