Bonds are generally seen through the prism of risk aversion. Investors are happy to escape recurring bear markets in stocks with barely a scratch — rather than claw marks grooved deeply into the net asset value of their portfolios. There’s capital protection and a reliable income.
Yet, in this contest between bond and bear, risk aversion sometimes yields more fruit for the bond than the bear. In the hands of a good management team, bonds can surprise to the upside. In a diversified portfolio, they perform when other asset classes flag. Sometimes this outperformance is protracted.
Most recently — in just about all markets except for emerging ones — bond returns have beat stocks for a whole decade — not quite the prediction of “stocks for the long run.”
But for bond funds to manage this outperformance, they have to go beyond plain-vanilla Government of Canada bonds. That could mean a mix of provincial and corporate bonds.
The top performer in the bond category is Beutel Goodman’s Corp/Provincial Active Bond Fund. It goes beyond federal bonds and into provincial issues and the investment-grade universe of corporate bonds.
Long-time investors scored a double win. Beutel Goodman provided an annualized 10-year return of 7.18% as against a 4.94% peer group return. And that return also compares, quite remarkably, with the average Canadian equity fund return or 3.22% (which ignores the outperformance of funds specialized in energy and materials stocks.)
Many think that active management doesn’t contribute very much to fixed income. Here’s the trifecta: Beutel Goodman has outperformed five-year GICs by roughly 40% over the past decade.
For Bruce Corneil, who heads the fixed income team at Beutel Goodman, those achievements are testament to experience — he’s been with Beutel Goodman since 1994 — and teamwork. “I’ve been really lucky. I’ve had a good team. I’ve been fortunate in my whole career that I’ve worked with very capable people.”
The team has many tasks to perform. “It starts with an approved list,” Corneil explains. “When I came to Beutel Goodman 16 and a half years ago, that was the first thing…what securities the operational people on the investment desk are allowed to buy. We do our own credit research and we don’t rely on rating agencies. We look for a number of criteria, probably the most important would be non-cyclicality and transparency.”
Transparency is a key issue, as many money market and some institutional investors learned — to their loss — during the meltdown of highly rated non-bank asset backed commercial paper in 2007.
“We avoided securities like ABCP, which were rated Triple-A,” says Corneil. “Obviously we viewed them as non-investment grade. So we didn’t hold them. In my career, when we get into those credit crunches, you basically find out if you’re able to manage through it.”
That’s where experience comes in. The last credit crunch in Canada was in 1992. But it’s also where independent analysis plays a crucial role. Individual bonds can seem to be straightforward for investors who hold them to maturity. But put them into an actively managed portfolio, and there’s more work to be done.
“Fixed income, or yield curves, are really a function of macroeconomic analysis,” explains Corneil. “To a large extent, that’s what we specialize in: where interest rates should be to reflect future prospects of inflation as well as the general outlook for economic retrenchment or rebounds. Basically, if you have reasonably good predictive skills and if you’re able to put that together with the mathematics of how bonds work and if you have a good approved list, clearly what you can do is add value and that’s what we’ve done.”
Beutel Goodman holds government securities and investment-grade corporate bonds. But the asset mix varies. “At certain times, we could hold 60% or 70% Canadas — or Canada equivalents,” he says. “At certain points in the cycle we could hold as little as 30%. It’s purely a function of relative attractiveness and our valuations within the interest rate environment — or within the bond markets.”
The macroeconomics of interest rates often indicate taking a contrarian stance. During the Great Moderation, “really what happened in the latter part of the 1990s and the early part of the 2000s was that people got complacent. It was very benign. But that made it extremely risky.”
Here’s where the kinks in the yield curve come in — the difference between short-term facts and longer-term risks. “The market differentiates the risk. And the credit quality is reflected in the spread, relative to Canadas,” Corneil says. Against that, “in finance, there’s only one true variable and everything else is an opinion. The only true variable is the overnight rate and if, for instance, we were to build a yield curve, all yields from beyond that overnight rate are the market’s interpretation of political stability, inflation, economic recovery, are you going to have a war, etc.”
Building off today’s short-term rates, Corneil expects the yield curve to flatten. “So that means we’re avoiding the belly of the yield curve. We still think that the corporates we like are relatively attractively priced, — not nearly as attractive as going back to the first quarter of 2009 — but we still like corporates.”
With the flattening of the yield curve, “the market opinion is that short rates will probably go up more than long rates.”
That’s where the opportunity to add value lies. “A large part of the returns on fixed income is not only the fixed income you get you get but also it’s the capital appreciation you get from when interest rates decline.” But that’s only one aspect of adding value — one it turns out, that helps account for the recent outperformance of bonds over stocks.
The other, Corneil notes, “is to actually look at it relative to an index. Clearly, relatively to an index, it doesn’t matter whether interest rates go up or down.”
The capital gains are icing on the cake. But beating the index is a sweet confirmation of experience, teamwork and analysis.
(08/27/10)
