Despite the recent sell-off in both equity and fixed income markets, the global economy remains robust and we believe it is likely to surprise to the upside as the year progresses. However, this strong economic growth will also continue to put upward pressure on interest rates and government bond yields, although we expect further rises to be more contained and gradual than February’s spike.
As a result, in the bond markets, the likely challenge over the next few years is likely to be to preserve, rather than seek higher returns on capital. This is particularly important given that global central banks are currently withdrawing monetary easing, a policy which has supported all asset prices over the last decade. We believe that active management will be crucial in this kind of market environment, particularly in the short-dated corporate credit space.
Despite the likelihood that government bond yields are likely to rise further this year, the global macroeconomic fundamentals continue to support corporate spreads for now. However, sector and stock selection is key in protecting capital as certain areas of the market are far more vulnerable. For example, looking at short duration bonds in particular, sectors such as sovereigns & sub-sovereigns have a current spread of just 30 basis points. With a supportive economic backdrop, spread widening is much less of a risk to capital values than yields rising in our view. To highlight the sector differentials, the below graph demonstrates the spread levels across the market, as well as the active positions of the LF Canlife Short Duration Corporate Bond Fund.
Source: Canada Life Investments and Markit, March 2018. Relative positioning = the Fund’s % exposure compared to that of the iBoxx 1-5 Year Index for each sector.
Why is this important?
Consider the decision to invest in a bond with a three year duration, approximately that of the benchmark. The options available are an insurance bond with a spread of 135 basis points and yield of 2.0%, or a supranational bond with a spread of 25 basis points and yield of 0.9%. If held to maturity, assuming no defaults, the return on the insurance bond would be 6% versus 2.7% on the supranational bond. If we just look over a one year time horizon, this higher yield also makes it much more able to withstand increasing interest rates, as shown in the table below.
Source: Canada Life Investments and Markit, March 2018. For illustrative purposes only. Not to be taken as a forecast for performance.
You should not 'buy the benchmark'
This is why we believe it is important that investors do not simply maintain an idle, passive exposure to the benchmark. If you were to buy an iBoxx Sterling Non-Gilt 1-5 Year Index tracker, you would be buying significant exposure to sectors that are very vulnerable to rising interest rates and bond yields. An additional way in which active managers are able to preserve capital is the ability to avoid defaults through good credit selection. While the huge tide of easy money lifted all ships in the credit market; as the tide starts to go out then good credit selection becomes important once more.
Where are we finding opportunities?
At Canada Life Investments, we have always managed money with a focus on strong credits and capital preservation and our internal credit research process is central to this belief. Our well-resourced and experienced in-house team cover more than 400 issuers and adopt a bottom-up approach to stock selection, with wider macroeconomic trends taken into account when we construct the portfolio.
Currently, we are overweight financials in general given the higher spreads on offer and the insurance sub-sector in particular. It is often viewed as a more specialist part of the market, with complicated financial reporting, however we feel that the additional work is justified with attractive yields on offer relative to equivalently rated bonds in other sectors. Many of these companies are globally diverse businesses with very strong balance sheets and their financial metrics should improve as yields rise across the globe.
Past performance is not a guide to future performance. The value of investments may fall as well as rise and investors may not get back the amount invested.
The information contained in this document is provided for use by investment professionals and is not for onward distribution to, or to be relied upon by, retail investors. No guarantee, warranty or representation (express or implied) is given as to the document’s accuracy or completeness. The views expressed in this document are those of the fund manager at the time of publication and should not be taken as advice, a forecast or a recommendation to buy or sell securities. These views are subject to change at any time without notice. This document is issued for information only by Canada Life Investments. This document does not constitute a direct offer to anyone, or a solicitation by anyone, to subscribe for shares or buy units in fund(s). Subscription for shares and buying units in the fund(s) must only be made on the basis of the latest Prospectus and the Key Investor Information Document (KIID) available at www.canadalifeinvestments.com.
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