Corporate bonds are in demand from institutional investors, and for good reason. They can increase portfolio returns while maintaining the attractive characteristics of fixed income. For investors willing to expand their horizons, thinking outside Canada can provide access to even greater opportunities.
Current market circumstances create a particularly compelling case to invest in corporate bonds. While the COVID-19 crisis has caused significant stress on financial markets, it has also created opportunity.
High-quality companies around the globe have been issuing debt at spread levels not seen in many years. At the same time, the high volume of government bond issuance is pushing index yields lower. An actively managed corporate bond portfolio can take advantage of these market dislocations and provide the potential for higher yield and increased diversification.
Why corporate bonds now?
The need for yield
Global economic forecasts point to significantly slowed 2020 GDP growth, followed by some improvement in 2021. This has led to a sharp decline in government bond rates. To combat this, there has been unprecedented global fiscal stimulus – over 8% of GDP in Canada and 10% of GDP in the U.S. – resulting in a sharp increase in government bond issuance.
For institutional investors, these developments lead to two important considerations. First, the weight of the government sector in market benchmarks is going to increase over the next couple of years. At the same time, monetary policy to support the economy will keep government bond yields low, dragging down the average yield on those benchmarks. Investors may find that funds benchmarked against broad market indices are no longer meeting their objectives.
The chart below shows the composition of long corporate bond yields over the past 17 years. Credit spread is now a much more significant driver of yield. This means that government bond investors may be missing out on a source of additional return. A standalone investment-grade corporate bond portfolio can be an attractive option to maintain typical pre-crisis yields.
The fixed income index is changing
Source: Bloomberg
Market volatility presents opportunities
Corporate bond market inefficiencies are amplified during periods of increased market volatility. Active managers are able to exploit inconsistent pricing between individual issuers, industry sectors or even geographies, to construct attractive portfolios.
During the COVID-19 crisis, credit spread volatility has increased as investors worried about the potential impact on issuers. This led many high-quality companies to issue bonds at spreads over benchmark Canada bonds not seen in recent history. Examples include Enbridge, denominated in Canadian dollars (CAD) at a 235 basis point spread, and Narragansett Electric, denominated in U.S. dollars (USD) at 292 basis point spread (including the impact of hedging cash flows into CAD). Since issue, spreads on these two new issues have tightened significantly, resulting in attractive returns for investors. The current market could present other attractive opportunities in the coming months.
Is the Canadian market deep enough to meet investor demand?
As demand for high quality long corporate bonds increases, the Canadian market may not be able to keep up.
There is limited supply in Canada, with long-term corporate bonds representing only $155 billion (or 8%) of the $1.9 trillion bond market in Canada (FTSE Canada data, June 2020). Active trading is more challenging, especially during times of market volatility. There are fewer names to choose from and long corporate bond investors, like pension plans, tend to hold to maturity or sell only at a high premium.
There is also sector concentration in Canada. Utilities, transportation and energy alone account for about 71% of the long-term Canadian corporate bond market. The top ten issuers make up 38% of long-term corporate issuance (FTSE Canada data, June 2020).
Our solution: Think outside Canada
Canadian investors can work with their managers to build a diversified “DIY” Canadian corporate bond portfolio by investing in foreign corporate bonds and hedging cash flows (interest and principal) back into CAD.
By accessing other fixed income markets, the U.S. in particular, investors can address the challenges in the Canadian market and target enhanced yield and reduced portfolio risk through diversification.
Target enhanced yield
Looking across the border reveals interesting opportunities for Canadian investors to increase expected return. For example, investing in the U.S. issuance of a Canadian company and hedging cash flows into CAD is an active management tactic that can take advantage of attractive pricing differences.
The graph below shows an example with two Trans Canada Pipeline bonds, one denominated in CAD and the other denominated in USD. Even though both bonds have similar characteristics – similar term, similar coupon and the same company credit – the USD bond with cash flows hedged back into CAD provides a 10 to 30 basis points spread advantage over the CAD bond.
