By Scott Ronalds
We’ve been vocal about our aversion towards federal government bonds. We noted in our Q2 Report that the Government of Canada 10-year benchmark bond yield dropped below 1.6% in June, and 10-year U.S. Treasury yields sit below 1.5%. Both Canadian and U.S. government bond yields are at or near all-time lows. Further, the German government issued 2-year bonds at auction last week which produced a negative yield for the first time ever. In other words, investors are willing to pay the government to park their money for two years.
These record low yields are an indication that investors much prefer the safety of bonds over stocks. We feel this safety is misplaced. Government bond yields have little room to fall further, thereby limiting their capital appreciation potential (when yields fall, prices rise), and the interest they are paying is paltry. Further, a rise in interest rates would be detrimental to government bond prices. We feel there are better opportunities elsewhere, notably corporate bonds. And in particular, U.S. banks.
The manager of our Income Fund, Connor, Clark & Lunn, believes that select bonds issued by large U.S. financial institutions offer compelling value. This is a contrarian view as negative sentiment still overhangs the U.S. financial sector, but many banks are in much better financial shape than they were a few years ago. They have recapitalized their balance sheets and restructured their housing exposures. Further, CC&L has a more positive outlook for the U.S. housing market as there are increasing indications that the sector has bottomed. While the manager doesn’t expect a rapid recovery, they feel the downside is limited and certain companies are well positioned to benefit from stabilization in the housing market. More specifically, they have increased the portfolio’s holdings in bonds issued by Citigroup and Bank of America (all foreign currency exposure is hedged).
Higher interest payments and yields are one attractive aspect of these bonds – they offer yields that are currently 2½ - 3% higher than 10-year U.S. Treasuries. Another benefit is that the manager believes their prices will be correlated (positively) to interest rate movements, which will help protect the portfolio in a rising rate environment, yet still provide a higher income stream until such an occurrence materializes.
The high yield sector is another area where CC&L is seeing value. The manager is finding opportunities in bonds issued by financial and consumer-related businesses as well as real estate investment trusts (REITs). Their focus is on businesses that are in a sound financial position and are producing strong operating results and growing their earnings. Examples include Great West Life, Hertz and Norbord (a producer of engineered wood-based panels used in the construction industry).
We’ve been advising clients for a while to be light on bonds in relation to their strategic asset mix, as we feel stocks are more attractively valued. That said, we don’t dislike all bonds. Corporate and high yield securities are our friends. This is reflected in the positioning of our Income Fund.