How to handle high-yield bonds

Historically, bond duration hasn’t been an issue.

That’s because “over the last 30 years, the correlation between high-yield returns and U.S. Treasury bonds [has been] close to zero,” says Nicholas Leach, vice-president of global fixed income and high yield at CIBC Asset Management. He’s the lead manager of the Renaissance High-Yield Bond Fund.

But that’s changed over the last two years, he adds, since “yields are at historically low levels and credit quality is very high. [As such], bond returns have become more sensitive” to interest-rate and duration risk.

Read: 4 obstacles to high-yield returns

And now, “there’s not as much cushion as there normally is [when it comes to] offsetting capital losses when interest rates rise.”

Still, Leach suggests clients may benefit from choosing high-yield over investment-grade bonds. That’s because “high-yield coupons [will likely] offset any rise in rates, and [they’ll be] more than enough to offset default rates relative to [their] investment-grade counterparts.”

Read: Good time to buy high-yield bonds

If interest rates were to rise by 1%, he adds, high-yield coupons would fall by 4.2% over their average 4.2-year duration.

In contrast, investment-grade coupons would fall about 7% over their average 7.3-year duration in the same scenario. That means, assuming markets remain steady, high-yield coupons could outperform by about 300 bps.

However, Leach doesn’t anticipate a rise in interest rates any time soon. “Rates will be anchored by central bank policy, and credit quality is also very high, so we expect defaults to stay low.”

Read: Investors dropped bonds too hastily

Mitigating currency risk

One way Leach makes use of the interest-rate differential between Canada and the U.S. is by investing primarily in U.S.-dollar bonds. When doing this, he makes sure to hedge the currency back into the Canadian dollar every three months.

Read: Going global in bonds

And Leach is optimistic about total returns for 2014. “When we look back at 2013, total returns were equal to the running yield at the beginning of the year. So, if we calculate the running yield now—which is found by dividing the average running yield divided by the average price—that gets us to about a 6.7% running yield we could expect to see over the next year, and that’s in U.S.-dollar terms.”

He adds, “When I hedge all of that back into Canadian dollars, we’ll be earning an additional 100 basis points, [which means] the running current yield in Canadian dollars is closer to 7.5% or 7.75%.”

Also check out:

Why to choose floating-rate loans

A progressive approach to fixed-income

How to create a yield cushion