Approach to changing market environment – new strategies and old – will be crucial to fixed-income success
A portfolio manager has pinpointed four major themes to guide his firm through the bond market over the next five years.
Geoff Castle manages the Pender Corporate Bond Fund, which gained 1.5% in August and has returned 7.2% per annum net of all fees and costs over the past half-decade.
The next five years, however, presents changes in the market environment, which investors must adapt to, as well as enduring lessons portfolio managers will be wise to remember.
The first theme for PenderFund Capital’s team is to focus on real return considering how the financial environment is now governed by two important policies – unlimited market interventions by central banks to keep a lid on interest rates, and aggressive fiscal policy designed to promote economic stability.
Castle said: “Print money as they will, however, governments will find it much harder to create actual wealth, and inflation is a highly possible outcome. In this environment, we are increasingly drawn to a few categories of security that can deliver real returns after considering inflation.
“Such securities include convertible bonds linked to quality businesses, discounted bonds with strong valuation coverage, and a range of misunderstood or out of favour hybrid securities including preferred shares and closed-end funds. In all of these cases, strong excess returns appear possible.”
Fixed-income investors should also have a commitment to liquidity, the importance of which was reinforced by the drastic correction in March. Castle said his fund did face some redemption activity at the height of the crisis but stressed that the team’s discipline with respect to position size and risk bands allowed them to maintain an “opportunity-focused posture” throughout the meltdown.
“This focus on liquidity is part of our business-as-usual process,” he said. “Tested twice in the past five years, we continue to integrate liquidity planning in all portfolio decisions.”
The fund’s ability to be active and flexible will also be crucial to the next five years, he added, giving it an advantage over passive credit mandates. He explained: “Sometimes this can mean negotiating improvements in outcomes for securities we own, as recently achieved in the case of Just Energy. On other occasions it can include having the flexibility to walk a deeply discounted holding through a bankruptcy or re-organization in order to achieve gains on the other side, as we did recently in Aceto and are in the process of with Chesapeake Energy. In a low-coupon world, returns don’t come for free.”
The final theme is to remember that the portfolio manager’s job is also to preserve wealth and, therefore, understand the units of return per unit of risk. This involves continually assessing probability of default of the issues in which you are invested and considering loss (or gain) given default in situations with higher risk.
Castle said: “For example, one of the reasons we like so much the wide-spread resets of an issuer like Bell Canada is not that the 6% running yield is so high, but that in the context of such a low default probability, it is a relatively rare risk/reward trade-off. This theme, while not new for us, remains a key driver in our quest to deliver strong risk-adjusted returns.”
