Jean-François Bordeleau: Good day everyone, and welcome to our webinar on Bond Basics. My name is Jean-François Bordeleau, or more simply, JF. I’m a Senior Practice Manager with MD. My focus is everything around education of investment, primarily internally with our advisors, but also in events like today with our clients. Joining me today is Carol Fensom.
Carol Fensom: Thank you, JF, happy to be alongside today. I am a Senior Portfolio Manager with our discretionary investment management service, MD Private Investment Counsel, and I work with physicians and their families, managing a book of over $400 million.
Jean-François Bordeleau: Well thanks, Carol, for being with us today. I know as we go through the agenda, I’ll to provide some of the more technical information and product-related expertise and I’m sure our listeners here will appreciate the insight and more practical information around why and how we are using some of the fixed income in our strategy, so thanks for being with us today.
Speaking of the agenda, we’ll first start with the basics. What is a bond? So we’ll provide some definitions and then we’ll move into one of the MD solutions in that space, the MD Bond Fund. Moving over, we’ll talk about the relationship between bond yield and bond price. And Carol’s going to come in and talk to us about why bonds? Which I think is a very important part of today’s presentation, especially around the environment that we are in with fixed income. Some people are challenging or questioning whether we should actually have exposure to bonds or fixed income. And then coming back to talk about the different types of bonds or fixed income investments available in the market. Carol will talk about a couple of investing strategies that are available for fixed income investors. And we’ll close things off today with a discussion around how MD is applying all of this knowledge and we’re seeking, we’ll call it risk adjustment returns in the fixed income space.
But before we do this, maybe I’ll provide just a little summary or retrospective on MD. So what about MD? We’ve been in the business now for actually close to 50 years. We’ll celebrate our 50th anniversary in 2019. We are the wealth management company as trusted most by Canadian physicians. We are number one based on market share. And our Private Investment Counsel firm, MD Private Investment Counsel, is the largest non-bank-owned Private Investment Counsel Company in Canada. These are a couple of stats about us.
And if you’re looking for a few more numbers, just a few other things that I like to point out is that on fees, because we are owned by the Canadian Medical Association, because you are members, we are able to provide you with some fairly good deals on fees. In our mutual funds we average about 30% lower. Our asset under management total is over $46 billion. And you’ve got also 300 advisors at MD available to spend time with you and provide you with advice on the right investment, insurance or estate strategy that’s right for you.
Now why learn about bonds? Why learn about fixed income? This is a topic that has taken a bit more prominence over the last couple of weeks, over the last year. Given some of the renewed media attention to fixed income—we’re going to talk about renewed media attention is the fact that now we’re starting to see a couple of headlines about some central banks like the U.S. Federal Reserve in the U.S., the Bank of Canada here in Canada, rising interests for the time in actually many, many years. And rising rates as we’ll see later in our webinar, does have an impact on the value of fixed income holdings and that has some people concerned about the prospect for fixed income. Not only that, but we are starting from a place where what we call the yield, which is I’ll call it the rate or the return that you’re getting on fixed income, is pretty much at an all-time low. So faced with that prospect, a lot of people are questioning the rationale to be in fixed income, the rationale to be in bonds. And our webinar today is actually for Carol and I, to spend some time talking about that rationale, but also talking about some of the more basic aspects of bond investing.
When we look at bond, most people think well okay, I’ve never heard about equities, so how does that relate to equities? What’s a bond? How is that different? So we’ll try to explain actually the difference between the two so that you have a better understanding of what a bond is. And let’s start with equities.
Equities really represent ownership in a company, so you own part of the growth and you own part of the losses associated with that. So you own a share, you own a portion and so the company makes more money, you make more money. The company loses money, you do lose money. Whereas fixed income is totally different. You actually do not own a portion of the firm. You are owed money by the firm. In a way you’re like the bank to that company. So if Rogers wants to raise some money, they don’t want to issue more shares for people to own the company, they might say I’m going to seek a loan on the open market and I’m going to go to my bank. I will dictate the condition of that loan, so it’s going to be 5% over the next 20 years and anyone who wants to buy that loan, I’ll share a portion of that loan to people. So you don’t own the profit. You don’t have an ownership in the company. But the benefit of having that is that should the company fail, should the company go bankrupt, if anyone is going to get some money, you are kind of first in line to get some money ahead of the owners of the company because you are owed some money.
Last asset class, and to me they’re a bit of a subset of fixed income is what we refer to as cash and cash equivalents. And the main difference is that you may have some actual cash, but the cash equivalents are pretty much a debt instrument or a fixed income instrument with a very short term to maturity, so usually you will lend the money or the company will grow for 30, 60, 90 days, which is the biggest difference with a bond, which would usually be a couple of years in maturity. This is the main difference between equities or stocks, fixed income or bonds, and cash and cash equivalents.
If you look at it from another perspective, it is the relationship between risk and return and I think I have alluded a little bit to that in our previous slide. Equities, because you own the firm, you’ve got a potential for a much greater reward. But with that comes a higher level of risk. Whereas fixed income, because you are owed money and at maturity you will get your capital back and if everything goes well there’s no default in the firm then you will get your money. The risk you’re taking is lower. Well as a result, you’re return will also be somewhat lower than what you would have with equities. And with cash flow, it’s such short term that the risk is very, very low, so what you tend to get in return will be much lower than anything else most of the time. I want to be clear on that is that there could be time periods where let’s say the equity market goes down significantly and where fixed income does better. This will happen. But over the longer term, let’s say 10 year period or longer, equities do tend to outperform fixed income and fixed income does tend to outperform cash.
