Q. Why did you launch an investment grade income strategy 5 years ago?

Our Investment Grade Income Model was launched in 2018. We saw an opportunity to create an innovative investment grade bond strategy that combines our proprietary quantitative methodologies with extensive experience in income security analysis. Our review of the Canadian investment grade bond landscape identified several gaps in the marketplace that we felt we could fill with our solution.

Our Investment Grade Income Model compliments our Income Model, an income strategy that we have been managing since 1998. The Income Model has the flexibility to purchase higher yielding corporate bonds and debentures, preferred shares, REITs, and high dividend-paying stocks.

Q. What were the gaps in the marketplace?

1. Few pure Canadian investment grade strategies

Our review of the Canadian bond landscape revealed few pure Canadian investment grade bond options for Canadian investors. As of July 31st, the average fund in FundLibrary’s Canadian Corporate Fixed Income category had approximately 85% invested in Canadian corporate bonds, with the remainder a mix of mortgages, international bonds, government bonds, and cash. Only 23 of over 140 funds within the category had more than 95% of their portfolios invested in Canadian corporate fixed income. Our Investment Grade Bond Model invests exclusively in Canadian investment grade bonds, making the model an ideal solution for Canadians seeking reliable income from our country’s leading businesses.

2. High concentration in Financials and the Largest Bond Issuers

Canadian banks, insurers, utilities, REITs, and the major communications companies make up the bulk of investment grade bond issues. Canada does not have depth in technology, health care, or consumer products to make these sectors a major part of the investment grade bond landscape. Moreover, there are typically a handful of large players in each major sector. Consequently, many Canadian investment grade bond strategies tend to be concentrated in the same sectors and companies. For example, Canada’s largest investment grade bond ETF, the iShares Core Canadian Bond ETF, has nearly a quarter of its assets invested in the big five Canadian banks, with the combined Financial and Energy sectors representing over 60% of the ETF.

Our Investment Grade Income Model places a 3% notional limit per security and our industry weighting is notionally limited to 25%. These limits provide greater security and sector diversification.

3. Lack of Investment Innovation

Our approach utilizes a factor approach to investment grade bonds. While popular in the United States, few Canadian managers utilize a quantitative approach for investment grade security selection.

Crafting our investment process was a significant undertaking. Investment grade bonds present an interesting challenge: there are thousands of bonds but liquidity is sporadic. The end solution melded our quantitative tools with old school, over-the-counter trading.

Q. Can you elaborate on your investment process?

Our starting point is a universe of over 1,000 investment grade bonds. We rank bonds on their duration, yield, financial strength, and momentum. 

1. Duration. Duration measures how long it will take for an investor to be repaid the bond’s price from the interest payments received from the bond. It also serves as a measure of how sensitive a bond’s price will be to changes in interest rates. For example, a bond with a duration of 6 years will be approximately 3 times more sensitive to a 1% increase in interest rates than a bond with a duration of 2 years. In our model, the lower duration the better.
2. Financial Strength. Bond issuers are rated on debt-to-equity, interest coverage, and profitability.
3. Momentum. Bonds are ranked on their relative performance over the last 12 months.

4. Yield. Bonds are ranked on their option-adjusted spread (OAS). A bond’s OAS is the difference between the bond’s yield and the risk-free rate of return, adjusted to consider embedded options in the bond (e.g., a call option which gives the issuer the right to redeem prior to maturity).

Using our economic model, TEC^TM, we make an interest rate forecast that influences the target duration of the portfolio. If we feel interest rates are likely to rise over the intermediate term, target duration will be less than the investment grade benchmark’s duration (typically 6-7 years).

Our proprietary TRAC^TM system is then used to optimize buy and sell decisions for targets and portfolio holdings.

Q. How do investment grade bonds fit within a portfolio?

Within a portfolio, investors can rely on their allocation towards investment grade bonds to deliver consistent income with very low default rates. Historically, investment grade-rated corporate bonds have had a very low default rate. According to S&P, the average annual default rate for AA-rated bonds over the last 30 years has been 0.20%. The default rate for AAA-rated bonds has been close to zero.

As safer and less volatile income securities, investors cannot expect the same total return that other income alternatives like high yield bonds, high dividend yielding equities, real estate, or infrastructure provide over an expansionary economic cycle. However, over the entire economic cycle, investment grade income serve as an important component within a portfolio, providing reliable income and low volatility and default rates.