The modern struggles associated with Canadian fixed income investments can be summed with one damning conclusion: in the current environment, most investors don’t even expect decent returns from the fixed income portion of their portfolios.
Despite the negativity, opportunities do remain in the fixed income space. However, they may require advisors to rethink their fixed income strategies. Portfolio manager at PenderFund Capital Management Geoff Castle believes that using the traditional ‘bond ladder’ structure has been one factor holding back fixed income portfolios. He thinks that dynamic rebalancing is better suited to the current market.
“The problem with a passive bond ladder is that prices change,” Castle says. “Watching the price of a bond over the course of a year, one may see it move from, say, 100 to 105 and then maybe back to 100 again. Through regular rebalancing, our team makes the holdings in the fund compete for weight, selling the expensive and adding to the cheap. We rebalance within risk bands so as not to change the overall risk positioning of the fund as we trade. We believe there is considerable value to be gained from a well-managed, dynamic rebalancing process.”
Castle believes that fundamental credit evaluation strategies should be followed instead of traditional ratings-based credit analysis techniques. He has seen many advisors and portfolio managers define risk solely by looking at ratings, a move he describes as “outsourcing to conflicted rating agencies the hard work of credit.”
“We do fundamental credit valuation and liquidation value analysis and supplement that with the use of default risk models,” Castle says. “We look at ratings, but only as an indication of what market participants may do if they change, rather than as a tool in our core process of evaluating a credit position.”
In recent years, many investors have done very well from investing in passively managed index funds and ETFs, which acquire pieces of the largest bond issues, as defined by issue size. Castle and PenderFund have taken a different view: they actively trade against the index.
“So, for instance, in 2016 we acquired our position in Energy XXI second lien bonds after the bond was downgraded and kicked out of the index with a forced sale at 11c on the dollar,” Castle says.
“Our analysis showed that the value attributable to these bonds was more than four times the traded price. The fund was indeed able to realize that value over the next twelve months. We took advantage of the opportunity to be on the other side of a trade of a counterparty who was not thinking about value only rating.”
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