Bonds have a reputation for dullness. The bond market is where insurance companies and pension funds slug it out for what are often small gains. Yet the very professionalism of most of its players makes it the most cerebral of all capital markets. Unlike stocks, which tend to trade as much on market mood as on serious analysis of company earning prospects and balance sheets, the bond market is all about macroeconomic trends, expectations of moves by central banks and credit analysis of issuers of corporate bonds. It’s tough to break in without a good grounding in calculus and a chartered accountant’s nose for earnings statements.
Michael McHugh is a veteran of the Canadian bond market. At the age of 48, he has managed the Dynamic Canadian Bond Fund for eleven years. With $705-million in assets, the Dynamic fund is part of the $3 billion total he pilots in a variety of bond and money market funds. It’s a big job in a part of the investment industry where managers would kill to boost their annual gains by just a quarter of a per cent.
McHugh’s results show he is managing well. For the 12-months ended April 30, 2009, the Dynamic Canadian Bond Fund was up 5 per cent. That may not seem like a great deal, but it’s a strong result that places the fund in the top quarter of all Canadian fixed income mutual funds for the period. It’s also more than double the average annual gain of similar funds that were up just 2.4 per cent for the year. Moreover, McHugh’s portfolio lost nothing. Compared to the 33.4 per cent drop in the value of Canadian stock funds for the 12-month period, it’s big win.
“We made the right calls in the last year,” McHugh says. “In an environment of despair and forced selling, we recognized the attractive prices of Canadian corporate bonds from strong, well-capitalized companies. We increased our weight of those bonds by 20 per cent to half of the entire fund portfolio, and that helped to drive our returns in 2009.
“We have come through a very challenging time,” McHugh notes. “We avoided a lot of problems that other bond funds and money market funds had by not buying Asset Backed Commercial Paper — the I. O. U.’s that turned out to be constructed on bad collateral. We could not identify the assets that generated the returns, so we stayed away.”
This is more than shrewd trading. McHugh works through historical statistics and financial models to find potential returns that others are missing. And then it takes conviction and courage to put money on that analysis.
“Bond investing is much more competitive than stock investing,” McHugh explains. “The problems begin with figuring out how to blend government bonds that have no risk of default and, these days, offer very little yield, with corporate bonds that always carry some default risk and with high yield bonds that have terrific returns and significant default risk.” He also needs to keep some cash on hand to buy other bonds.
With a background in economics and a résumé that includes duties as an analyst at Walwyn Stodgell Cochran Murray — a Bay Street powerhouse taken over by an American bank — McHugh worked his way up through the Hospitals of Ontario Pension Plan. The task in every case, he says, was to manage risk.
“You have to maintain yield with the correct level of risk, balancing credit risk, the risk that interest rates will rise or fall, availability of bonds and the receptiveness of the market to trading,” he explains.
BOND YIELDS WILL RISE AGAIN
After work, McHugh retreats to his home in a bedroom suburb of Toronto where he sits down to an after dinner menu of reading financial history and economics. “My job is an extension of my hobbies,” he explains.
“We are at the end of a secular decline in bond yields and at some point, yields will rise. So it is important to think about ways of reducing interest rate risk. When rates rise, existing bonds with low interest rates will be unappealing and their prices will tend to fall. So we have to think about ways of reducing this risk of price decline.”
McHugh lays out the ways his bond fund can take a defensive position so that it will not be hurt by rising interest rates. First, he can sell long-dated bonds that are the most sensitive to rising interest rates. Second, he can buy floating rate notes that reset their payouts and produce rising income that can parallel rising interest rates. Third, he can use the bond futures market to fix future bond income flows. “Those will be useful strategies once the global financial crisis has ended and growth accelerates,” he explains.
Long run planning is only part of the job. The other is following news that impacts the bond market. McHugh starts his day at 6:25 a. m. when he boards a commuter train and starts to go through
“…some time in 2010, we will see money moving out of government bonds as people become more comfortable with investing in stocks. That will cause bond prices to drop and corresponding interest rates to rise.”
financial news in print and on his Blackberry.
Then, at his office, he starts his pre-market pencil work.
“I review pricing on government debt and corporate debt, do conference calls with traders and sales reps for information of what is trading, what new issues are coming to the market, and what amounts of money I have to invest. Our average trade is in the $15 million to $30 million range. That’s a baby size compared to what a big pension fund does. But we are able to hold our spreads between bid and asked to two to 10 basis points of yield [there are 100 basis points in a single percentage point] on government bonds and 10 to 30 points on corporate bonds. Those spreads are a tenth of what a retail buyer pays on a sale.
The bond market goes through sea changes — call them long waves — that are nearly unknown in the stock market. Interest rates rose with rising inflation until, by August 1981, Canada’s prime rate of interest was 22.75 per cent. In that environment, prices of existing bonds with single digit coupons collapsed. Then from 1982 until now, interest rates generally declined, creating one of the best markets in history for government bonds, though leaving corporate bonds with potential defaults in limbo. Today, the bond market is going through a period in which major dealers, such as big bank brokerages, are reluctant to hold bonds in inventory. That makes it hard to find and trade bonds, McHugh says. The problems of bond investing have become more tactical than usual. But risk management, he adds, is still the main driver of returns.
“Recovery for the world economy is going to be slow,” McHugh explains. “We have global overcapacity in industrial production. Along with rising productivity, it means that goods can be produced with fewer workers. That will tend to keep wages down and prices low. There will be rising unemployment as well. Consumers will continue to have high levels of debt and rising food costs will reduce money available for other goods. All of that will tend to restrain interest rates.”
But rates will eventually rise, McHugh says. “That will be some time in 2010. We will see money moving out of government bonds as people become more comfortable with investing in stocks. That will cause bond prices to drop and corresponding interest rates to rise. As well, governments will be adding to the supply of long bonds, further depressing their prices. All that will be pushing up interest rates.
“And it will spread down to bonds due as soon as five years. This means that the defensive place to be will be in investment grade corporate bonds and government bonds due in two to five years. And that is where we will be.”
In the end, McHugh is playing in a field in which winning is good but losing is worse. “Bond managers have to work with uneven risk,” he says. “The rule in this business is that you must not lose money and then, with that done, you try to get the best risk-adjusted return you can. We have a fund with fees below average and we are delivering returns that, even with the fees figured in, are beating the market.”
Andrew Allentuck is the author of Bonds for Canadians (Wiley, 2006). His latest book, When Can I Retire? Planning Your Financial Life After Work, was published by Penguin Canada earlier this year.