The Bond Rebound

The Bond Rebound
Bringing Diversification Back From The Dead

By Duncan Webster Chief Investment Officer, CIBC Global Asset Management

There are several ways to bring diversification back from the dead, and the most notable way is to invest in corporate bonds.

The current balanced portfolio for the typical Canadian pension plans is 60% equities and 40% bonds, according to Mercer Investment Consulting. Pension plans have diversified in recent years mainly through purchases of foreign equities in industrialized countries. But what about bonds?

From a strategic asset allocation rebalancing perspective, recent sharp equity market declines are prompting calls to sell bonds and buy equities. The problem with this approach is that Canadian portfolios are vulnerable in a high volatility and low return environment. Portfolio risk has become concentrated as a result of rising correlations with Canadian equities, and foreign exchange exposure is too concentrated due to exposure to only a few currencies.

Correlations between asset classes and equities have changed significantly. Foreign equity markets are much more correlated with the Toronto Stock Exchange (TSX) than before. On the other hand, domestic and international government bonds have gained a stronger negative correlation with Canadian equities.

In recent years, Canadian earnings have experienced spectacular growth thanks to booming commodities. Despite recent weakness, Canadian earnings remain nearly 40% above trend earnings. But with Canadian earnings being highly cyclical, further downside from here is very plausible. Canadian corporate bonds, on the other hand, are a lot less volatile than Canadian equities. Even with the equity market’s recent rebound, Canadian bonds have outperformed equities over the past 20 years.

The classical bond mandate may now be an “uneasy” mix of corporate and government bonds. In our baseline scenario, Canadian corporate bonds are projected to significantly outperform Canadian equities.

Opportunities exist beyond common equity for those familiar with Canadian companies’ capital structure and their underlying securities.

Credit spread widening has caused a divergence in the correlation of the various Canadian bond sectors to the TSX. While government bonds have become more negatively correlated with the TSX, investment grade corporate bonds have become positively correlated. Even with this increased correlation, portfolios could still enjoy better diversification by increasing their corporate exposure through bonds rather than through additional equities. By holding these corporate bonds to maturity, these portfolios could collect the attractive liquidity premiums currently embedded in corporate bonds.

Traditional international diversification—via EAFE and the U.S.—has not met expectations. For higher return potential, pension plans may have to extend their international equity diversification farther afield.

Exposure may have to drastically shift from the industrialized (low growth) world to the emerging (high growth) world. In a high volatility and low return regime, tactical asset allocation can reduce portfolio risk and help meet funding targets. Opportunities exist in tactical foreign exchange and bond overlays. Inflation-linked bonds are also likely to prove attractive during various phases.

Canadian plan sponsors should reconsider their existing strategic asset allocations (SAA). Is the SAA appropriate for the “brave” new world of higher volatility and lower returns? Sponsors should look across the capital structure of Canadian firms and distinguish between Canadian government bonds and Canadian corporate bonds. Rebalancing into corporate bonds could be a better way to increasing corporate risk rather than moving straight into equities. In addition, keep in mind that as an asset class, currencies need to be managed, while international equity exposure should be shifted more into high growth regions.


 




Transcontinental Media G.P.