Where are we now? So we’re talking about what about bonds? Why this is important and that kind of stuff. So before we go into more detail with Carol in a few minutes, one thing with fixed income that we all need to be aware of as bond investors or fixed income investors is that interest rates, not only in Canada, but pretty much around the world, have been going down for the last 35 years or so. So they peaked back in 1981. Some of you that maybe be listening today may remember a fairly high inflation in the early 1980s, where you could have a Canada Savings Bond at a rate of about 18%, which is one of potentially the safest investment options available from fixed income. But the reason for that was because inflation was also quite high, like 13, 14, 15%, so you needed those very high rates to compensate for the fact that you had high inflation. Over the last couple of years inflation has been quite low in Canada and we’ve seen rates as they go down consistently over the last 30 years up until this summer where we’ve seen the Bank of Canada and Federal Reserve and now maybe other central banks considering raising interest rates in the near future. So that time period where we’ve seen rates go down, is it the end? I don’t know. But it’s definitely something that’s top of mind for a few investors out there.
Now, when you open the newspaper you rarely hear about bonds. The only time you’re going to hear about bonds is whether there’s a big company that basically defaulted, has gone bankrupt, and then the people will figure out whether they’ll get some or all their money back. And this is the headline you’re going to see about bonds. You’ll see some headlines about interest rates going up or down, but it is very rare that you’ll see a headline that is very specific to a specific bond. It does happen, but it’s rare. Compare that to equities, you open the business page in a newspaper and it’s all going to be about the hot stock story of the day or the hot stock market story of the day. That’s what you see all the time. So wouldn’t you like to believe that the equity or stock market is everything there is? Well the reality is that the fixed income market is at about twice as big as the equity market. And why is that? Well if you’re the Government of Canada, you will issue debt. You’re not going to issue equity. The same thing with the Government of Ontario, same thing with a municipality, so you have many more debt issuers or bond issuers than you actually have equity issuers. But the reason why you see more about equity in the media is this makes for much more interesting headlines of stock going up, stock going down, people making money or losing money, so it’s a bit more exciting and that’s probably the reason why it’s a bit more media friendly.
Now already I’ve used a little bit of jargon in our presentation today. I haven’t defined all of these terms. The presentation Carol and I are making today is I will to define and articulate some of the words and the terminology that we do use today. And on this slide you can see a couple of definitions. We talk about face value. So face value is I don’t want to call it the guaranteed value, but if you were to hold your bond to maturity, you will get that face value back. Whereas a coupon rate, it would be the interest that you’ll be receiving on that bond. I’m simplifying here, but that gives you a bit of a sense as to what are some of those terms. The other term that’s very important with a bond is that it does have a maturity, so a bond does mature. So if you buy the Government of Canada bond, 2025, well it will mature in 2025 at a specified date on that bond. These are all terms that Carol and I will use today in the webinar and we hope that you feel comfortable with as we do progress on today’s event.
Another concept which is, I don’t want to spend too much time on, but it’s very important to determine how much return or yield, that’s another term. Yield is not exactly a return, but we sometimes use these terms interchangeably when it comes to fixed income. One that will determine the yield and the coupon is the bond rating. So a very safe issuer, let’s take the Government of Canada, would have a very high bond rating and would be able to issue their bond at a much lower rate than let’s say a corporation like Rogers or Bell that may be issuing debt as well, which might be good in some companies, but it would not be as solid as the government. So they would have a lower credit rating. And because of that lower credit rating, they would have to offer a slightly higher interest rate to entice you buy that bond.
Now there is a category of bond called high-yield bonds. Some people refer to them as ‘junk bonds’. As we may learn in today’s webinar, it’s not because they are a higher yield or that they’re necessarily junk and that they will automatically default. Some of them are actually of quite reasonable quality if you do your homework and can provide for some higher return or yield in your portfolios. That could be a very good instrument, but it’s usually not for the novice investor to consider. You do need some expertise and time to really do what we call the “credit analysis” to see whether those higher yield or junk bond style bond would be suitable for your portfolio.
On that, I think I spend quite a bit of time to provide a bit of background information on what are bonds and some of the terminology that may be useful. Carol, what I’d be really interested to hear from you is okay, well you’ve heard all of this, client is in front of you and they say well, okay I’ve heard you Carol but why should I have bonds in my portfolio and why should I dedicate a portion to bonds or a fixed income?
Carol Fensom: Great question, JF. So why bonds and why always? Before I address the question specifically, I want to take a short step back and confirm that in the 25 years I’ve been working directly with investors, I can say that we need to be careful in how we define and measure investment success. Investment success is not an exercise in chasing returns. Successful investment plan is anchored by a specific goal with a specific timeframe in mind. And we must then establish with each individual client where their preferences lie, and investors need to understand how they may behave under different market conditions. These are all of the factors that I must take into account when I’m making investment recommendations.
Where I’m going to start my comments is looking at the last 10 years of history. We’re going to look at where the fixed income markets have been and where the equity markets have been. And we’re going to see, I believe, even given these historically low interest rates that we are grappling with right now, that bonds continue to play a valuable role in the construction of a successful portfolio.
Let’s look then at 10 years of history. There are three lines on this graph. The upper most line, which is orange in colour, represents the path of the Canadian Bond Universe. Bond Universe, it sounds like a complicated term. It is simply the performance or the rate of return you would have earned if you owned every single bond that is issued in Canada. So this is really just a proxy for how the bond markets have behaved over the last 10 years. That’s the upper most line.