A skilled active manager with scope to invest in both geographies can add additional value by carefully monitoring the spread volatility between the two markets. A manager can then leverage this information to opportunistically sell out of the U.S. issue at higher prices and buy into the Canadian issue at lower prices, or vice versa.
Trans Canada Pipelines bond opportunity in the U.S.
Source: Bloomberg
Target reduced portfolio risk through diversification
The U.S. corporate bond market complements the Canadian bond market through its size, breadth of sectors and diversified issuers. Investing in the U.S. corporate bond market can help reduce concentration risk for Canadian investors.
The U.S. corporate bond market is more diversified
Source: Bloomberg and FTSE Canada (June 2020)
A recent example is Omnicom, an advertising company that issued a 10 year USD bond in late March. With no similar issuer in Canada, this bond can add diversification for Canadian investors, as well as enhanced yields. The bond was issued at a spread of 372 basis points over Canada government bonds (including the impact of hedging cash flows into CAD), significantly higher than Canadian issues in the communications sector.
Creating DIY Canadian corporate bonds from foreign bonds provides the benefits of accessing the U.S. corporate bond market, while maintaining the domestic interest rate and hedging characteristics of a Canadian bond portfolio. The foreign bonds will track Canadian bond indices and liabilities while still targeting higher returns and greater diversification. The hedging strategy may also further enhance yields.
What can investors do now?
Low interest rates and wider credit spreads have created a compelling case to invest in high quality corporate bonds. Demand is likely to increase as investors consider the potential for attractive risk-adjusted returns and the benefits of building a DIY Canadian corporate bond portfolio.
We believe asset allocations must ultimately help investors achieve their long-term objectives. When evaluating how corporate bonds might fit into your portfolio, ask yourself these 3 questions:
- Is my fixed income fund (and its benchmark) still meeting my objectives?
- Am I taking advantage of market opportunities, within Canada and outside of Canada?
- Could I be getting more fixed income yield for my risk budget?
Why corporate bonds?
We believe there are 3 key reasons to invest in corporate bonds – yield, risk management and opportunities to add value.
Potential for additional yield
The additional yield (or credit spread) on corporate bonds has historically more than compensated for the downgrade and default risk that the investor bears. Over the past 14 years, the corporate bond index outperformed the overall index by 1.2% per annum, when compared on a same duration basis. This outperformance reflects the impact of downgrades and defaults.
The corporate bond index has outperformed
Source: FTSE Canada
Risk management
Corporate bonds are a key risk management tool for liability-aware investors, providing similar interest rate hedging characteristics as federal and provincial bonds. They also provide additional credit exposure for liabilities that are discounted with reference to corporate credit spreads, such as accounting and solvency liabilities.
Opportunities to add value
Corporate bonds are traded through a negotiated process, where relationships and market knowledge can provide an advantage. Additionally, not all sectors perform equally during each stage of the credit cycle. During times of crisis, defensive sectors such as utilities and infrastructure tend to outperform. Active managers can use their credit research and expertise to select attractive issuers and sectors throughout the credit cycle. These dynamics provide opportunities to outperform passive index funds.
This document is intended for Canadian institutional investors only. It is not for retail use or distribution to individual investors. The information in this document is not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information contained in this document.
SLC Management is the brand name for the institutional asset management business of Sun Life Financial Inc. (“Sun Life”) under which Sun Life Capital Management (U.S.) LLC in the United States, and Sun Life Capital Management (Canada) Inc. in Canada operate. Sun Life Capital Management (Canada) Inc. is a Canadian registered portfolio manager, investment fund manager, exempt market dealer and in Ontario, a commodity trading manager. Sun Life Capital Management (U.S.) LLC is registered with the U.S. Securities and Exchange Commission as an investment adviser and is also a Commodity Trading Advisor and Commodity Pool Operator registered with the Commodity Futures Trading Commission under the Commodity Exchange Act and Members of the National Futures Association.
Unless otherwise stated, all figures and estimates provided have been sourced internally and are as of June 26, 2020. Unless otherwise noted, all references to “$” are in CAD dollars.
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