by Tom Bradley

Last week in Vancouver, we hosted a ‘Fireside Chat’ with Larry Lunn, the founder of Connor, Clark & Lunn Investment Management (CC&L), the manager of our Income Fund. After a storied career, Larry is retiring at the end of March, so we wanted to grab him while we could.

We should note that Larry has never managed our fund directly, but has advised us on a number of occasions and been involved in CC&L’s asset mix decisions.

As a side note, the session took place on a red letter day. We had just heard that the Income Fund is #1 for 10-year returns in Morningstar’s performance rankings for Canadian Fixed Income Balanced Funds.

We covered a lot of ground in the hour. Here are the highlights.

Interest Rates

When it comes to rates, CC&L has been in the ‘lower longer’ camp for a while now. This has been the right call, although with the recent rise in rates, we asked Larry if this theme still holds.

They believe we’ve seen the lows in interest rates. He noted the 10-Year Government of Canada bond, which now yields 1.6%, was less than 1% for a short time last year. There are reasons to believe rates will continue to rise – a pickup in economic growth, central banks buying less bonds and inflationary government policies in the U.S. – but CC&L isn’t looking for them to climb higher in the short term. Some of the forces that have pushed rates down are still in place – debt levels, demographics and technological innovation.

Bonds

What does this mean for the Income Fund? Rising interest rates would be good for income investors in the long run, but would cause bond prices to go down in the short term. If the rate rise is gradual, the impact will be manageable. In periods when they rise quickly, however, the fund will likely experience negative returns, as it did in the fourth quarter (-1.8%).

CC&L have been upgrading the quality of the bond holdings over the last two years. Larry explained that this not only means focusing on issuers with steady earnings and strong balance sheets, but also ones that have a stake in keeping their credit rating high (i.e. insurance companies and utilities). In other words, companies that are likely to be friendly to bond holders. That’s opposed to strong companies that are more likely to do shareholder friendly things such as acquisitions and share buybacks, both of which weaken the bondholders’ position.

Part of the quality upgrade involved shifting capital from corporate to provincial bonds (now 29% of the fund). The bulk of the allocation is in Ontario and Quebec issues, which offer a yield advantage of close to 1% compared to comparable Government of Canada issues. CC&L is of the view that both provinces will make progress in getting their fiscal house in order. Indeed, Larry pointed out that the new projection for the Ontario deficit is much reduced.

High Yield Bonds

By nature, high yield bonds (sometimes called junk bonds) are anything but high quality. They were introduced to the Income Fund about five years ago because Larry and the team believed the extra risk was more than offset by higher yields. Larry pointed out that so far CC&L has yet to have a default in this category, although that record will undoubtedly be tested because defaults are a part of high yield investing.

Larry confirmed that the high yield component of the Income Fund is currently very conservatively positioned. Half of the fund is in investment grade bonds, which is consistent with the quality emphasis mentioned above.

Stocks

Stocks make up just over a quarter of the Income Fund. CC&L’s approach has been to hold a mix of high dividend stocks (utilities; REITs) and stocks of companies that are growing their dividends. This mix has served the fund well, as dividend-paying stocks have been a key driver of performance over the fund’s history.

As for recent moves, CC&L has been reducing the weighting in interest-rate sensitive stocks and adding to stocks that are more sensitive to economic growth. For instance, the REITs have been brought down to about 4% of the fund, while Finning and Open Text are new additions. Larry pointed out that cap rates (or earnings yield) have been following interest rates down. When rates rise, there will be pressure for cap rates to rise, which will reduce property values.

Larry and I didn’t have time to reminisce about the changes he’s seen over his 40+ years in the business, but for those who are interested, CC&L’s most recent Outlook delves into this.