Gearing up for rate risk
Portfolio manager says there’s never been a better time to hedge fixed income
Fixed income has been a pretty easy trade for the past 30 years or so. If the company or country didn’t go bankrupt, you made money. But in an environment of low yields and rising risks, bonds traditionally haven’t been able to deliver.
Whenever the normalization of interest rates occurs, and whatever that looks like, investors can still participate today, but they need to be ready.
Phil Mesman, senior partner and portfolio manager at Picton Mahoney, considers rate risk in government bonds the biggest threat in the fixed-income market today.
“The case for having hedging in fixed-income portfolios has never been stronger,” Mesman said.
“Nobody has an information advantage over where and when rates are going, every central bank in the world that can ease is easing, and much of the investor base is young so it has never seen a bearish rate market before. I don’t like the setup of the rate market.”
With more than $7 billion in assets under management primarily for institutional and high net worth clients, the firm offers the Fortified Income Fund to all investors.
Mesman focuses on portfolio construction, looking for challenges in the markets, and building solutions around them. Another key is protecting the portfolio, which is concentrated in medium-grade corporate bonds in the B to BBB range, and only developed markets. Currency is hedged back to the Canadian dollar.
The portfolio manager believes we could see more volatility in fixed-income again, and the environment reminds him of the energy credit market in 2014 and 2015, where investors were really uncertain.
Mesman also highlighted the challenges created by regulations that prevent dealers from providing liquidity to the market.
“It is a game changer,” he said. “Now the bonds go right to the market, which is fine as long as markets are behaving normally. But when you get into a challenged market, you’re getting liquidity-driven sell-offs that are more dramatic than what investors are used to within fixed income.”
That was very evident during the Taper Tantrum of 2013, and during the liquidity-driven sell-off in late2015, early-2016.
Mesman invests the portfolio in two buckets, the first of which is labelled “patient capital.” Representing the majority of the portfolio, it consists of coupon clipping the most stable corporate bonds, with low volatility.
He highlighted HCA Healthcare Inc. as an example, given that it’s stable cash flow business that has been around for a long time, in addition to potential for a ratings upgrade.
That part of the portfolio is complimented by “yield with upside,” which targets catalysts for better returns.
Mesman believes some of the best risk-reward opportunities are in really good companies that are taking out a bond to optimize either their capital structure (such as get cheaper financing ), bond structure (to take out a restrictive covenant), or organizational structure (to simplify the overall company).
The portfolio manager bought two Great-West Lifeco Inc. bonds earlier in 2017 that were trading at a discount to what he believed they would get called at — par ($100) — at the next call date.
“These bonds were trading at a discount because the company decided not to call a similar U.S. pay bond, since it was cheaper to leave it outstanding,” Mesman said. “That penalized these two bonds in the process, as investors were worried they wouldn’t call them either.”
He studied the bond covenants and financial choices, and concluded that the company would likely take them out. The company concurrently issued a new Euro pay bond at much cheaper financing, which affirmed that view.
Picton Mahoney also tries to extract value by approaching companies directly through “friendly activism.”
One example of this was when Viterra Inc. was being acquired by Glencore Plc a few years ago.
Glencore offered Viterra bondholders in both Canada and the U.S. a concession — a few points — to take out the covenants and no longer require reporting from Viterra.
The U.S. bond investors signed off, but the Canadian investors said no. Glencore offered a little more money, but Viterra investors still said no.
“Glencore walked, no deal,” Mesman said. “We saw that as the beginning of the opportunity.” The bonds sold off, Picton Mahoney took a position and eventually became one of the largest holders.
The firm waited several months, then approached Glencore directly, highlighting that it didn’t make any sense to have this bond outstanding, particularly because the covenants were restrictive.
“We negotiated with them directly, found a price that made sense for both parties, and they took the bonds out,” Mesman said. “Today, covenants are probably more powerful than they’ve been since the early 2000s.”