Fixed-income investing: Traditional or alternative options?

Many investors think of fixed-income investments as bonds and GICs, but there are many options to consider — especially at a time of higher or uncertain interest rates.  

Advisor.ca spoke to four industry professionals about what fixed-income exposure could look like in the current economic climate in Canada.  

Here are the different approaches they shared. 

Approach #1: Stay traditional 

Josh Sheluk, portfolio manager with Verecan Capital Management Inc. in Burlington, Ont., made the case for revisiting government bonds, seeing how interest rates appear to be on a downward trajectory.  

“Today there’s probably greater merit in having a more traditional allocation to government bonds, whereas a couple years ago, your return outlook for government bonds was very, very challenging,” he said. 

Sheluk also suggested increasing duration.  

“A couple years ago, when interest rates were super low and inflation was sort of rearing its head, that was the time when your duration on fixed income, as an example, likely was going to benefit from being very short,” he said.  

“Whereas today, as you see the Bank of Canada start to pivot into reducing rates and potentially continuing that reduction, [a] more traditional duration balance would be, I think, more suitable.” 

Sheluk said an investor’s remaining fixed-income allocation depends on the portfolio’s mandate, but suggested “it’s not the time to get exotic with investment allocations in the fixed-income side.” 

“At the margin, I would say that government bonds are reasonably attractive today, whereas credit is not very attractive today, because credit spreads are extremely low in a period of potentially higher uncertainty economically,” he added. “You’re not getting very well compensated for taking on additional credit risks today.” 

Approach #2: Look to alternatives 

Kevin Foley, managing director of institutional accounts with Oakville, Ont.-based YTM Capital Asset Management Ltd., shared a different perspective.  

Foley said investors should consider fixed-income options that are less exposed to interest rate risk, adding that a core bond or universe bond mandate “hasn’t worked for a long period.” 

As such, he suggests the following allocations in a 60/40 portfolio: 10% short-term government bonds, 7.5% corporate credit, 7.5% mortgage funds, 5% private debt, 5% infrastructure funds and 5% real estate. 

“It’s not zero interest-rate risk, but it’s probably less than what you once relied upon,” Foley said. 

In terms of corporate credit, investors can get direct exposure by owning corporate bonds or funds that isolate exposure to corporate credit spread, Foley suggested.   

“Investment-grade corporate bonds, especially shorter-term ones, have much less volatility than the interest rate portion of a [government] bond, so that’s one of the benefits to funds that have focused on isolating that credit spread and proven to outperform traditional fixed income in the last many years,” Foley explained.   

To mitigate credit risk, Foley said investors should assess the liquidity and historical volatility of corporate bonds before investing in them. Diversification within a portfolio can also help an investor manage credit risk, he added. 

As for infrastructure funds, mortgage funds and private debt, Foley said investors should ensure they have been valued fairly and recently — and be mindful of long lock-up periods.  

Further, he said real estate is expected to generate steady long-term capital appreciation with low correlation to other major asset classes, particularly equities.   

“It’s long proven to be an effective part of a portfolio,” he said. “I will note … infrastructure and real estate seem to have sort of inflation built into them, so they help the portfolio, [and] offset the rise in inflation.”   

Approach #3: Diversify using convertible bonds and covered-call ETFs 

Vernon Roberts, options strategist with Global X in Toronto, said covered-call bond ETFs are a robust option for diversifying a fixed-income allocation.  

The premium received from selling bond call options provides an income stream on top of the covered-call bond ETF’s yield. However, covered calls limit upside potential and don’t prevent losses. 

Roberts said a more risk-averse investor should lean toward shorter-duration covered-call ETFs. Conversely, active, longer-duration products that write fewer calls offer more potential for upside participation when the yield curve shifts downward, he said. However, such products may involve more volatility. 

In an environment where interest rates are falling, Roberts said rising volatility may cause some covered-call bond ETFs to generate additional yield than would a comparable bond portfolio.  

Convertible bonds also present an underappreciated opportunity in fixed income, Roberts said. They “can be interesting because they allow you to get access to common stock and be able to convert from the bond to the equity,” he explained.    

The main draw of convertibles is that they offer the relative certainty of a bond along with the opportunity to participate in a company’s growth.   

The downside, however, is that an investor must accept an interest rate that’s lower than the bond’s risk level would justify in exchange for the potential equities gain.   

A more risk-averse investor can lean toward a portfolio that is weighted more toward covered-call bond ETFs than convertible bonds, Roberts suggested.   

On the other hand, during times of increased market volatility, he said a less risk-averse investor may consider convertible bonds as they offer a chance to participate in a rise in the underlying equity price.  

Approach #4: A blended approach 

Depending on an investor’s risk tolerance, a fixed-income bucket could be made up of three-quarters corporate credit, including 50% investment-grade and 50% high-yield corporate bonds, and a quarter government bonds and GICs, said Geoff Castle, lead portfolio manager of fixed income at PenderFund Capital Management Ltd. in Vancouver. 

He said in some sectors, yields from corporate credit are much higher than yields from government bonds — seeming to reflect the weaker economy that might result from this period of higher interest rates. 

As well, Castle said a higher-yielding portfolio can protect the value of an investor’s portfolio against inflation.   

“You really should look at … longer-term or more credit-exposed fixed-income mandates at this moment because there’s a lot of value there, relative, I think, to what value there is in cash,” he said, especially as cash’s recent stellar performance is an anomaly. 

Castle also recommends looking for companies that both issue convertible bonds and have underpriced stocks in out-of-favour sectors. For example, several technology companies’ stocks fell significantly over the past few years, presenting an opportunity, 

“Many of these were convertible bond issuers [with] bonds priced at 40 to 60 cents on the dollar,” he said.