Returning to quality in the bond universe

Hamish Lillico

Senior Associate, Intermediary Distribution, Greater Vancouver

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After a tumultuous first quarter in bond markets, many Advisors are wondering how best to re-orient their credit exposure in the face of heightened volatility. To help navigate recent trends and provide valuable guidance for the days ahead, veteran bond expert Hamish Lillico, Senior Associate, Intermediary Distribution, BMO Global Asset Management offers crucial insights and timely trade ideas that you can take straight to client conversations.   

Mission-drift in bond allocation

During the past 10 years, investors have benefitted from a consistent bull market that’s led to an unsettling shift in how bonds are used within the portfolio. Previously, credit was meant to protect your clients’ money from macro related risks, while equities were used to provide a growth component. It was the counterweight piece that brought balance from a risk-return perspective – yet in recent years there has been a slow drift from quality to high-yield bonds as managers reach for greater returns.

When benchmark interest rates were closer to their historical averages, a collection of quality bonds could earn you approximately 6%. However, due to accommodative central banking in the aftermath of the 2008 financial crisis, expected returns on high-quality bonds dropped closer to 2%, making them a tough sell to clients. The result: Many portfolio managers tilted their fixed income exposure toward riskier portions of the credit market.

This trend was interrupted by the COVID-19 pandemic, which spiked economic uncertainty so drastically that credit spreads began to widen, liquidity started to evaporate and investors worried about the likelihood of seeing their coupon payments. It was a wake-up call to the downsides of chasing yield, and also to the original purpose of owning bonds. One of my colleagues put it best, saying, “Bonds are meant to deliver a return OF your capital, rather than a return ON your capital.

With 2008 still in the rear-view mirror, central bankers knew it was vital to put a floor under bond prices by entering the market as a “buyer of last resort.”

The straw that broke the camel’s back

When asset prices started to decline in late February, the initial impulse for many investors was to reallocate their fixed income exposure to Treasuries and other high-quality credit. The market understood that a prolonged shutdown of the economy would cause greater harm at the lower end of credit spectrum – yet no one foresaw the complete deterioration of liquidity that would follow.

As the situation grew worse, it became extremely difficult to find “bids” across the bond universe. Proprietary trading desks at major banks, which had taken bonds onto their books in 2008, were unable to inject liquidity because of new capital regulations to limit their capacity. At the same time, many balanced funds were forced to sell bonds and buy equities in order to match target weightings in their portfolios.

This combination of factors drove the U.S. Federal Reserve and the Bank of Canada to intervene early. With 2008 still in the rear-view mirror, central bankers knew it was vital to put a floor under bond prices by entering the market as a “buyer of last resort.” And since then, we’ve seen a stabilization across the credit space, given that investors now have a willing partner to trade with if liquidity dries up.

Going forward, I expect low interest rates will continue for the near- to mid-term to account for growing unemployment, reduced consumer demand and contractions in GDP. There is tremendous slack in both the U.S. and Canadian economies, meaning inflation should not be a major concern, and government assistance will be needed for quite some time to get corporate profitability back on its feet.

The benefits of uncorrelated returns

Although low-yielding assets can be psychologically difficult to own in good times, sooner or later there tends to be a flight to quality, which can result in short-term price gains. So in addition to the diversification advantages of better-quality bonds, you can sometimes pick up bonus returns as well. Case in point: If at the end of last year you had bought 10-year U.S. Treasuries at 1.9%, you would have made approximately 13% return by late April.  

More importantly, quality bonds deliver uncorrelated returns to hedge against a potential decline in equity prices. This layer of protection can help insulate your clients’ overall yield from unforeseen shocks – such as a global pandemic – ensuring every $1 invested is returned intact, with the added benefit of coupon payments from companies with strong balance sheets.  

Growth of $10,000: May 15, 2018 to April 22, 2020

returning-to-quality-in-the-bond-universe-growth-of-10k-chart-image

Currency is displayed in Canadian dollars. Returns greater than one year have been annualized. The chart illustrates the impact to an initial investment of $10,000 dollars from May 15, 2018 to April 22,2020 in the BMO Core Bond Fund Series F (return: $11,311.40), the BMO S&P 500 Index ETF (Ticker: ZSP; return: $11,722.60) and the BMO S&P/TSX Capped Composite Index ETF (Ticker: ZCN; return: $9,461.00). It is not intended to reflect future returns on investments in the BMO Core Bond Fund Series F, the BMO S&P 500 Index ETF (Ticker: ZSP) and the BMO S&P/TSX Capped Composite Index ETF (Ticker: ZCN).

Performance is historical and does not guarantee future results.

Moving up the quality ladder

Given that market uncertainty could persist until a vaccine is developed, investors should stick with quality on the fixed income side of the portfolio. The BMO Core Bond Fund is an easy way to gain exposure to high-quality corporate, government and provincial bonds while keeping your product shelf as streamlined as possible. And unlike some broad-based funds that drifted into the lower credit space in search of yield, it has only 2% of the portfolio allocated to high yield, with a heavy focus on solid, secure Canadian bonds.

Investment mix (March 31, 2020)

  • Corporate Notes/Bonds: 58.6%
  • Provincial/Municipal Bonds: 24.9%
  • Govt. Agency Notes/Bonds: 16.4%

Source: BMO Global Asset Management. Percentages are based on the fixed income portion of the BMO Core Bond Fund portfolio.

Meanwhile, for clients seeking a more tactical approach, the BMO Core Plus Bond Fund can go to a higher weighting of high-yield debt when needed, allowing the manager to move in and out of timely positions according to the investment climate. It comes down to your view of the market, and whether you want a manager with the flexibility to chase more competitive yields.

You may even decide to access an independent high-yield exposure to complement your core bond allocation, in which case we have the BMO Global Multi-Sector Bond Fund, a more ambitious fund that also owns a lot of good credit. Although it is best used as a satellite on the fixed income side of your portfolio, it holds a healthy portion of investment grade bonds in order to compete in the high-yield space without taking on quite as much risk.

Finding the risk-return sweet spot

When discussing the trade-off between yield and safety, clients may ask why not simply use a Guaranteed Investment Certificate (GIC) to get a reliable return with minor accrued interest. I would remind them that GICs do not provide the possibility of capital appreciation that high-quality bonds offer during periods when interest rates are being cut. Moreover, the money put into a GIC is only guaranteed if you run it through to maturity; any attempt to cash out earlier would lead to some sort of penalty that could result in a capital loss.

Ultimately, the rationale for quality bonds is they protect capital AND generate uncorrelated returns in the portfolio. If you can provide clients with the right education around investor psychology and the value of a highly disciplined investment strategy, you can ensure the fixed income side of your portfolio delivers through the tough times, when you need it the most.

 

In this heightened period of uncertainty, we will continue to provide you with timely resources and new ideas to enrich your practice. For more information, contact your Regional Sales Representative at BMO Global Asset Management, and access the resources below:

Disclosures

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms.

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under license.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Commissions, trailing commissions (if applicable), management fees and expenses all may be associated with mutual fund investments. Please read the fund facts or prospectus of the relevant mutual fund before investing. The indicated rates of return are the historical annual compounded total returns for the period indicated including changes in unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Distributions are not guaranteed and are subject to change and/or elimination.

For a summary of the risks of an investment in BMO Mutual Funds, please see the specific risks set out in the prospectus. 

BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from Bank of Montreal.

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