MAKING WISE PREPARATIONS FOR HIGHER BOND YIELDS

BY JONATHAN RATNER

The U.S. Federal Reserve’s objective to gradually and slowly remove monetary stimulus may be clear, but its time frame and conviction are not, which is why Dynamic Funds’ fixed-income team anticipates higher bond yields coming in the next couple of years.

“However, that path is likely to be very bumpy,” said Michael McHugh, who manages the Dynamic Advantage Bond Fund with Domenic Bellissimo, Bill Kim and Daniel Yungblut. “It also remains unclear how the economy will absorb this change after five years of very low rates.”

As a result, the fund’s portfolio now has a lower duration of four years, compared to approximately 6.8 years for the Canadian benchmark DEX Universe Bond Index.

“We’re in an environment where it’s beneficial to reduce the interest-rate risk in the portfolio, because of the sensitivity of fixed income at low yields,” McHugh said.

The managers have also been shifting the fund’s asset mix by gradually increasing the credit quality of corporate bond positions.

“Fundamentals have been deteriorating, albeit slowly, and we’re seeing more leverage in the system,” Bellissimo said. “Income is growing slower than debt on corporate balance sheets, as companies are more willing to add debt through share buybacks and dividends.”

He also noted event risks such as leveraged buyouts are more prevalent in this environment.

With risk premiums in both the investment-grade and high-yield space in line with where they were in 2007, the managers believe valuations are vulnerable and are looking for periods of volatility to add to their corporate bond weighting.

The fund’s corporate bond weighting (including foreign and high yield) has fallen to about 55% today from 65% in late fall 2013.

Some of that money has moved into federal government bonds and floating-rate notes (7% of fund), prompted in part by a decline in two-year yields to around 0.9%.