The lower line, which has decidedly a greater jag to it or a profile, the lowest line is the performance over the last 10 years, or the path of the Canadian Stock Exchange which we fondly call the S&P TSX Composite. The TSX, as it’s nicknamed, is made up of approximately 250 of Canada’s largest stocks. The middle line on this diagram is a combination of both the Bond Universe, the upper most line, and the Canadian Stock Market, the bottom line. So what we’ve done in this exercise is we’ve combined those two influences at the rate of a 50/50 blend.
I think the most striking thing that I see in this diagram is that the results, no matter which path you’ve chosen, are identical. The outcome is identical. What also jumped out at me about this diagram are the two circled areas. Two-thousand and eight (2008) was a test of every investor’s tolerance. At one point during the year, the market started to drop on June 6th, 2008, and it hit a bottom around November 15th or so. At one point it was down by 50%.
Now a bond or a portfolio that was, in 2008, made up of 50% bonds and 50% equity would have fallen by less than half that amount. Why is that significant if at the end of the 10 year period the returns are the same? The challenge is this: we call it generally investor psychology. During those deep dark market selloffs, you may be tempted to abandon that high-risk stock market only strategy. If you abandon that strategy at the very bottom, you will actually impair the portfolios ability to recover. If you had done so in the context of this diagram, you’re outcomes certainly would not be the same as we see on the diagram. Market timing, in other words, it’s not a strategy, again, to JF’s point around how the press reports equity markets. One would think that market timing is the only strategy. We believe otherwise. When you anchor your decisions based on your preferences, your goals and your timelines, we think you will have a better chance at success. So again, just to summarize, even though we’re in a period of historically low interest rates, we can see that history has shown us that fixed income plays a very important role in a portfolio.
I’m going to transition now to spend a minute on the subject of investor psychology. And I can tell you in practical terms, when the market is falling, I get more e-mails and telephone calls than I do when the market is rising. I have not yet had a telephone call where somebody has called to ask me why the market is rising so well. It just never happens.
This is a real fear; the age old advice is ‘stay the course’. That’s very difficult to do when the markets are dropping. It’s these potential to create to ill-timed selling decisions that can impair your portfolio.
The slide we’re looking at now represents the outcome of a Boston based consulting firm’s study called The Quantitative Analysis of Investor Behaviour. This diagram capture the average annual return over a 20 year period of the various investments that would make up the average portfolio. The conclusion that seems fairly obviously here is that the average investor who is making their own investment decisions has achieved an average annual return over this 20 year period of 2.5%. So one has to ask the question, when that investor had access to the average annual returns of the green bars to the left, how is it that their return was so much lower? The answer Dalbar discovered partly fees and taxes make up part of the difference, but the rest is investor behaviour. Essentially what we’re seeing is that when markets are stretched, investors are making the wrong timing decisions. And individual investors are often driven by fear and greed. Dalbar calls these the points of maximum impact. Consider the period where equity markets have been rising for a long period of time. They tend to become a sure thing, but markets cannot continue indefinitely upwards. This is the role of bonds. When we see these inevitable corrections, when markets are overbought, bonds provide that safety net as seen in that line diagram a few slides back, the addition of bonds into a portfolio creates a better floor for your portfolio to participate in the recovery.
Individual investors, even though we try so hard not to let our emotions get in the way, time and time again, as proved by this study over a very long measurement period, cannot be avoided.
I’m going to move now to an overview, if you will, of some of the benefits that bonds bring to a portfolio. We’re going to dig a little bit deeper into some of these concepts a little later in the presentation.
I’ll highlight three concepts on this slide: capital preservation, income and volatility reduction. I’ll remind you again that no individual investment decision should or could be made without consideration for the goal that you’re trying to achieve. Let’s consider a short-term goal, perhaps the purchase of a car, or perhaps the purchase of a cottage, or the payment of a child’s education. A short-term goal requires a greater degree of stability. And as JF has already pointed out, bonds will guarantee repayment of capital if held to maturity. The shorter your timeframe, the greater you will rely on that guarantee, the more appropriate a bond investment is for a shorter time horizon.
Equities or stocks tend to pay quarterly dividends, but many may be surprised to know that those dividends are not contractual. Each quarter, the board of directors of a corporation needs to declare that a dividend be paid. During the 2008 financial crisis, Manulife had to cut its dividend in half. And the day after that announcement, by mathematical logic, the stock price dropped in half, thereby preserving the yield, but decimating the capital.
Bonds, GICs, fixed income instruments are actual contractual arrangements that pay interest to the holder on a schedule of about every six months. So that income, particularly if you’re a retired person, can be counted on.
Volatility reduction we’ve seen. Bonds tend to have a lower degree of volatility than do stock markets. There is a phrase which perhaps is not well socialized outside the investment world. It’s called the flight to quality. So in a crisis like the 2008 financial crisis, when stocks were dropping and nobody knew if there was an end in sight, sellers of these equities would put their money into something that has a safer profile, like a bond. The safety and security of a Canadian Government Bond, that’s the highest rated bond as JF has mentioned. So by their very nature when equity markets are selling off, we can count on, we can set our watch by the fact that bonds will increase in value because they become the more attractive asset class. Capital is fluid and capital will move where it feels there is the greatest opportunity.
Now I’ll be back to talk about bond strategies in a short bit, but I’ll hand it back to JF to take a look at the MD Bond Fund.
