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Canadians’ credit conundrum

Fixed Income Investment Directors Amar Reganti and Anand Dharan make the case for Canadian investors to broaden the fixed income “toolkit,” including a more diversified approach to credit investing.

The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

The FTSE Canada Bond Index is often the “go-to” fixed income universe for Canadian investors seeking high-quality, liquid fixed income exposure. Historically, this broad index has provided several critical benefits for fixed income investors: portfolio liquidity, risk diversification, total return, and steady income. However, as discussed in A COVID-era guide to fixed income, we believe investors can no longer rely solely on traditional, high-quality bond indexes to meet all of their fixed income objectives. Particularly in today’s ultralow-interest-rate environment, we believe Canadian clients should begin to think differently about fixed income and to structure their portfolios accordingly (Figure 1).

FIGURE 1

Two ways of constructing a fixed income allocation

The challenges

With regard to the current interest-rate backdrop, we do not anticipate so-called “mean reversion” in rates anytime soon. While there may be some cyclical upward moves in rates going forward (e.g., during periods of economic recovery from crises, such as COVID-19), we believe the recent downward trend in global developed-market rates is long-term and more structural in nature.

While it is challenging for all clients to navigate an era of stubbornly low rates, Canadian fixed income investors face additional obstacles – for example, not having a sufficiently diverse domestic universe of corporate credit, together with a large index concentration in provincial credits and substantially smaller high-yield bond and bank-loan markets.

As shown in Figure 2, the corporate-credit portion of the FTSE Canada Bond Index is heavy on the financials sector, without much in the way of countercyclical credit allocations to areas like communications, technology, and consumer staples.

FIGURE 2

FTSE Canada vs "Blended Credit" allocation: Corporate sector breakdowns

Our proposal

To overcome these challenges, Canadian fixed income investors might consider utilizing a broadly diversified credit approach in order to expand the universe of assets available for their portfolios’ credit allocation. Using a framework similar to that described above (Figure 1), we believe an income- and total-return-oriented credit strategy can help Canadian clients pursue multiple key goals at the same time:

  • Further diversify the credit exposure of the FTSE Canada Bond Index by corporate-credit sector.

  • Incorporate higher-yielding components such as bank loans, high-yield bonds, and securitized credit.

  • Adapt to the current “lower-for-longer” interest-rate setting that the COVID crisis has helped to usher in.

  • Increase, perhaps meaningfully, the portfolio’s expected total-return potential and its income-generating capacity.

Implementation considerations

Sizing: Our portfolio optimizer tool indicates that a hypothetical index blend consisting of an 80% allocation to the FTSE Canada Bond Index and the remaining 20% to a “Blended Credit” allocation may deliver a superior overall risk-return profile for Canadian fixed income investors (Figure 3).

FIGURE 3

Blended Credit/FTSE Canada universe efficient frontlier

Duration: Since a 20% “Blended Credit” allocation/80% FTSE Canada Bond Index approach will likely have a shorter average duration than the FTSE Canada alone, such a blended portfolio may require adding a “top-up” of rate duration from other sources in order to achieve the client’s average-duration target.

Currency: While most Canadian clients might be inclined to automatically hedge the US dollar (USD) risk of a blended credit approach, it may be better to not do so. The reason is straightforward: The USD has often rallied relative to its Canadian counterpart during extreme risk-off events, as happened in March 2020, for example (Figure 4).

The currency factor

The relationship between USD-CAD and sovereign/corporate bond price movements tends to be inverse, meaning that while the currency exposure can mitigate negative returns when sovereign/credit spreads widen, this can often dominate the return experience. This can happen while all credit asset classes are selling off, causing sharp (though generally short-term) pain for clients and their stakeholders. It is worth further exploration for any broader credit allocation, as our colleagues Simon Henry and Adam Berger have discussed in previous insights.

FIGURE 4

US dollar vs Canadian dollar

Go a step further

Finally, along with diversifying their portfolios’ credit exposure, we would encourage Canadian investors to go another step further. Specifically, these clients might think about building a broader, multi-pronged fixed income strategy for optimal diversification, greater total-return potential, and other portfolio benefits. Depending on the client’s individual risk tolerance and other needs, this type of strategy can focus primarily on credit assets or leverage the full universe available to a fixed income manager, including (but not limited to) credit, global rates, and currencies.

In any case, we believe enlarging the fixed income “toolkit,” so to speak, can help Canadian clients succeed in an altered landscape where yesterday’s solutions may not be equal to today’s challenges.

Please contact your Canada relationship team to further discuss these topics and learn more about how we can help.

Please refer to this important disclosure for more information.

Additional disclosures
Performance is based on historical index returns and does not reflect the results of any actual Wellington Management portfolio or account. Index blends are considered hypothetical because there was no live portfolio managed in this style. Performance is developed with the benefit of hindsight (i.e., actual knowledge of market conditions, results of similar strategies) and thus has many inherent limitations. This is a simplified analysis using indices only and the actual performance of a credit portfolio may differ. Index returns do not reflect the deduction of management fees or expenses, which would lower the results shown.

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