Inside the fixed income strategy that ignores interest rates

The consensus on when the Bank of Canada will hike rates is shifting constantly, but should investors be taking note?

Inside the fixed income strategy that ignores interest rates

The consensus on when (or if) the Bank of Canada hikes interest rates seems to be shifting from week to week. First, on June 13th, the Bank of Canada Governor Stephen Poloz hinted in an interview that the central bank was moving closer to raising its benchmark rate for the first time since 2010 as the economy continues to strengthen.

Investors reacted and, according to Bloomberg calculations on overnight index swaps, traders priced in a full 25 basis point increase by the December meeting. Economists also bought into Poloz’s hints. In a Bloomberg survey of 17 economists, the majority projected a rate increase this year – a week earlier only two forecasters were projecting a hike in rates.

But then, last Friday, the Bank of Canada’s attempts suffered a setback. Inflation data released by Statistics Canada found that Canada’s consumer price index rose 1.3% in May from a year ago, the slowest pace this year. “We think prospects of a move next month have been dealt a blow today,” Josh Nye, an economist at Royal Bank of Canada, said in a note to investors on Friday.

Whatever the outcome, Canada is likely to remain a relatively low rate environment for some time, which is creating ongoing struggles for fixed income investors and fund managers. Yields are low and many investors are earning around 1.5% after fees from fixed income vehicles. It was with that challenge in mind that Brian D’Costa of Algonquin Capital launched the firm’s alternative fixed income fund, which aims to generate returns regardless of what the central bank does with rates.

“Overall, we think we will still be in a low yield environment for quite some time and that will be challenging for fixed income,” D’Costa says. “Returns are low and even the risk-reward is not very attractive. Our view is that, in the interest rate market, having a long duration asset is risky.”

Data shows that somewhere between 75 – 85% of a fixed income portfolio’s returns are created by interest rate movement, so a key component of D’Costa’s strategy is to hedge out those possible changes. The Algonquin fund focuses on investment grade corporate bonds, and particularly bonds with an average maturity of three to four years. “We buy a corporate bond and we go short to hedge out the interest rate risk, that means we’ve isolated the credit risk of that security,” he says. “We believe credit risk compensates investors well. Furthermore, those credit spreads are not very volatile and so allow us to apply modest leverage to the portfolio.”

D’Costa believes his fixed income strategy is positioned to perform well regardless of what Stephen Poloz and the Bank of Canada decides. The bulk of the fund’s returns are created by its exposure to credit spreads and active trading in the corporate bond market, whether that's relative value, momentum, or new issue trading. “We target a 6 – 9% return a year whether interest rates go up, down or stay the same,” he says. “The combination of thpse two investment components allows us to achieve that.”

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