What to Do with Fixed Income

In this issue of Insights, Keith Patton, Managing Director, Global Head of Unconstrained Fixed Income, BMO Global Asset Management (EMEA), discusses why Canadian investors searching for a more effective fixed income strategy should consider a non-traditional multi-sector approach.

The bond market, at the best of times, can be difficult for investors to navigate. In the current economic environment there exist cautionary indicators, such as yield curve inversions or employment rates, which have foretold recessions in the past, but at present are not yet indicating anything that severe.

Uncertainties and complexities are the new reality, as fixed income investors wrestle with the end of an era of central bank intervention. Of course, every cloud has its silver lining. In this case, the unprecedented environment has fueled extraordinary innovation by fixed income fund providers to satisfy continued demand for effective solutions from concerned institutional and retail investors.

BMO Global Asset Management has been successful and proactive, pulling together global resources and thought leadership to drive innovation and create new solutions that satisfy traditional expectations of the fixed income sleeve in most portfolios. This includes BMO Core Plus Bond Fund, for those seeking modestly higher income and more growth potential with a bias towards Canadian interest rate exposure, BMO World Bond Fund for clients seeking diversification away from Canadian interest rates, BMO Global Multi-Sector Bond Fund, an income-oriented, mandate achieving well diversified credit exposure from within the main credit asset classes that can be considered a core component of a forward-looking bond portfolio, and BMO Global Absolute Return Bond Fund (GARB)*, to act as an asset allocation vehicle for clients looking to de-risk but still maintain a highly flexible strategy towards market allocations. These strategies offer our clients the ability to emphasise exposures to the different drivers of return (interest rates and credit) to meet their specific needs as economies move through the cycle.

True Diversification Requires Dexterity

For all our funds with a credit emphasis, the starting point, not surprisingly, is diversification. We take an unconstrained approach to our investment universe; however, unconstrained doesn’t mean risky and reckless but diversified and risk controlled. We achieve this diversification by investing across by investing across global marketplaces, whether it is euro, sterling, US and Canadian dollar denominated, and all the sectors within those geographies, and all credit ratings with a bias towards BBB/BB (crossover).

Generally, fixed income managers hoping to achieve a multi-sector approach will allocate to the major asset classes, investment grade, high yield, emerging debt, investment-grade securitised, and loans, and run them as a single-asset-class fund. At BMO, we exploit the integrated structure of our credit teams to seek out anomalies from within these asset classes, leaving aspects of these asset classes that do not meet our requirements. One such anomaly is in the crossover space where passive portfolio construction rules and investment restrictions create opportunities, as issuers move between investment-grade and high-yield rating categories forcing investors to buy or sell as the issuer moves between the investment-grade and high-yield indices.

An unconstrained approach also has distinct advantages, as we can adjust our exposure to different interest rate markets to benefit from or avoid the many different fiscal-monetary-policy, political, growth and inflation cycles across a variety of global markets.

Your clients might be surprised to know that there is very high correlation, and therefore little diversification, in owning both Canadian and global bond funds hedged to Canadian dollars – both of which are typically long duration with little credit exposure. A multi-sector or global absolute return strategy can change the profiles dramatically, making them a meaningful complement to a traditional Canadian or global bond fund.

Our Global Absolute return fund has the flexibility to take a short position to benefit from rising yields or rising credit spreads, providing real diversification benefits to a traditional index-based strategy.

Bottom-Up Focus on Issuers – Not Asset Classes

By not restricting our investment decisions to allocations between fixed income asset classes, we place greater emphasis on security selection. This “bottom-up” approach to achieving a desired amount of credit risk avoids some of the less attractive characteristics that are often present during the cycle. As an example, the high proportion of low-rated CCC securities in the high-yield index are less attractive towards the end of an expansionary cycle, as these securities will become distressed and default as the economic environment deteriorates. Similarly, within investment-grade markets, the most credit-worthy bonds – AAA and AA-rated securities – offer limited credit premium. As such, our portfolios tend to take a focused approach around BBB within investment-grade and higher-quality BB securities from the high-yield asset class.

In addition, this security selection approach seeks to ensure that a higher proportion of our portfolios are allocated towards those bonds that we consider to offer attractive risk/reward relative to the market. The alternative of allocating to asset classes usually means accepting a high number of very small holdings, many of which do no more than help “fill a bucket.”

Our multi-sector approach provides value-add to your fixed income investments by embedding yield from a global universe of corporate securities, adding diversification, and setting an appropriate risk management strategy that works with the overall portfolio though a combination of “bottom-up” security selection and top-down allocation to the core drivers of fixed income portfolios, interest rate and credit exposure. The benefit to your clients is more sophisticated and deeper diversified exposure that provides true diversification, peace of mind, and the ability to optimize the return of their fixed income allocations over the long term.