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Investor insights

March 06, 2020

A do-it-yourself Canadian corporate bond portfolio

Read Canadian Investment Review’s summary of SLC Management’s Investment Innovation Conference presentation on investment grade corporate bonds. The article looks at challenges in the Canadian corporate bond market and  opportunities outside Canada as investors build their own Canadian corporate bond portfolio.

Corporate bonds are an important asset class for pension plans, but there are shortcomings in the Canadian market, particularly when it comes to long-duration corporate bonds, said William Honce, head of business development for Quebec and Eastern Canada at SLC Management.

According to BlackRock’s 2019 Global Institutional Survey, with data as of December 2018, 42 per cent of global pension plans intend to increase their allocation to long-duration fixed income over the next year.

In addition, there has been a steady increase in corporate bond usage among pension plans. Over the past five years alone, the average allocation to fixed income among the top 200 defined benefit pension plans around the world has risen by more than 10 per cent, according to a Pensions & Investments top 1000 largest plan sponsor survey, with data as of September 30, 2018.

Yet, there are going to be numerous challenges to executing these strategies in a Canadian market, Honce noted. “The first challenge is a simple one: it’s a supply and demand challenge. The Canadian market is a relatively small market.”

Another challenge is that the Canadian market is extremely concentrated, he added, and there is also a lack of diversification that is quite prominent in the long-duration segment.

For example, in Canada, there is essentially no technology exposure in the long-end, said Randall Malcolm, a senior managing director and portfolio manager for Canadian public fixed income at SLC Management.

These issues, coupled with the fact that investors around the world are looking to increase allocation to corporate bonds and long-term bonds, might make it difficult for Canadian investors to only invest in Canada, Honce said. 

A possible solution is to look outside of Canada. “It’s basically a pretty simple idea,” Honce said. “It’s the ability to tactically go and get some carefully selected foreign credit and apply hedging strategies to them to effectively transform them back into a Canadian equivalent of themselves.”

The U.S. market is a lot deeper than the Canadian market. “We look at the U.S. population, [and] it’s about nine times the size of Canada,” Malcolm said. “You look at the [gross domestic product], it’s about 12 times the size. If you look at their long corporate market, it’s about 18 times the size of Canada. So, relative to the economy in the U.S., the long corporate bond market is significantly larger and that winds up giving you a significant amount of choice.”

There are many ways to convert U.S. corporate bonds back to Canadian dollars, he noted. “If we’re hedging back something short, something that might be pre-payable, we might just use a currency forward. And there are investors out there that will use currency forwards out to 30 years. [A] currency forward is great to cover your currency exposure, but what it really misses is getting that yield curve back into Canadian terms. So we tend to use a cash-flow swap, which is more of a total return swap.”

This allows the investor to take a view on both the spread and the swap, Malcolm noted. “The benefit here is not really to take the U.S. index and throw a swap on. It’s to take the best of the best out of the index, out of the U.S., and swap that back.”

Overall, it’s a tough market to invest in, and pension plans can use this kind of strategy to maintain most of their liability hedging properties but at the same time improve diversification, and potentially find “nuggets of enhanced performance,” Honce said.

This article first appeared in Canadian Investment Review.

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