Special to the Globe and Mail
Published May 8, 2014

By Tom Bradley

When I headed west to join Phillips, Hager & North in 1991, I had to learn about bonds, and fast. My background as an equity analyst wasn’t going to cut it with the balanced pension clients I’d be working with. Fortunately, PH&N was already one of Canada’s top fixed-income shops and I had a good teacher in bond legend Tony Gage.

When I sat down with Tony to learn about the senior market, he told me that all our bonds were single “A” rated and above. Portfolios were made up mostly of federal and provincial government bonds, with a sprinkling of high-quality corporates. That seemed reasonable at the time – bonds generated a healthy income and were the stable part of client portfolios, while stocks provided more than enough growth and volatility.

Today, that single “A” restriction seems ludicrous. When I read commentaries from leading bond managers, look at institutional portfolios, or get pitched on new products, it’s all about high-yield bonds (they were called junk bonds in 1991), emerging markets debt, private company loans and distressed debt. Some funds own virtually no government bonds, and it’s now more common to see managers using leverage to enhance returns.

Clearly, in the current low interest-rate environment, we need to be more adventurous than we were in 1991, but what are the consequences of this full-on shift from defence to offence?

The income component of portfolios is riskier than it’s ever been. The risk of default, or credit risk, is considerably higher. A diversified mix of corporate bonds eliminates the possibility of a total loss of capital, but high-octane issues can behave like resource or tech stocks at times.

The investment industry does a poor job of discussing risk in fixed income. There’s often little mention of downside, especially when the economy is strong, and capital is thirsty for yield.

A mistake too many investors make is substituting aggressive fixed-income funds for their GICs and bond ladders. Needless to say, levered loans and high-yield funds aren’t appropriate replacements. They should be replacing stocks in many cases. I use the following rule of thumb – if an investment product is promising a return that equates to a good year in the stock market (7 to 10 per cent), then it belongs in the equity section of the portfolio.

It follows, then, that new-age fixed income is more correlated to stocks, and therefore provides balanced portfolios with less downside protection. Default risk and leverage lead to higher returns in strong markets, but you reap less of the benefit of diversification in weak ones.

Another consequence of the shift to offence is that portfolios are less liquid than they used to be. A Government of Canada bond can be sold in any market environment, but the ability to trade private loans, mortgages and high-yield bonds ranges from limited in good times to impossible in times of stress.

With more aggressive and exotic income products, the challenge we face is determining if the yield is high enough to justify the illiquidity and default risk. High-yield bonds are a case in point. Currently the U.S. Merrill Lynch High Yield Bond Index is yielding 5.2 per cent. This is meaningfully above U.S. Treasuries, but the additional yield of 3.9 per cent is at the low end of the historical range. In other words, great enthusiasm for high-yield bonds means investors are receiving less income per unit of risk.

We also need to take the advertised yields with a grain of salt. The more complicated the product, the more likely it is to fall short of its target due to any number of factors – rising interest rates, overvaluation, sales commissions, high fees, defaults, forced liquidations and overly optimistic investment bankers.

Most importantly, we have to recognize that high yields are only good if they fully compensate for the additional risk and complexity.