Jean-François Bordeleau: Thanks Carol. Maybe just before I do that, there were some very important points that I think you made in your part so far in the presentation and correct me if I’m wrong, I know I’m looking at it from a very practical perspective, but if you were to look at just pure straight return, like let’s assume I’m a fairly rational investor and I’m seeking for the maximum return out there and I’m just considering traditional equities, fixed income and cash. I potentially should be all equities. If I’m rational and I don’t have any emotion, I want a best return, that’s what I should do. But as we’ve seen in some of the slides that you’ve shown is that the average investor, as much as they try to be rational, emotions do get in the way and it’s very hard for most of us to keep that discipline. We tend to sell at the wrong time, so one of the reasons to include fixed income in one’s portfolio is to somewhat minimize that what we’ll call volatility or the range of the highs and the range of the lows, so that emotionally we don’t feel as compelled to take action on our portfolio and by sticking to our discipline, ultimately that will likely lead to a higher return than if we just try to time the market all the time. Is that part of the reason why you feel that bonds are important? Why you use diversification in your practice?
Carol Fensom: Absolutely. A strategy is defined by the ratio of stocks to bonds that you would have in a portfolio and a strategy should have a little bit of wiggle room, and we’ll talk a little bit about that later in how MD does use our own view of the economy to make opportunistic shifts between stocks and bonds. But your bond strategy is a basic core strategy that is absolutely necessary to achieving your goals and making sure that you don’t commit the very biggest error that an investor can make and that is changing strategies at the wrong time. And so if you have a portfolio that’s more volatile than you can actually stand, you will likely only realize that at the period of maximum strain and that will be the exact wrong time to make any changes.
Jean-François Bordeleau: Great Carol, really appreciate that additional presentation to the topic we were just talking about.
And let me be brief on that. I just want to look at one of our investment solutions here called the MD Bond Fund, one of a few solutions that MD Management and MD Private Investment Counsel do offer. Actually MD Management in that case offers in the fixed income space.
MD Bond, this is an example of our webpage or MDM.ca webpage on the MD Bond Fund. It describes MD Bond Fund as a low to medium level of investment risk. And how I mention that is used in the MD Precision Portfolios. Okay, interesting information, but what does that mean in some more practical terms? Well what that means is that low to medium level of investment risk, so we talked about that a bit earlier. Equities would tend to be more volatile and as such are perceived to be riskier. MD Bond, because it’s primarily invested into Canadian good quality corporate Canadian based fixed income instruments or bonds, will have a lower level of risk or volatility than those pure equity products. The usage in MD Precision Portfolio is that our MD Precision Portfolio is a portfolio architecture that we do have here at MD, where we are blending different funds, different money managers, to go to the goal that Carol was talking about earlier on, that diversification, so that people, if we match the right portfolio to the right risk level, people are much more likely to stick with that investment discipline and realize the returns that they expect and that they do deserve.
Now, I’ve mentioned primarily Canadian, but I do need to clarify that MD Bond, and we’ll talk about the details of that later. I also have what we refer to as an opportunistic sleeve. And what that means is we do have some investments that are outside of Canada. We do have some investments that may not be into the top highest quality of fixed income. We have what we call higher yield investment as well, so there’s a few things that we do on the margin and MD Bond and all of our fixed income solutions at MD and at MD Private Investment Counsel to improve what we refer to as the risk return profile of our fixed income fund. But MD Bond in a nutshell is very much diversified. It has some risks. It’s not risk-free because you have a diversified portfolio and it is used as part of our building block in our Precision Portfolios. And the diversification aspect of it and the ability to invest in foreign securities is what you do see on the slide I’ve just showcased right now.
Just maybe before we move into the next section, I know that sometimes I’m using the term bond and I’m using the term fixed income, and I seem to be using those interchangeably. It’s like sometimes we talk about stocks and equities, and we use them interchangeably. Just to maybe use a bit of a medical analogy, I may suffer from acid reflux, which is a gastrointestinal condition. Well I may have a gastrointestinal condition, which may not be acid reflux, or by the same token, a bond is a fixed income instrument, but not all fixed income instruments are bonds. So I know we tend to use these two terms interchangeably in this presentation, and usually when we refer to fixed income today, we are referring to bonds, but do keep in mind that fixed income is a bit of a broader term than just bonds, which is a very specific type of fixed income investment.
Let’s now move on to the relationship between bond yield and bond prices. I’ve defined yield a little bit earlier in today’s presentation and the concept of price is pretty self-explanatory.
Now when we look at yield and price, there is actually a third factor to actually influence the relationship between the two and it is the interest rate change. So most of us, over the last couple of weeks, we’ve opened a newspaper and we’ve seen that the Bank of Canada increased their overnight lending rate. And the market did react accordingly. So to reflect that interest rate rise, the yield has to take that into account, so the yield itself does rise. Well if one thing does rise, well the other thing does have to fall and what that means is the price does fall. It’s always a bit of an equilibrium relationship between all of these three components. And not to get into complexities, but to why do you see the price falling? Well it goes back to that concept of having a coupon. We talked about coupons earlier, so if something pays me 5%, and when I issued that bond the market rate was 5%. Well everything is equilibrium, so I would buy that bond at $100 and if rates don’t change, if I sell part of my share I would sell at $100. But now the market says oh, no, no, no. You could have another bond at 5.25. Well if I’m only paying 5%, I’m not as desirable anymore. So to become more desirable, I do have to lower my price and through a lower price, because of maturity, I’m going to get the exact same amount of money. I’m going to get my capital back. You do the math. You do come up with a higher overall yield because you did get a discount at the time of purchase. So conceptually, I know I may have gone over this concept quickly, but this is the relationship between price, yield, interest rate and that side concept of a coupon, which is the payment that I’m going to continue to receive regardless of the relationship between all of these components. I hope that that was clear enough. But if not, this is the very question that you could ask after today’s event to your MD Portfolio Manager or your MD Financial Consultant.
