Time to take a risk with non-core bond funds

If you’ve been investing for a while, you probably have fond memories of the good old days when you could load up on investment-grade domestic bonds and earn plenty of income. You likely enjoyed periodic capital gains too, because bond prices received a boost when interest rates were trending down. Well, that golden era of investing appears to be over, now that interest rates have hit a trough of record lows. And then there’s the risk that interest rates will start climbing and cause capital losses, since bond prices move in the opposite direction. Thankfully, there are still some options to fix up your fixed income—at least to some extent.

One good strategy is to look beyond traditional domestic investment-grade bonds for some of your fixed income allocation. This is often called a “core/non-core” strategy, since you’re adding somewhat riskier “non-core” investments to the larger “core” that remains invested in stable and reliable investment-grade fixed income. The key thing is to be highly selective about adding non-core investments and do it only in modest amounts. “Really skilled managers that can find nuggets of underappreciated opportunities can be a real boost to your portfolio,” says Christopher Davis, director of manager research at Morningstar Canada.

In what follows, we review different options to add “non-core” fixed-income allocations, including high-yield North American corporate bonds and higher-yielding international bonds.

A word of caution

The main objective of adding non-core fixed income is to generate a little more yield without taking on too much extra risk. Often, they are also a little less interest-rate-sensitive compared to core fixed income. But there’s no free lunch. Non-core investments generally involve more credit risk and often perform poorly when economic conditions deteriorate, which typically happens when your stocks are also suffering. Therefore, you need to be selective. These days, “you have many investors who are stampeding into these riskier asset classes just to get higher yield,” says Davis. “What could end up happening is that in order to earn a little more income, you can end up losing a lot more money in the end.” (If you’re moderately conservative, my general advice it to limit non-core holdings to 10% to 20% of your fixed income.)

Before we proceed, it’s also worth noting here that preferred shares, which offer a hybrid of equity and fixed-income features, should never be considered part of your fixed-income allocation without making allowances for their specialized risks. Preferred shares have higher credit risk than bonds of the same company and no maturity, so you have no assurance that you’ll get back a fixed amount of principal after a set term. On the other hand, they provide relatively reliable income under most circumstances. In “A great time to buy preferred shares” below I discuss why they may appeal to certain investors right now.

Take a trip abroad

The idea behind going with higher-yielding international fixed income is to get a team of global experts to scour the world for the best opportunities wherever they occur. “You can add some potential yield and spread out your risk by adding fixed income from around the world,” says Dave Richardson, head of enterprise distribution strategy at RBC Global Asset Management.

RBC recommends adding this type of non-core holding to many of the portfolios it helps manage. For example, if your risk tolerance is moderately conservative, an RBC financial planner in a branch might recommend an RBC Select Balanced Portfolio of RBC mutual funds, with 17% of the fixed-income component allocated to non-core higher-yielding international bonds. That’s achieved mainly through the RBC Global High Yield Bond Fund and the BlueBay Global Monthly Income Bond Fund.

If you’re interested in what other fund companies offer, two respected examples are managed by PIMCO and Templeton, as noted in the “Boost Your Yield With Non-Core Funds” table to your right. The PIMCO Monthly Income Fund invests in a number of high yield areas but is best known for its savvy investing in U.S. mortgage-backed and asset-backed securities. The Templeton Global Bond Fund has demonstrated a particular knack for picking sovereign bonds offering decent yields in strengthening economies, and may take sizeable positions in diverse currencies such as the South Korean won or Mexican peso.

Richardson believes the trade-off of a little higher yield with less interest sensitivity at the cost of greater credit risk works well at the moment. “The theory is when you’re in a rising interest rate environment, that’s typically a signal of a stronger economy, and that reduces default risk and improves the relative performance of those non-core fixed-income assets,” he says. Of course, international bond managers must also deal with currency risk, which they can either eliminate at a cost through hedging, or deliberately take on as part of a currency strategy.

