Current market conditions can best be described as challenging for bond investors. There are historically low yields; rising interest rates in the US; slowing global growth (specifically in Europe and China); and compressed corporate spreads. Yields in the US and Canada are at extremely low levels. In the US, 10-year treasury bonds are yielding 2.03%. In Canada (as of Oct. 21), it’s an anemic 1.57%. This barely keeps pace with inflation.
There’s also the prospect of US interest rates rising. Central banks including the US Federal Reserve have made it clear interest rates will remain low – despite talking about the potential for higher rates. The risk/reward picture is bleak. Even if the Fed raises rates, it’s not necessarily all gloom and doom.
According to Ned Davis Research, of the 12 Fed hikes since 1948, investment-grade bonds were positive half the time. Contrary to popular belief, historically, tightening monetary policy cycles don’t necessarily mean huge losses in bond markets.
Nevertheless, for argument’s sake, let’s assume the Fed raises rates and at the very least, government bonds lose value. One possible solution for enhancing yield while maintaining downside protection is, use an actively managed core-plus strategy. Start with a value-based, actively managed core portfolio, and add high-yield and preferred shares.
Benefits of a core-plus strategy
By employing a core-plus strategy with atypical balanced portfolio, the risk/return characteristics are enhanced. Returns rise with high-yield corporates and preferred shares. As well, these securities are in general positively related to the growth phase of the economic cycle, corresponding to rising inflation and interest rates. Moreover, studies suggest a core-plus strategy provides similar downside protection against shocks such as stock-market corrections and sharp declines in oil prices. The studies also suggest this strategy provides enhanced returns in bull markets and rising interest-rates environments.
The added yield compensates for duration-based price declines. A note of caution here: beware of the value trap in chasing higher yields. The promise of high yields can be very enticing. But keep in mind the market demands higher returns for a reason. One efficient way of gaining exposure to these areas is through broad based ETFs. However, skilled portfolio management based on fundamental research and rigour is a smarter way of mitigating the higher risk involved in preferred shares and high-yield bonds.
Questrade Wealth Management Inc. (“QWM”) is a registered portfolio manager. QWM manages and issues the QWM family of exchange traded funds. The views and opinions expressed herein are those of the author and do not necessarily reflect the view of QWM. QWM does not guarantee the quality, accuracy, completeness or timeliness of the information provided. QWM assumes no obligation to update the information. QWM disclaims all warranties, representations and conditions regarding use of the information provided
James Youn, CFA, is a senior portfolio manager with Questrade Wealth Management.