Another concept that comes into play here because we talked about yield and prices just as kind of a linear relationship, but the duration is another concept that comes into play here. And people sometimes will confuse that with what we call term to maturity or time to maturity. They’re not exactly the same, but I think for the purpose of today’s discussion, they are pretty similar. They’re kind of aligned to each other. So the importance of the duration is that it’s going to tell us how sensitive the price of a bond will be to change in interest rates. But as we talk about here, it is not exactly the same as a bond’s term to maturity. And the reason for that is sometimes you’ll have some different bonds and you’ll weigh them together and this is where you will calculate an actual duration for your portfolio. Long story short, if you have a longer duration your investment will usually be more sensitive to changes in interest rate and vice versa, which is what we do see here on this next slide.
So again, if something is short-term, it doesn’t mean it’s not going to be volatile when there are interest rate announcements. But because you have less time to maturity, the duration is up. It’s going to be a bit less volatile. It may lose less value. There are exceptions to that rule, but again, for the purpose of today’s webinar, this is true I would say about 95% of the time.
And that’s a bit more complex slide that we do have here that tried to summarize everything that we’ve just talked about. So if I’m trying to maybe use a current situation that interest rates have been rising, for example, in the U.S., but also in Canada, well as we’ve talked about in the last and previous three slides, this can cause the price of some bonds to go down in what we refer to as the secondary market. And here’s what happens if you’re managing a portfolio of bonds, such as the MD Bond Fund that we talked about earlier. So you’re not managing only bond. You have a lot of bonds in that portfolio. If let’s say MD Bond was to be primarily investment grade government bonds, this is the core of mostly bond funds like the MD Bond Fund, so all of the prices will decrease in the short-term as we’ve talked about earlier. There’s going to be some longer-term positive is that we have some of the losses, but now we still have some of the income coming in and that kind of stuff, and now there will be some bonds with higher coupons that may become available as a result. So the money manager has the ability to start to do a bit of shifting in a portfolio and to rebalance to some of those higher yielding or higher coupon investments. And as we’ve got higher interest income, we kind of recuperate some of these short-term losses that we’ve experienced in the portfolio. So although in the short-term you may have that negative impact, long-term to higher income, you will recover some of these shorter term losses and that’s the relationship that we always have to keep in mind in a bond fund versus holding an individual bond where at maturity we would get that capital back regardless unless the firm does default.
I’ve actually introduced some of the types of bonds. I’ve referred to municipal already, corporation. I’ve talked about Government of Canada, but I just want to maybe summarize some of the different types of fixed income instrument or different types of credit quality we do have available on there. So the core that we’ve talked about earlier is government bonds. So here we’ve got a sampling of the MD Bond Fund. And you see Province of Ontario, Government of Canada, Canada Housing Trust, which is really backed by the Government of Canada, the Province of Quebec, and the Province of Ontario. A couple of interesting concepts here that you can see, for example, you see the Province of Ontario at 2.6%, Government of Canada at 3.5%. Why the difference? Well you see the maturity date. One is 2025. One is 2045, so 20 more years of maturity. It’s a longer duration. You’re taking a bit more risk, so the reward here is a higher coupon or rate that will be paid.
Now let’s look at the relationship between the Canada Housing Trust and the Province of Ontario. So Canada Housing Trust is longer, yet it has a lower coupon. Why would that be? Well the Government of Canada, which is backing the Canada Housing Trust, would make that a slightly safer bond for the Province of Ontario, which is still very safe. Well because of the province, it’s a little bit riskier than the Government of Canada, which is larger. So as a result, the Province of Ontario or Quebec would have to pay a slightly higher coupon than the Government of Canada would for a same term to maturity.
Now, something that may be a little bit of an anomaly here, you see a Province of Ontario at 3.5% within 2024. So you say well JF that defies everything you’ve just talked about. The one thing I don’t know is when was that bond purchased? Maybe it was purchased 15, 20 years ago when interest rates were much higher than maybe the other Province of Ontario maybe was issued 10 years ago or five years ago when rates were much lower. So these are all components of when it’ll impact the coupon and when you take into account the maturity and the issuer, the actual return that you will get or yield you would get from those fixed incomes. But you see here, the government bonds tend to offer a perfectly low coupon, especially when you compare them to some of the corporations here that some have in their portfolio. So you see a TMX group, which is the TSX, the market index there, the company that is the stock exchange. You see it’s 2018 at 3.25%. So much shorter than what we’ve seen around Canada about a rate that is actually quite competitive. And you see at Toronto Hydro, which is not a crown corporation, but maybe a bit of a safer issuer, a bit of a lower rate. And then you’ve got TransCanada Pipe Line, which is maybe a bit of a riskier issuer that is offering a much higher coupon out there. So depending on the credit rating of the firm you will have a much wider range of coupon available and again, that will translate into a much wider range of potential yield to maturity for these investments.
