Manager Views

Managing fixed income in a low interest rate environment

It takes active management and intensive research to add yield to a fixed income portfolio in a low interest rate environment. Below, Steve Locke and Dan Bastasic discuss not only how they are adding value, and positioning their portfolios in anticipation of rising rates. Co-leaders of Mackenzie’s Sentinel Fixed Income Team, Locke focuses on core fixed income and money market securities, while Bastasic focuses on high yield corporate bond and equity income securities.

How are you positioning the fund in a low-rate environment?

Locke: We can do a number of things to position our portfolios to take advantage of this environment. Three methods we are currently using include overweighting corporate debt, using a barbell term structure, and looking for opportunities within an expanded investment universe.

Let’s begin by discussing your overweight position in corporate debt

Locke: One way to position fixed income portfolios to reward investors in a slowly rising interest rate environment is to be overweight corporate bonds. There is a very strong correlation between rising, expected inflation and the performance of corporate bonds, including high yield and investment grade bonds. So when we are looking at a potential rise in inflation expectations and therefore a potential rise in bond yields, we want to be overweight in corporate debt. Current valuations support an overweight position as well.

Corporate bonds are still cheap relative to government bonds. Compared to the last cycle in 2002 and 2003, we are still at a wider yield spread. Right now, the spread is roughly where it was in September 2008 before Lehman Brothers filed for bankruptcy.

The spread is important to us. With the central banks indicating that a low yield environment is likely to prevail for some time, we are well positioned to receive higher income from our overweight in corporate bonds. Over time, with policy rate and yield curve normalization, we expect to see corporate bonds outperform government bonds.

Please explain your “barbell” strategy

Locke: We started to implement a barbell term structure in our bond portfolios about a year ago, concentrating holdings in the short- and long-term ends of the maturity spectrum. Since we are still in a steep yield curve environment, we will continue with that strategy. Going forward we expect the barbell structure to pay off as policy rates normalize, the yield curve flattens and we are able to reinvest the short end of the curve to produce stronger yields.

Do you look abroad for higher yields?

Locke: One of the strategies we always like to use is to cast a wider net by looking around the world for opportunities to bring good returns into the portfolio. For example, earlier this year we purchased some Australian bank senior debt that was yielding about 2 to 2.5 times the interest being paid on a Canadian bank senior bond offering. These are the types of opportunities that we look for to enhance portfolio yield.

How do you approach risk?

Locke: We are also looking for good credit. We do not plan to overreach on the risk side, because there are some companies that are going to continue to have problems. We actively manage the portfolio to try and get into the right credits at the right time.

Double the yield

As the chart below shows, investment grade corporate bonds pay much more than GICs and government bonds, but as of August 31, 2010, high-yield corporate bonds offered more than double the yield on investment grade bonds.

What separates high yield fixed income from other assets?

Bastasic: High yield fixed income doesn’t generally act like other fixed income securities; it is a completely different animal. There is very little correlation between interest rates and high yield bonds. Instead, high yield bonds behave more like equities, reacting more to company-specific events than changes in interest rates.

How has the high yield sector been performing?

Bastasic: High yield bonds performed very well over the past year, but they are not a one-year phenomenon. Valuations are still relatively cheap, and there is still a lot of risk in the economy. If you want to help protect yourself on the downside and still have the opportunity to participate in a very significant way on the upside, high yield is likely a place you are going to want to be.

How will high-yield bonds react to a changing economy?

Bastasic: High yield corporate debt performs well under almost all economic scenarios. If the economy goes into a recession or there is an increase in default rates or inflation rates, high yield tends to follow the stock market performance and not do as well. But slow to moderate economic growth, which is what we expect for the next few years, is particularly good for high-yield corporate bonds. In such an environment the economic problems aren’t bad enough to cause an increase in defaults, and at the same time you collect fairly high income. So all in all, having an exposure to high yield debt is beneficial in most economic scenarios.