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Developing a fixed-income strategy in a low-interest environment

As rates rise slowly, diversity and active management can help, Mackenzie expert says

Date: May 23, 2017

With interest rates finally starting to rise in the United States, fixed income investors need to hone their strategies, says head of Mackenzie Investments’ fixed income team.

Some fixed-income investors’ portfolios have wallowed in the past few years because they haven’t adjusted their strategies to deal with a long term era of low but potentially rising interest rates.

“They should be looking for product solutions that help diversify the portfolio and maybe have less traditional elements than they had in their investment history of 10, 20 or 30 years ago,” advises Steve Locke, Senior Vice President, Portfolio Manager, Head of Fixed Income Team at Mackenzie Investments. “Active management can [also] allow a bit more market reach [and] actively hedge certain types of risk.”

In March, the U.S. Federal Reserve raised its benchmark overnight rate by 25 basis points to a range of 0.75 to 1.00%, following similar increases in December 2015 and December 2016. The Federal Reserve predicted that if the economy remains healthy, it will raise rates two more times this year and three times in 2018.

“The fact that the Fed has started to raise rates doesn’t alleviate pressure on savers, and rising yields in 2016 hurt performance of traditional bond funds” notes Locke. “It is certainly a helpful step, but only to a small degree,” Mr. Locke explains. He says holders of Canadian fixed-income should note that the Bank of Canada has not raised rates and is not expected to do so this year.

Even with the U.S. Federal Reserve’s optimism, the outlook is, at best, for a slow progression of rate hikes. “And that’s all subject to economic growth maintaining its moderate pace and inflation not becoming an issue in the U.S. economy,” Mr. Locke says.

Steep hikes in interest rates are not on the horizon, as most developed economies also have “debt overhang” which means consumers and households, because of existing large debt, are unable to withstand sharp interest-rate increases.

“In 2017 it’s really more about diversity in your fixed-income holdings,” Mr. Locke says. “Traditionally, they might have thought about a bond fund -- something with a mixture of federal, provincial and high quality corporate debt -- as a sole fixed income strategy. That portfolio, although helpful in mitigating volatility in an overall balanced portfolio, doesn’t generate much income.”

Even if interest rates rise slightly this year and next, the increases will be relatively modest, Mr. Locke points out.

Investors looking for income should consider looking at non-traditional fixed income in this situation.

“Areas of the bond markets that we still find attractive today are investment grade corporate bonds, the tradable bank loan (also called floating rate loan) market, parts of the high-yield bond market, as well as global issuers in certain regions,” Mr. Locke says. “A diverse mixture of these assets is helpful in generating more yield in a lowyield environment and also mitigating the individual risks that may come from credit markets over the next few years or from the interest-rate cycle.”

“Floating rate loans are typically issued by non-investment grade companies. The floating rate loan market is mainly a U.S.-dollar-based market, approximately $900 billion in size. It’s large and robust for credit investors.

The yields in this market tend to be in the 4- to 7-per-cent range. It’s an area that investors should look at adding to their fixed income holdings. It does help to diversify,” Mr. Locke says.

While this is an attractive yield in today’s low-interest environment, investors must balance the additional yield against the credit risk. “Active management is important when looking at non-investment grade credit. Our team conducts rigorous fundamental credit research and assesses whether the yield offered represents good value for the credit risk taken. We try to avoid undesirable credit risk, and make sure we’re being compensated appropriately for the risks we are taking,” says Mr. Locke.

One thing fixed-income investors should learn is to tune out most of the day-to-day news about markets and the short-term economy, he adds.

“Investors should really think of themselves first as investors and second as traders,” he points out. “An investor will have a longer-term point of view, thinking about building a diversified portfolio and understanding how it will move up and down with the changes in risk and return through the market cycle. A trader is more reactive, trying to anticipate the next news item, the next price change, trying to understand how the noise and the facts impact the portfolio from day to day.”

Active management by professional portfolio managers can help, Mr. Locke adds. “An active manager can shift the portfolio tactically as the market backdrop changes, and can be vigilant about risk management, removing risk from the portfolio when appropriate. This takes the market timing decisions off the minds of investors.”

Produced by Globe Edge Content Studio. The Globe’s editorial department was not involved.

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‘The floating rate loan market is an area that investors should look at adding to their fixed income holdings.’

Steve Locke
Senior Vice President,
Portfolio Manager,
Head of Fixed Income Team at
Mackenzie Investments

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