Over the past few months, we have returned to a historically low interest rate environment, due to weak Canadian economic data and Brexit. With low Canadian bond yields, some institutional investors are wondering about their asset allocation strategy and how they can better manage their portfolio to increase the yield and at the same time, take advantage of the current interest rate environment. In order to do so, it may be worth looking at investing in non-traditional Canadian bonds, including foreign bonds and/or high yield bonds.
Foreign bonds can be used to diversify the fixed income portfolio and to provide potentially higher yield, and typically consist of sovereign bonds and investment grade corporate bonds. Sovereign bonds are issued by national governments. These bonds can offer a better yield, but also have a higher default risk due to less stable economies compared to Canada. Foreign investment grade corporate bonds are non-Canadian corporate bonds that have a rating of BBB- or better according to Standard & Poor’s. These foreign corporate bonds can offer a better diversification in the fixed income portfolio alongside Canadian corporate bonds and can provide an improved risk-return profile. Since foreign bonds are often denominated in foreign currencies, one must consider the currency risk.
High yield bonds, on the other hand, are non-investment grade bonds (rating lower than BBB-). Since the high yield bond market is small in Canada, high yield bonds are mostly denominated in foreign currency. High yield bonds have higher risk of default, but offer a better yield. Because the risk is higher than investment grade bonds and sovereign bonds, it is important to understand the risk impact on the overall portfolio. The allocation should depend on the investor’s risk tolerance. High yield bonds can also provide better diversification and a better risk-return profile in the fixed income portfolio. In addition, high yield bonds usually have a shorter duration, which is advantageous in an increasing interest rate environment.
Alternatively to investing directly in foreign bonds and high yield bonds, in order to attain better diversification and potentially higher yields, Core Plus Bond strategies are also an option. Core Plus Bond strategies invest in traditional Canadian bonds, but also have the ability to invest in a spectrum of non-traditional Canadian bonds (the “Plus” sectors), which can include sovereign bonds, high yield bonds, mortgages and emerging market debts. The manager of a Core Plus Bond strategy has the ability to invest in the “Plus” sectors only when deemed advantageous, up to a certain weight as prescribed in their investment policy. A Core Plus Bond strategy can add value from having higher yields in the “Plus” sectors and by entering or exiting the “Plus” sectors at an advantageous timing, which is reflective of the fund manager’s skill. Hence, a Core Plus Bond strategy can usually provide the investors with a better risk-return profile over time compared to traditional Canadian Bonds.
In today’s low interest rate environment, investors do have alternatives in the bond market, in order to seek higher yield and improve their risk-return profile. These alternatives may result in a higher portfolio risk and should be analyzed in a risk framework. Finally, investors can choose to be exposed directly to foreign bonds and high yield bonds, or indirectly through a Core Plus Bond strategy, which offers a more active approach to asset management.
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