As interest rates rise, investors should rethink their fixed income approach
Last year was difficult for the fixed income portion of many pension plans’ portfolios. The DEX Universe Bond Index (DEX), which captures the broad Canadian fixed income market, posted a return of -1.2% for the 2013 calendar year—its first negative annual return in 12 years and only its third in the past 34 years. The 2013 performance wasn’t a blip; it’s likely to become a new reality.
Bond investors make money by taking on exposure to a combination of credit risk (whether or not you’re going to get paid) and interest rate risk (what your money will be worth when and if you do get paid back). The key to navigating higher interest rates is to isolate one risk from the other and build exposure to the risk you want versus the risk you want to avoid.
Good Risk, Bad Risk
Today, the risk to avoid is interest rate risk, which no longer offers enough reward to compensate for potential losses due to rising interest rates. The current running yield of the DEX is approximately 2.5%, representing a historically low return that leaves little protection from rising rates. In fact, you can measure the exact amount of protection that the DEX currently offers by calculating its break-even rate, which is now 42 basis points (bps).
If medium-term interest rates rise more than 42 bps in the next year, the DEX will produce a negative return. That’s a very thin protection margin. Given that rates will likely move higher, exposure to the interest rate risk factor becomes wholly undesirable.
The credit risk factor is much more appealing in today’s environment. Credit risk is measured by credit spreads: the difference in yields between corporate bonds and benchmark government bonds. (Benchmark bonds offer a standard against which the performance of other bonds can be assessed.) The higher the spread, the higher the compensation for future default.
Using the worst-case scenarios from the past 50 years and making a conservative assumption in terms of losses due to forced selling upon downgrade, the amount of excess spread required per year to compensate for taking on investment-grade corporate credit risk is about 20 bps. However, pension investors can build a diversified portfolio of Canadian investment-grade corporate bonds today and achieve a weighted-average excess spread of approximately 120 bps, which implies an excess credit premium in the market of about 100 bps. This excess credit risk premium makes the credit risk factor attractive, even in today’s environment.
Separation Anxiety
So how can you isolate the interest rate risk factor from the credit risk factor? Our strategy is to pair each long (purchased) corporate bond position with a short (sold) government bond position of the same duration. By matching the durations of the long and short positions, investors can effectively get immunity and remove the interest rate risk associated with the corporate bonds, leaving the portfolio solely exposed to credit risk. Applying modest leverage can also increase the number of units of credit risk, thereby enhancing returns.
The past 30-plus years of declining interest rates produced a generational fixed income bull market. With that tailwind now over, investors need to reassess the role of fixed income in their portfolios and the types of strategies they use. It’s often said that “past performance is not indicative of future results”—and nowhere is this truer than in today’s fixed income market.
George Young is vice-president and portfolio manager with Gluskin Sheff + Associates Inc.
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