Investors have become accustomed to a landscape where interest rate risk wasn’t much of a threat to their fixed income investments. But with the broad bond market offering a combination of low compensation and high risk, investors must be increasingly mindful of the level of interest rate risk inherent in their existing fixed income portfolios.
Twenty years ago, an investor might have seen an average five per cent yield with the duration required to earn that five per cent coupon comparable to today.
“Interest rates would have had to move significantly before they started moving the price of your bond portfolio enough to eat through your entire coupon,” says Ian Marthinsen, portfolio strategist, Lysander Funds Ltd. , an experienced Canadian employee-owned investment fund manager. “We’ve never been in a period where broad fixed income has offered such low compensation for taking on such high levels of interest risk, so a tiny increase in interest rates can easily wipe out any coupon you’re expecting.”
With interest rates under pressure from both higher post-pandemic economic growth and higher inflation, the potential for that risk is growing. Under those pressures, how can investors maintain the same level of diversification that exposure to the fixed-income asset class has always provided? It’s a question Lysander has worked to address with its approach to Lysander-Canso fixed income funds, managed by its sub-advisor Canso Investment Counsel .
“Our contention is that you still need that diversification fixed income provides,” says Marthinsen. “But you require active management to increase your yield at a given level of risk, at the same time as you lower your exposure to that risk. Canso has an excellent track record of achieving that through rigorous analysis and individual credit selection.”
The selection process always begins with asking the fundamental question: “are we getting properly compensated for assuming this risk?” That expertise involves more than selecting the appropriate credit, but also in shifting credit exposure within its portfolios.
“When Canso doesn’t see value in the marketplace in terms of credit spread in fixed-income issues in the high-yield space, they’ll go to high quality and protect the downside,” says Marthinsen.
While Canso’s proprietary ratings are an important part of that selection process, Marthinsen notes that Canso goes one step further, investigating the likelihood of recovering its investment under a default scenario. In a world of “covenant-light” bond issues, Canso looks for stronger covenants that place it at the top of the capital structure and first at the table to recover its capital in the case of default.
But it’s not just selecting the highest yielding credits. It’s also knowing when the market is overvalued and there’s not enough value in the marketplace to take that risk — and then taking that risk off the table.
Sometimes that decision can mean underperforming acceptably in the short term in search of long-term out-performance. Canso did exactly that following a credit event in 2015, as it focused on a greater level of high-yield exposure. As its positions matured and spreads continued to tighten, Canso continued to high-grade its portfolio, concentrating on investment-grade floaters which offered safety from both a credit and interest rate perspective.
During this period, Canso underperformed marginally against the broader bond market using the FTSE Canada All Corporate Bond Index as a benchmark.
“But we were keeping our powder dry, knowing that when something happened in the credit markets, we could deploy capital quickly and effectively to buy high-yielding securities to provide lots of alpha,” says Marthinsen. “That’s essentially what happened in March 2020 at the start of the Great Lockdown. It wasn’t that Canso was anticipating a pandemic. It was a Black Swan event that caused the brakes to blow out of the market, and Canso was positioned correctly to capture that opportunity.”
The old 60/40 rule recommends that investors place 60 per cent of their money in stocks and 40 per cent in bonds. That’s still a valid investment theory, says Marthinsen
“But all bond investment opportunities are not created equal. In today’s economic environment, active management can preserve fixed income yield while providing protection against interest rate risk.”
For more information on Lysander Funds, visit: lysanderfunds.com
For more information on Canso Investment Counsel, visit: cansofunds.com
This story was created by Content Works , Postmedia’s commercial content division, on behalf of Lysander Funds Ltd., who is a member and content provider of this publication.