Income investing’s never been more challenging. All traditional bond investors have been able to do, says Philip Mesman, a portfolio manager at Picton Mahoney Asset Management in Toronto, is decrease bond duration and increase cash. “That results in mediocre returns; or, as we saw last year, negative returns.”
This doesn’t mean clients should flee fixed income and load up on stocks. Instead, they should consider alternative strategies for the fixed-income portions of their portfolios.
Long and short
Mesman’s approach uses long and short positions to capitalize on good buys and hedge the risks that stymie typical strategies. His long positions focus on the middle of the North American corporate bond market—firms rated B to BBB. Familiar names include Bombardier, BCE, Telus and TransCanada. Mesman says such companies are often worth more than they’re priced.
Within this set, he sees the best value in shorter-duration high-yield and lower-quality investment grade bonds. He specifically goes after bonds issued post-credit crisis, between 2009 and 2012. “They have some of the best structures and coupons I’ve seen,” Mesman says. “Coming out of the crisis, these companies were forced to offer attractive covenants to get their deals done.”
The short side of the portfolio hedges three key risks:
- Interest rate risk – the bond’s price falls when rates rise
- Price risk – the bond costs too much
- Credit risk – the issuer may default or go bankrupt
The severity of each factor varies over the investment cycle. Currently, interest rate and price risk dominate, he says. To hedge interest rate risk, Mesman shorts government bonds. Just like shorting stocks, you’re betting bonds will lose value.
Point of comparison: a high-yield bond ETF is 7/10
But how does that happen? Explain it to clients this way: Say you hold 10-year government bonds with $100 face values, issued at a rate of 1.5%. If the rate jumps to 2%, newly issued bonds are more attractive.
To match that 2% coupon, your price would have to dip below $100. Your bonds’ current effective value, in other words, has gone down even though you don’t intend to sell. To hedge price risk, he shorts expensive bonds with weak credit profiles. Right now, lots of new high-yield issues sport these characteristics. “A high-yield company at 5% for 10 years is too expensive.” The asset class has historically commanded close to 8% and with shorter durations.
Annualized returns from this strategy have been around 8.5% (after all fees) since 2009, notes Mesman. “That’s with less than 4% volatility, a 0.44 beta to the high-yield market and negative correlation to investment-grade and traditional fixed-income investments.” Clients must be accredited investors to participate.
He expects interest rate and price risk to persist for the next couple years, so the main components of his current approach will stay in place. But he’s starting to see signs of credit risk. Last year saw a record number of bonds issued on the riskiest end of the spectrum: CCC-rated corporates. And the average covenant per bond deal has gone from five to three. That means less protection for bondholders.
Mesman’s adjusted accordingly. “I’m adding positions to short against it. One of our recent shorts was a mid-sized oil and gas company. We believed its balance sheet was over-levered and the bonds mispriced. When it reported Q4 earnings, the numbers reflected our concerns: its bonds went from $100 to the mid-to-low $80s.” Interest rates will normalize, he says, when governments pull back from interventionist policies such as quantitative easing. At that point traditional bond strategies will again be effective.
Dean DiSpalatro is a Toronto-based financial writer.