Investors don’t need to resort to high-yield bonds or other risky parts of the fixed income market for cushioning against interest rate hikes, according to Canada Life’s David Arnaud (pictured). 
The manager of the CF CanLife Global Bond fund says there are other, safer ways to generate attractive yields from bonds that don’t involve such a high element of risk.
Arnaud points out that no asset class is without headwinds, due to the volatility of equities and the plummet in the value of commodities. As such, he explains in the below list how investors can make the most out of bonds in an environment that is generally bearish for the asset class.
Don’t buy into high yield
Arnaud points out that investors don’t have to buy ‘junk bonds’ and risk their capital to hedge against a rise in interest rates, and argues that this can be detrimental to your portfolio.
According to data from FE Analytics, 75 out of 83 high-yield bond funds have returned less than 5 per cent over the last 12 months, with City Financial High Yield Opportunities and M&G European High Yield Bond suffering the biggest losses of 11 and 9.8 per cent respectively.
Performance of funds over 1yr
Source: FE Analytics
“When you buy bonds you can buy government bonds which are completely exposed to interest rate movements, but you can also buy corporate bonds, which our fund does,” he said.
Specifically, the manager says that protection against rate rises can be increased by seeking corporate bonds that will benefit from a pick-up in the US economy and an increase in consumer spending.
While many investors will nevertheless be deterred from investment-grade bonds because of their lower yields, Arnaud points out that there are still varying levels of risk and return in the investment grade space.
In order to prepare for a potential rate rise, the manager is also buying into the highest spread of products within the investment grade space as possible.
Currently, CF Canlife Global Bond holds between 5 and 10 per cent in hybrid bonds, which are a mix between an equity and a fixed income bond, and 5 to 10 per cent in CoCos, or contingent convertible bonds.
“These products are so much cheaper, but obviously that’s because they’re riskier for an income investor,” Arnaud admitted.
“If the bank you’ve invested in gets in trouble, for instance, you shouldn’t be impacted if you’re a bond investor in theory – your debt is not going to be written off. With those CoCos, it can be.”
Arnaud says these assets can be very lucrative but investors must be selective and thoroughly research the products.
“Some of those bonds have a high yield rating, but the reason they’re high yield is because of the structure, it’s not because of the issuer. That’s why I say I don’t buy high yield bonds because I don’t buy high-yield issuers,” he explained.
Don’t hedge currency
Unlike many of his peers, Arnaud chooses not to hedge the currency in his portfolio. Again, investors may initially shun this idea due to the rapid depreciation of currencies across the globe.
“The fund is sterling denominated but I will buy US dollar assets, euro assets, anything. The first question I get asked is how I manage my currency risk,” he said.
“The answer I give is diversification. The idea is, if you provide enough diversification within your basket of currency, one loser is the other one’s winner.”
“Slowly over time I’ve begun taking stronger views on currencies. When we started the fund the idea was, I’m not a currency trader so let’s stick to what I do best, which was selecting corporate bonds and taking duration views.”
Arnaud says that now the fund has been running for three years, he is more inclined to take currency views. This is not only because his skills have expanded into the FX world, but because he believes currency views are more important than ever based on where yields are at the moment.
The manager believes that, because yields are so low, it is becoming increasingly difficult to generate returns purely from fixed income.
“You can obviously see the downside, the upside is harder to see. At the same time currency movements have been really big over the past two years and you need to have your currency mix right if you don’t hedge,” he explained.
“Most people would hedge the currency risk, but for me I think it makes it a bit different from other products.”
Recently, the manager has reduced his exposure to Europe following the depreciation of the euro and increased his exposure to the US, chiefly because quantitative easing in the region has increased downside pressure on the euro, causing it to depreciate.
Performance of currencies vs sterling in 2015
Source: FE Analytics
Instead, Arnaud has increased his exposure to the US in light of impending rate rises, which he says will be beneficial for the currency.
“Rates in the US are going up and everyone is preparing for that, even though we have a 50 per cent chance of a rate rise in September, which means 50 per cent of investors don’t think this is happening. In any case, if it happens in September, or October, or December, the US dollar is going up, and that’s exactly the same story in the UK,” he said.
Arnaud is also buying into sterling assets for a similar reason and believes that if investment grade bond holdings are struggling, an investor can boost their overall performance significantly through currency plays.
Don’t let the bond bears put you off
Arnaud says the big three themes being discussed by the financial media – China, oil and central banks – are overshadowing good stories for bonds, chiefly the recovery in Ireland and Europe.
Over the last two years, the fund has been significantly overweight compared to its benchmark in both regions and holds between 5 and 10 per cent weightings in each.
“Both economies have been doing extremely well – they have been the highest-growing economies in Europe. All that tension within the eurozone, either we were spending months talking about Greece, or we just spoke about German growth and how important the French economy has been,” he explained.
“I think the good news in Spain and Ireland has slipped under the radar, so I think the media should give them a bit more credit for that.”
Ultimately, Arnaud says that utilising the bond market is a case of seeking value and adopting a stock-picking approach as opposed to taking heed from the bond bears and focusing purely on macro.
“Coming back to a fundamental analysis approach, you should look for pockets of value in the market like a traditional investor should, and you look at whether the business holds good ideas for example,” he said.
“That ethos completely disappeared over the past two years. Last year it didn’t matter what you bought or where you were buying, as long as you were buying peripheral Europe, you were going to make money.”
“Now, all that trade is finished and you need to be more selective than ever.”
CF CanLife Global Bond has underperformed its peer average in the IA Global Bond sector over the past three years. However, it has narrowed the performance gap between the composite over the last year, returning just 0.32 per cent less.
Performance of fund vs sector over 1yr
Source: FE Analytics
The fund has a clean OCF of 0.83 per cent and yields 3.07 per cent.