High yield closer to home

Robert Pemberton, managing director and head of fixed income for TD Asset Management, also embraces “core/non-core” strategies, but sees a narrower set of attractive non-core opportunities at the moment. Right now, Pemberton sees value in selective high-yield North American debt rated just below investment grade at BB or B.

“In the current environment, I’d much rather have my non-core investments in quality BB or B issues in an industry I understand well, with a management team that’s grown up in that BB or B environment,” he says. “They know how to run a company like that, know how to generate the cash flow, know how to grow the business and know how to build stable long-term opportunities at that level of leverage.”

These days, however, Pemberton doesn’t think the risk-reward trade-off works so well for other non-core areas like emerging markets debt compared with other options. For example, he says if you invest in a 10-year Brazilian government bond and hedge it back to the Canadian dollar to eliminate currency risk, the resulting yield is similar to what you can get from a 10-year Canadian telecom company bond, which offers more familiar credit protection to bondholders. In that comparison, Pemberton thinks the Brazilian bond is no bargain. “I’d rather own a Canadian telecom bond,” he says.

Simply done

One good approach to setting your fixed-income allocation between different areas of core and non-core is to pick a mutual fund that simply does it for you. That’s the approach of the TD Canadian Core Plus Bond Fund.

“It allows the portfolio manager to look beyond the Canadian market when you’re appropriately compensated to do so, but it doesn’t force you to be in that asset when it’s expensive,” says Pemberton. The fund can invest up to 30% overall in non-core investments, but it makes substantial shifts between different core and non-core sectors according to where it sees the best combination of risk and reward.

If you want to pick your own non-core high-yield North American corporate bond fund, TD offers the TD High Yield Bond Fund, which focuses mainly on BB and B rated issues at the higher quality end of below-investment grade and mostly hedges its U.S. currency exposure back to the Canadian dollar. Another respected fund is the Fidelity American High Yield fund. The version of the fund unhedged for currency achieved particularly good returns in 2014, partly due to the strength of the U.S. dollar. (The currency hedged version charges an MER of 2.2%, which is relatively high.)

While all the strategies listed above can help boost yields in your fixed income, just be aware they may not give you as much yield as you’d like. As Hank Cunningham, fixed income strategist at Odlum Brown, points out, “There’s not much more yield in this market.” Sometimes you have to accept that’s all you can get.

A great time to buy preferred shares

If you own “fixed reset” preferred shares, you’ve probably noticed that their prices have taken a huge hit recently. But for new investors this might provide a good buying opportunity, says preferred share specialist James Hymas. Fixed resets were designed to counter the vulnerability of traditional “straight” perpetual preferred shares to rising interest rates. In contrast, fixed reset dividends are typically based on spreads over five-year government bonds, then reset after five years based on interest rates that prevail at that time-—making them less sensitive to increasing rates. After the 2008-2009 financial crisis, many investors wanted reliable yield but feared rising rates, so they piled into these investments. Now fixed resets comprise roughly 2/3 of the preferred share market versus only 1/3 for traditional straight perpetuals, he says.

Unfortunately, for fixed resets issued in late 2009 and 2010, interest rates have gone down rather than up. So as these issues have hit their five-year reset date, dividends are being reset downwards. The consequences have been severe. For example, the dividend of a widely held issue of TransCanada Corp. (TRP.PR.A) was reset 29% lower last December.

But after investors reacted by dumping fixed resets and driving prices way down, many fixed resets now offer good values, says Hymas, author of the PrefLetter newsletter. “As far as I can make out, straight perpetuals are cheap, fixed resets are even cheaper,” he says, noting that he recently recommended an Enbridge fixed reset (ENB.PF.G) which was yielding more than 4.5% when we went to press. In addition, fixed reset dividends could increase at the next reset date, if interest rates eventually do go up.

Preferred share dividends of Canadian companies get the same preferential tax treatment as Canadian common share dividends, so they’re best suited to non-registered accounts. These investments should appeal to some investors in specialized situations but come with specialized risks, so do your homework before buying.