Ways to rethink fixed income

Bonds won’t be the big cash cow they once were. So do you still need them?

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Investors tend to rely too heavily on fixed income to pad returns. While it’s true we’ve been spoiled for 30 years—falling yields have pushed bond prices higher—fixed income is meant to balance out a portfolio’s ups and downs and provide some regular yield. It’s not meant to give assets an equities-like capital gains boost. “We have to get back to the point of view that it’s a shock absorber to equity markets,” says Philip Petursson, managing director at Manulife Investments.

It’s only a matter of time until yields rise and bond prices fall, Petursson says. The great rate hike hasn’t happened yet—and countries are still cutting, but things will turn around eventually. With that in mind, some are calling for a dramatic reduction of fixed income in portfolios. Petursson disagrees. Firstly, bonds lose less money than equities—2013 was the last year Canadian fixed income was in the red, and it only fell by 1.13%. Secondly, the top three performing asset classes in 2008 were bond related. Bonds, he argues, have value as a steadying force in a portfolio.

While people’s perceptions of fixed income need to change, so too does the way they look for opportunities. Canadians have, naturally, gravitated toward Canadian government bonds. But with the 10-year benchmark bond yield paying 1.5% and inflation topping about 2%, you’re actually losing money on yields. Instead, look across the globe and the yield curve, Petursson says.

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Bond managers for instance are finding opportunities in the corporate credit space in Canada and the U.S. investment grade bonds are paying about 140 basis points more than government bond yields at the moment. High-yield issues meanwhile are paying about 620 basis points, or 6.2%, more than U.S. treasuries.

Of course, higher returns mean greater risk. According to JPMorgan, defaults on junk bonds have climbed to around a 7% annualized rate in the first quarter. Strip out energy and that number is closer to the 2%, in line with the average default rate over the last five years, Petursson says. The takeaway? Steer clear of energy and look towards U.S.-based healthcare and consumer staple bonds, such as Heinz and fashion retailer Limited Brands, if you’re following this line of strategic thinking. Hospitals, Petursson adds, are particularly attractive operations with a low risk of default. He likes Hospital Corp. of America in this space.

Outside of North America, Petursson is keen on bonds from Australia and New Zealand. Both countries have stable economies and rates higher than Canada’s. As for emerging markets, look to more solid, investment-grade nations, such as Philippines, Singapore and Indonesia and watch out for countries that have current account deficits.
Be careful about chasing yields—buy lower-quality bonds for the higher payout and you could be raising your default risk. Ultimately, investors need to think globally, focus on stability and yields and forget about making big bucks on gains. “It comes down to managing risks,” Petursson says. “You need to maintain a stable level of income and mitigate portfolio volatility.”

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How to buy global bonds

In today’s volatile stock market environment, balanced investors should hold about 50% of their assets in bonds, Petursson says. He thinks the stock market will need that balance going forward. “I want to position myself for that downside shift,” he says.

However, it’s difficult for investors to purchase individual bonds. They’re expensive to buy on a one-off basis and most can’t access international offerings as they’re not listed on an exchange. Canadians also have to think about currency exposure and whether they want to buy hedged or non-hedged securities as most bonds are denominated in the currency of their home country.

The easiest way to get into this space is through a bond fund. Petursson suggests investors consider a multi-sector unconstrained bond fund, where the manager has the ability to buy into any sector and any country around the world. See what’s in the fund before purchasing, though. You don’t want a manager to be 100% in high yield. Diversification is important in these funds.

As for duration, mid-to-short term is ideal, Petursson says. Manulife’s average duration is around five years; much longer and you can lose money when rates rise, any less and you won’t make any yield at all. When it comes down to it, deciding what to own truly relates to what you need. Require more yield? You’ll have to take on more risk. Can’t stomach losing money? Own more bonds. “When it comes to fixed income, there isn’t one formula that works for everyone,” Petursson says.

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