And another category which is interesting is emerging-market bonds. And emerging-markets have a tendency to pay a higher yield, not necessarily because they are riskier. Some of them would be riskier, but it’s because I would say also probably the people are not as knowledgeable, as comfortable with debt of countries other than say Canada, the U.S., Germany, France, to name a few. And we could have a long debate as to whether Indonesia is more solid from a debt perspective than the U.S. I know there could be a few people out there that say you know what? Indonesia is actually fair solid. But we’re not going to have that debate today. The perception out there is that Indonesia has different market rules. It’s a bit further away, not as liquid market or as a solid market as let’s say the U.S. or Canada. And as a result, it does have to pay a much higher rate to entice investors to that market. And so emerging-markets, if you do your homework, can offer some very nice returns and very nice diversification without necessarily adding significantly to the level of risk in one’s portfolio. And we’ll talk about the strategies a little bit later in our webinar today.
Now we’re kind of out of bonds. We’re getting into I don’t want to call it the dark side because there’s nothing dark about the securities. But this is the kind of stuff that sometimes causes people to be worried, especially in light of what has happened in 2008 in the market. So we refer to stuff like mortgage-backed securities. There are some leveraged loans. There are convertible bonds. So these are just other forms of debt instruments or fixed income. They might not always be issued by a corporation on an IOU. They’re a bit different. But for example, mortgage-backed, it’s a bit of an IOU, but it is backed by the mortgage payment of, for example, it could be residential home owners or other types of homeowners.
Asset-backed, same principle, but rather than being mortgaged, it could be car loans. It could be credit card payments, things like that.
Leveraged loans, you have a levered concept here and we’ll get into I wouldn’t say a more complex, but we’re going to do terms like floating rate loans that are made to maybe non-investment grade companies where there’s a bit of a higher risk level there.
And then there’s the last one which is interesting, which is convertible. So these are bonds, but on the specific condition those could be converted to common shares at a certain point in time. They’re kind of variations of your traditional plainer vanilla bond, but including those in one’s portfolio can help to add diversification or return to the form of higher yield.
On that, I’d like to turn it back over to Carol because I’ve known Carol from a very practical perspective. And you’re a portfolio manager. People come to you and they say well, what are some of the strategies that we could use in our fixed income portfolios? I know that’s a question sometimes people ask you and I’d be interested to hear some of your thoughts around some fixed income strategies.
Carol Fensom: Thanks, JF. At MD and at MD Private Investment Counsel, we employ both passive strategies and active strategies, so we’re going to look at both of those options. And again, keeping in mind that we’re working towards a goal and certain strategies will line up better with certain goals.
The first strategy we’re looking at is a passive strategy and it’s called a ladder or in this case it’s a bond ladder. The theory, there are five pillars in this particular illustration, and this individual would take the funds to be invested in bonds and they would divide them into six parts. Each part generally equal in size will be invested to a separate term. So 1/6th will be invested for one year and 1/6th invested for two years and so on. The last six you invest for a term of six years.
When the one year bond matures, column two, you reinvest that for six years. So you have this perpetual ladder, so a ladder has rungs or steps, which we can see illustrated here nicely. Every year, 1/6th of your portfolio is coming due and can be reinvested at the prevailing rates. So when would this strategy make sense for you? Well it would make sense if you anticipate rates to be rising gradually in the future. Let me give you an example. Today, if you were to invest your whole fixed income portfolio in a one year GIC, your rate would be 1.5%, and I took the best rate. If you were to say well I need a higher return than that to achieve my goal, you might consider a five year GIC. Today, a five year GIC has a yield of 2.5%. So you might be tempted to say to yourself, given the headlines that JF has covered, central banks in Canada and the U.S. potentially overseas, are keeping an eye on economic growth, should they be raising interest rates? If the central banks raise interest rates, we know that mortgage rates following, well the GIC rates will follow upward as well. So if you happen to hold the notion that interest rates are in an upward moving direction, then you would be certainly remiss to invest your whole portfolio one year at this currently low level of rates, and you would be remiss if you invested the whole sum in five years. So this laddered strategy is specifically well-designed for an environment of gradually increasing rates. It’s a low-risk strategy and it’s very dependable and reliable, and your yield will move slowly, higher.
A second concept which we introduced into our Private Investment Counsel portfolios and the MD family of funds in 2013, specially in response to this historically low interest rate environment in Canada. We felt strongly that it was time to open the doors of our portfolios to global opportunities.
In 2008, the best performing asset class, 2008, the global financial crisis, equity markets ended the year down globally around 28, 30%. The category global bonds were up about 17% in 2008. Again, that flight to quality, bond markets are bigger than equity markets, and that flight to quality drove bond prices down and yields up.
The slide we’re looking at right here represents the top 15 securities in our MD Strategic Yield Fund. So the difference the two, this is a passive strategy as well. This is an exchange traded funded, which means that we hold many, many hundreds of securities within each of these line items. Diversification, again, back to JF’s point that different bonds in different countries and issued by different corporations have different risk profiles. The one relationship we know exists is that if we can benefit from taking more risk, if we diversify that risk by holding many securities rather than fewer securities, we can have our cake and eat it too. We will achieve higher returns without the additional risk of taking on a single instrument.
We’re going to look at active fixed income strategies. MD Private Investment Counsel and MD Management, employs a 'manage the manager' approach. This affords our clients access to the best fixed income strategies and managers.
