Market bets on bond funds

By Mark Noble | November 11, 2009 | Last updated on November 11, 2009
5 min read

If the term “hot seller” can be applied to the investment product industry, fixed-income would fit the bill. Despite the run-up in equities, non-government bonds are driving interest with attractive yields and comparative price safety.

Domestic fixed income funds led the way in net sales in September, according to the Investment Funds Institute of Canada, with sales totalling $1.42 billion, up from $838.7 million in August and down $42.7 million from September 2008.

The trend makes sense. Many clients are not willing to fully commit to the equities market, but neither are they interested in the miniscule yield on money market funds and government bonds.

For slightly more risk, investors can take on a lot more yield on investment grade debt, according to Jeff Frketich, vice-president with Ridgewood Capital Asset Management.

Ridgewood is launching the Ridgewood Canadian Investment Grade Bond Fund, a mandate it acquired from its purchase of the Mulvihill Capital Management. The fund has annualized returns of more than 7% over the last five years investing only in investment grade Canadian bonds.

Frketich thinks this Canadian investment grade bond space is an attractive area for investors, because the yields are still high — Ridgewood’s fund has a yield to maturity of 5.25% and a current yield of 6.3% — in what is still a volatile market.

The main risk bond investors face is a spike in interest rates, but Frketich points out his firm doesn’t see any immediate threat from this. With high unemployment in both Canada and the U.S., and central banks with a mandate to keep inflation in check, he suspects any increases in rates will be incremental and will likely not take place until after 2011.

“We think rates will be flat through 2011, a lot of guys are worried about inflation. They say, The government has printed a trillion dollars, how are they going to pay for that? Unemployment is over 10%, it’s probably closer to 16%, the economy can really get rolling for a while before there are any inflationary pressures,” Frketich says. “We have had a couple of guys say to us, if interest rates go up 5% in a week, what could you do? First of all that would be a meltdown, in which case we would rather be in bonds than stocks.”

He adds, “Our bond fund manager, Mark Carpani, can also put a barbell trade on them. Right now our duration on the bonds is about six and seven years, we can move investment trades to very short-term securities if we need to.”

Bond funds also have an advantage in actually getting their hands on highly coveted debt offerings. There have been some attractive issues of late, but many of these are oversubscribed. One recent issue for a large Canadian financial institution was worth $1 billion, but was oversubscribed for $2 billion.

“For example, we picked up a CIBC issue at 9.5% over a 10-year term. Brokers never get a chance to see those bonds offerings, it’s all snapped up by institutions. We at least get a shot at that stuff,” Frketich says. “There always guys that have to adjust their duration, pension funds and insurance company’s have to sell some of their stuff. Some of that is off the [yield] curve and not that attractive to institutions. If the yield and credit quality are good, our manager can go in there and pick it up. We’re always keeping our yield high relative to the market, but were not sacrificing anything in the way of credit quality.”

Criterion launched convertible bond fund

Criterion Investments, which is owned by First Asset Investment Management has launched Canada’s only convertible bond fund available to retail investors. Again, this fund is aimed at investors looking to increase their risk marginally but not fully willing to commit to equities.

Convertible bond space in Canada, is fairly limited—about 150 issuers—these securities are typically bonds that pay a coupon rate and mature at face value. Unlike normal bonds, they have a conversion option usually within a five-year window where the bond holder can convert the bond into common shares of the issuer at a strike price.

As Lee Goldman, senior vice-president with First Asset Investment Management, and manager of the fund, points out, as the underlying common stocks surpass the strike price in value the bonds start to trade at a premium like options do. If the stock doesn’t surpass the strike price, the investor can still get an income yield from the bond. Typically the strike price is 20% to 30% above the price of the stock at the time of issue.

“You could view this as a defensive equity fund, or you could treat it as a more aggressive bond fund. I think of it as more of a bond fund with potential upside rather than an equity fund. In talking to advisors, to be more conservative from their point of view, they’re treating it as a defensive equity fund,” Goldman says. “The fund is going to offering a 5% distribution, plus there is potential upside from the underlying equity because the equity has gone through the conversion price.”

Goldman says he would only convert bonds into shares if the underlying equity’s growth and income prospects are attractive. Instead, the money convertible bonds could probably be sold for a nice capital gain, or he may continue to hold the bond to maturity if its yield is attractive.

“Sometimes a stock may go through the conversion price but you still want to hold the debenture, in that case you will still maintain the defensive characteristics of the bond. If the equity falls off, there will still be a bond floor for the client,” he says. “If it’s a non-dividend paying stock, you’re still earning income while holding the debenture, versus converting it to equity and not earning the dividend. You can always just sell the bond if you think the equity has a good run.

Where Goldman see value in this security space is the actual valuations of the convertible bonds. He says the market is tending to misprice the bonds on the downside. Many of the issuers are small to mid-cap companies that don’t have credit ratings. They offer convertible bonds as a cheaper alternative to going through the rating process. For this reason, many of the buyers are retail investors who misprice the value of the convertible option,” Goldman says.

“The market does not value the option part as much as they should be,” he says. “The typical term on these bonds is five years. Basically, during that five years if the underlying stock gets through that conversion price, you can convert and get gains above and beyond just getting your interest right away.”


Mark Noble