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Finding the “Sweet Spot” in Fixed Income

Government bonds or corporate credit? Domestic or global? In this PM Corner, global bond specialist Keith Patton reveals where fixed income investors should go for improved returns.

September 2021

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Keith Patton

Global Head of Unconstrained Fixed Income

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Key Takeaways

  • Global Investment Grade bond market offers a much wider opportunity set (CA$85 trillion from 3,191 issuers vs. Canada’s $2.4 trillion from 233, as of August 20211)
  • Liquid derivatives and exchange-traded futures provide cost-efficient risk management
  • Higher-return anomalies can be found between BBB and BB

Let’s get the most overused question out of the way: what market trends are keeping you up at night? What are your team’s three biggest concerns?

KP Well, our first concern is the rise in inflation and the impact it could have on financial markets if the increase is not as “transitory” as many officials are suggesting. Second is the eventual reduction of quantitative easing by the U.S. Federal Reserve (the Fed), which is likely to coincide with an ongoing increase in fiscal policy (bond supply). We’ve already seen the Bank of Canada and the Bank of England start this process. Finally, there’s no doubt that market valuations are stretched. Equities, in particular, could be vulnerable to a correction given that geopolitical risks are rising, monetary policy is becoming less supportive and concerns of the Delta variant forces countries back into lockdown. Our first two concerns could potentially result in higher yields, however, the third may lead bonds in the opposite direction, so the key for us is to maintain active strategies which can respond to these conflicting possibilities.

On the equity side, most Institutional and Advisor-based portfolios are dominated by mega cap stocks. How do bonds ensure adequate diversification within the portfolio?

KP For Canadian domestic investors, diversification is complicated by the fact that mega cap stocks in the broad equity index are also large issuers in the domestic bond index. So ultimately, you have to ask yourself, “What are the bonds doing in your portfolio?” If they were included to diversify equity risk, then stay committed to government bonds where the correlation is low and employ strategies like our BMO Core Plus Bond Fund and BMO World Bond Fund, which are suitable for this purpose given their longer duration characteristics. On the other hand, if clients need bonds to deliver income and growth rather than a counterbalance to equities, consider using non-government debt in their portfolios. This is where our BMO Global Multi-Sector Bond Fund really thrives, as a benchmark-agnostic strategy that seeks to harvest the credit premium of global bond markets with substantially lower duration than the Canadian core market. Finally, there’s the BMO Global Absolute Return Bond Fund, an alternative for investors that want to de-risk or replace their long duration bonds with a more active strategy that can work hard to produce returns in the current low yield environment.

You mentioned the Global opportunity set vs the Canadian domestic market. How do they compare in terms of size and number of issuers?

KP The Canadian Bond market measures to approximately $2.4 trillion – with 233 non-government issuers, as of August 2021.1This number is quite impressive in a vacuum; however, the Global Investment Grade market stands at approximately C$85 trillion with 3,191 non-government issuers as of the same date.1 When we add High Yield and Emerging Markets debt, the universe grows by another $5 trillion and 1,800 issuers. So, the ability to diversify and find opportunities from a global perspective is immense relative to that of a Canadian domestic bond investor’s perspective. Add to this, rates continue to be low despite the Fed signalling some rises to come next year, meaning that the ability to go overseas for returns remains valuable to investors.

We’ve all seen headlines about the potential for rising rates and inflation. What tools does your team utilize to manage these two risks?

KP Across all our portfolios, we have the opportunity to use liquid derivatives to help manage the risks in a cost-efficient way. And within our credit-based strategies, we use exchange-traded futures to reduce the interest rate risk if we expect yields to rise, which are comparatively low-cost and also very liquid compared to selling a number of corporate bonds with wide bid/offer spreads. Alternatively, when it comes to reducing credit exposure, we have the choice of selling cash bonds or using index-based credit derivatives. The latter allows us to quickly and efficiently reduce the market exposure, giving us more time to seek out a good price for the cash bonds.

The BMO Global Absolute Return Bond fund makes extensive use of derivatives for hedging, and also for providing additional return by creating long/short strategies across global rates and currency markets. Currently, investors are concerned about the potential for higher yields from inflation being much stickier than the market has currently priced, as well as increased bond supply and reduced buying from central banks. We have taken off some duration across our strategies, moving the BMO Global Multi-Sector Bond Fund down to 3 years, BMO World Bond Fund to 6.2 and BMO Absolute Return Bond Fund has gone negative duration benefit from rising yields.

Why does the BMO Global Multi-Sector Bond Fund make sense for investors who already have a core bond strategy? What makes you unique?

KP Many Canadian investors own a core fund that offers an opportunity set with diversified credit and less duration. We are not suggesting clients sell out of these, but they should consider allocating more money to this space in total and diversifying their exposure by the manager’s style. After all, different PMs seek to gain diversification in different places. We believe the BMO Global Multi-Sector Bond Fund is not only complementary but offers a significant difference in market specialisation compared to Canada’s biggest bond funds.

Our focus is on global credit, and identifying anomalies within the BBB/BB area. This corner of the universe is rich with bonds that are being downgraded and upgraded between Investment Grade and High Yield. By contrast, the two biggest bond funds in Canada have a much greater focus on US dollar denominated assets, with a particular emphasis on U.S. securitized assets. We, on the other hand, keep our US assets under 35% with no mortgages and no US dollar risk – all foreign bonds are hedged back to the Canadian dollar.

What makes us unique is that we don’t allocate to asset classes with the intent of running the strategy as a group of “index +” portfolios. We actually dive into each space and target the sweet spot between BBB and BB rated assets, seeking out rare opportunities to minimize the inherent tail risks and build the portfolio one security at a time.

1 Bloomberg.

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For a summary of the risks of an investment in the BMO Mutual Funds, please see the specific risks set out in the prospectus. ETF Series of the BMO Mutual Funds trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

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