In 2014, we reshaped our bond offering at MD by hiring Franklin Templeton and Manulife Investment Management. These bond managers have access to a variety of strategies which we’ll see on the next slide, which are really best left to professional fixed income managers. There are four concepts here that are being taken into consideration: Duration, which JF valiantly took on the concept of. We’re going to talk about that again in a second. Bond sector allocation: High yield, so that’s industry differentiation. Geographic diversification: So we can invest in Canada, we can invest overseas. And credit analysis. These are the tools that Franklin Templeton and Manulife are employing to both manage the risk in the investments that they choose, but also to manage the opportunity to outperform the Canadian bond market.
This slide tackles the subject of duration management and yield curve positioning. This diagram is what’s known as the yield curve. On the left hand side of the diagram we see the rate of interest that a one month investment would earn. It’s approximately 0.7%. The far right hand side of the diagram represents the interest rate you would earn if you owned a 30 year Government of Canada Bond. So the yield curve maps out the rate of return you would earn depending on the term to maturity of your individual investment. This is considered an upward sloping or positive yield curve meaning that the short-term interest rates are lower than the long-term interest rates. Upward sloping yield curves are a positive sign of economic growth.
And another term, which I’ll bring up at this point, is an inverted yield curve. There’s an old an old saying in the investment business that equity market values don’t die of old age, they get murdered by recessions. The number one predictor of a recession is an inverted yield curve, where the long end or the 2030 yields are lower than the short end of the curves, the one year, two year, three year end of the curve. That is not the case here and that gives us some positive feelings around the fixed income and equity markets at the moment.
Before I move off of this slide though, I’m going to tackle the subject of duration management and JF touched on this, but this is I think the visual companion. Consider the fact that this curve does not move necessarily in a uniform fashion, that the 30 year end of the curve could move up or it could move down quite independently of the middle of the curve, it could stay put and the short end of the curve, one year, could also move at a higher or lower rate. So the yield curve does not necessarily move in a parallel fashion. But let’s assume for the purpose of looking at the concept of duration that it does.
On this slide we’re looking at again, sensitivity to changes in interest rates. So duration, which tends to closely reflect the term to maturity, so a 20 year bond would have a duration probably less than 20, but it would have a duration near 20. A duration of 20 indicates that if there is a parallel shift in that yield curve by 1%, that bond will change in value by 20% up or down depending on the parallel shift of the yield curve. And that’s an extremely significant concept. Again, I’m containing my comments in the sense that we delegate bond management strategies outlook to the professionals where these concepts belong.
Now the next concept addresses two interest rate environments. So there are two separate tables. The table on the left indicates what we have observed in a rising rate environment with bonds of varying quality. The right hand table represents falling rate environments, so interest rates going lower what is the impact or the outcome based on varying quality of bonds.
What I find interesting is in the left hand table, the rising rate environment table, we see that the Government of Canada bonds are producing a negative return and the convertible bond has the highest positive return. What I find interesting, and this is not a surprise to me, consider that a rising interest rate environment is often the condition present when the economy is growing. When the economy is growing, investors generally are taking on less risk. There is more revenue to pay the bills, to pay the bond holders, to pay dividends to the stockholders, you’re selling more of your goods and services and your earnings are going up. That’s a generally positive economic backdrop.
So a U.S. Government Bond, which we’ve decided is that’s the gold standard, it’s always going to pay you the last return because it’s virtually guaranteed to pay you back. So the flight to quality when markets are in a positive mood, works in reverse. This diagram on the left is surely telling us that convertible bonds, bonds that could be converted into stock or equity, under the conditions of positive economic growth, is positive for the convertible bond and it’s negative for the U.S. Government Bond because they’re less attractive. Capital is moving towards higher risk assets because the risk is actually declining. The risk-return ratio is in the investors favour. So it’s really understanding when these opportunities present themselves there are lots of signals that bond managers read to understand the direction and mood of the market. Given the fact that it is so much larger than the equity market, it certainly does deserve a little more attention. These managers are just as tied into economic signals and the financials of companies as equity analysts are.
Now I’m going to transition back to JF to elaborate on the subject of risk-adjusted return.
Jean-François Bordeleau: Well thanks Carol, and a really good insight into the different strategies: the active, the passive. One thing that I really like is that at MD we don’t judge that one is good and one is bad. We go out there and look at the different strategies available and try to benefit from what’s good in all of these different strategies out there while employing quality money management like the likes of Templeton and Manulife who will manage the duration, who will manage the credit spreads, who will manage a geographic diversification amongst our things on our behalf. This is the kind of stuff for me that will allow me to sleep fairly well at night when I’m considering some investments some of our MD PIC solutions or MD Fund solutions, so thanks for that really good overview.
So speaking of, we’ll actually do, I’m going to call it deep, deep dive, but we’ll still look at one of our kind of fixed income mandate, which is in this case we’re going to look at the MDPIM Canadian Bond Pool, which is one of the few offerings that we do have in the fixed income space. So even though the MDPIM Canadian Bond Pool is primarily Canadian, as we’ve mentioned earlier, most of our funds do have some exposure to something I called opportunistic fixed income, which is either non-Canadian or slightly lower investment grade than your traditional plain vanilla, very traditional fixed income fund.
Here, if you look at the chart, you see that the Canadian investment grades, so that would be your Government of Canada, your good quality corporations, your provincials, your municipals, your good quality asset-backed paper, that’s about 82% of the portfolio. Strong core, solid, from a pure risk perspective, this is potentially the least amount of risk that you can have other than being with cash. But to make sure in this low rate environment, this low yield environment that we’re able to provide some returns that are interesting with fixed income space. We have at our weekend added depending on market conditions, some opportunistic exposure. And right now we have 12%, which would be what we call foreign investment grade fund. It could be in the U.S. It could be an emerging-market. It could be in a lot of other countries. And then we have about 6% in what we call higher yield or non-investment grade categories. So you look at it, that’s about 18%. We are allowed actually to go a little bit higher than that. So we are not at the maximum right now because this is a dynamic allocation. If we feel that we will get more return or much less risk from domestic investment rate, this is where we’ll be. So we’re not kind of betting the form. We’re adding them to a portfolio in a very thoughtful manner, discussing with Manulife and Templeton, the proper allocation to these opportunistic mandates.
If people are curious, JF, you’ve been talking about opportunistic. What does that actually mean in plain language? An example of these asset classes that would be part of that, I’d say roughly 20% that I’ve talked about earlier, so I’m not going to go into them one by one. But on this slide where you can is the name of what we call the asset class. And the maximum allocation that each of MDs or MD fixed income Fund or pool can have to that. I want to be clear, it’s not you can have 15 in opportunistic, plus nine in high-yield, plus nine in 10. Overall, the total of that is capped and within those this is the max that you can have. So it’s a well thought matter to add return while preserving the overall risk profile of our fixed income portfolios.
If we look at the MD Precision Portfolios, which is our portfolio solution on the MD Management side, on the MD Private Investment Counsel side we actually built portfolios into the individual components. We do something similar with the Precision portfolio. The big difference was that you don’t get to see those individual components as much. You see that fixed income in our balanced income portfolio at June 30th is about 56%. And that 56% fixed income is not just one fund, it’s actually the bulk of it is the MD Bond Fund. We do believe that longer term will lead to some higher return, which is why we have bias to a longer term bond fund, complemented with a smaller exposure to short-term bond and some strategic yield, which is kind of a pure opportunistic fixed income mandate added to the overall mix to provide diversification. Bond and short-term bond have access to a bit of that opportunistic as well, so that overall you’ve got pretty good diversification and good risk return profile within a fixed income portion of your Precision Portfolio.
And if you are maybe a bit more risk averse, you don’t like to see volatility, you’re quite happy with a solid yield, but it’s primarily driven out of short-term fixed income, MD has a fairly unique solution in the market called the MD Stable Income Fund (MDSIF). This is not a typical investment. People have to be aware that this is an insurance-based investment, which is issued by our life insurance company, MD Life Insurance Company. It is based on short-term fixed income rates, but it does have access to the same opportunistic mandate that we’ve talked about earlier. The level of income is not guaranteed. The capital itself is not guaranteed either, but the way that this priced and the way this is sold and redeemed is fairly unique.
So if you feel that this might be something that’s right for you, I definitely encourage you to talk to one of the MD Financial Consultants who will be able to share with you some more legal and product information on the MD Stable Income Fund (MDSIF).
And just a few more highlights before we get to close our event for today. All of the MD Precision Portfolios, even the one that has the highest equity exposure has some bond or fixed income exposure as part of its makeup. They will generally hold the MD Bond in the short-term bond. At MD Private Investment Counsel, I know that Carol there are two core bond pools that you have access to: the Canadian one called the Long Term, but you also have access to the Strategic Yield Pool to compliment that in the portfolios where it does make sense. And so the Long Term Bond Pool as the name implies would be a longer term in duration. Actually out of all the MD fixed income solutions, this is the one with the longest duration. So that actually does create some interesting opportunities in terms of yield for our Private Investment Counsel client, but we also have the more average duration MDPIM Bond Pool that is also available to our investors. So as they come to me with a strategic yield, I can say it’s a great offer for our Private Investment Counsel as well.
So a few last thoughts at my end and maybe Carol, I’ll open it up to you as well. But with fixed income and what I’m taking out of our event today is that we do need to be prudent. There are a lot of good things in fixed income. Yes, rates may go up. That may worry a few people a little bit, but MD is taking a lot of steps to manage whether it’s duration, credit quality, to minimize any short-term impact of those interest rate increases, keeping in mind that in the long-term with the higher coupons that we may be able to buy, that with time that will kind of compensate. These are very short-term losses. We’re very deliberate in the way that we do things and what matters too is that you have access to professionals like Carol who will take time to structure the right portfolio for you and not to steal your thunder, Carol, but you talk about the discipline to diversification, so I know that these are things you will ensure that you have the right portfolio for the right client. Anything you’d like to add maybe Carol before we close the call for today?
Carol Fensom: Thank you very much, JF. This has been what we would call a very deep dive into the subject. And I would simply echo your comments. Bonds are another lever, another tool that we have at our disposal, to assist in achieving your goal in the most reliable, repeatable way year after year. That is our goal and I believe that bonds are at a bit of a pivot point. There’s one last interesting fact I’ll bring out. When equity markets have a significant selloff, it could take years to recover. When bond markets, which bond markets have these kinds of challenging years where we have rates resetting higher, subsequent years tend to produce positive returns and we don’t typically see back to back difficult years for bond markets. So to your point, it’s an asset class that deserves a little more attention and it plays a very positive role in achieving our clients’ most basic goals.
Jean-François Bordeleau: Well thank you Carol. I hope that our event was very informative, that you’ve learned a lot today. And as a follow-up, if you do have any questions you would like to know more about fixed income in general or MD solutions in that space, we do encourage you to talk to an MD Financial Consultant or an MD Private Investment Counsel portfolio manager. Thank you.