In this issue:

• What’s New
• 2014 Prediction Review and 2015 Outlook
• The One Fund to Own for 2015
• Improved Fund Rating System for 2015
• Portfolio Strategy – Rate Rises Spell Trouble for Bond Investors
• Beware of Prospectus Risk Ratings
• Reader’s Questions

What’s New

♦ Final Index Returns – All things considered, it was a pretty solid year for investors, with most major indices showing gains in Canadian dollar terms. In a few cases, for example EAFE, Europe, and Japan, the only reason Canadian investors finished in positive territory was because of the sharp decline in the value of the Canadian dollar. Over the course of the year, the dollar fell from $0.9402 to end the year at $0.8620. The returns of some of the key market indices can be found in the table below:

Index	2014 Return (Total Return, C$)
FTSE TMX Canada Universe Bond	8.79%
S&P/TSX Composite	10.55%
BMO Small Cap Blended	-0.09%
S&P 500	23.93%
Russell 2000	14.35%
MSCI EAFE	4.12%
MSCI World	15.01%
MSCI World Small Cap	11.54%
MSCI Europe	2.82%
MSCI Japan	4.96%
MSCI Emerging Markets	7.03%

 

♦ Mutual Fund Sales pick up in November – Not even the nasty return of market volatility could keep investors away in November, as more than $4.3 billion in new money flowed into mutual funds in the month. This was up nearly 70% over October, and 7% higher than last November. For the past 12 months (ending November 30), more than $62 billion of new money has been invested. In November, balanced funds attracted the lion’s share of fund flows with more than $3.3 billion of inflows. Equity funds ran a very distant second, seeing $588 million of net sales. Total assets in funds sat at $1.16 trillion, up slightly from the previous month.

 

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2014 PREDICTION REVIEW AND 2015 OUTLOOK

By Dave Paterson, CFA

Now that we have turned the page on 2014, I thought it might be a good time to take a look back to see how many of my predictions from last year turned out. But before I do that, let me point out that when I make a forecast, it is just that, a “best guess” on what I think will happen based on the data points I have available to me at the time. As we all know, what we think should happen doesn’t always pan out as expected. I guess that’s what makes it so much fun.

General and Economic

My general thoughts last year were that equities would outpace bonds. Within equities, I expected that the U.S. would again lead the way with Canada not too far behind. I had expected more uncertainty out of Europe, but thought that the emerging markets were poised for a turnaround.

I was mostly right. Equities, at least Canadian and U.S. equities outpaced bonds for the year. Europe continued to struggle, as did the emerging markets.

I had also expected to see a continuation in the economic recovery in the U.S. By and large, that has played out as expected, with recent data showing increasing momentum. In Canada, evidence is starting to show a bit of a slowdown emerging, however with the U.S. recovering shifting up a gear or two, this is likely good news for Canada.

Another positive is the recent weakness in our dollar relative to the U.S. greenback. The Canadian dollar sank from $0.9402 to $0.8620 over the year, with most of the drop happening in the last quarter of the year. It should come as no surprise that this drop also coincided with the rapid decline in the price of oil.

While I had been concerned about valuation in the energy sector, and had expected prices to moderate a bit, I in no way expected to see the swoon in prices we witnessed. With worries that a slowing global economy will continue to dampen demand combined with increasing supplies and OPEC’s refusal to cut output, we saw oil sink by 46% in the year. This is likely to be a net positive for provinces like Ontario and Quebec, putting more money in the hands of consumers. However, an extended period of lower prices could prove disastrous to Alberta, Saskatchewan and Newfoundland.

As I look ahead, I expect that the economic recovery in the U.S. will continue to lead the way higher. As this happens, the Fed may be pressured into moving overnight rates higher sooner than many expect. The consensus now is somewhere mid-year. However, if we see continued gains in job growth, they may move even sooner than that.

In Canada, I expect we’ll see a rebound in the second half of the year as our export sectors benefit from an improving U.S. economy and a lower dollar. While the Bank of Canada is under no pressure to start moving rates higher, a lower dollar gives them the flexibility to move sooner than if the dollar were trading closer to par. That said, I don’t expect to see much, if any movement from the BoC this year.

Fixed Income

For fixed income, I will admit I got it wrong. Last year, I expected flat to modestly higher gains out of the FTSE TMX Universe Bond Index (formerly the DEX Universe Bond). My rationale was that there would be increasing pressure on yields, as the U.S. Federal Reserve unwound its massive bond buying program. While I didn’t expect to see yields spike, I thought they would at least move higher. Well, I was wrong.

Bonds rallied as yields dropped much more than anyone had anticipated. In Canada, the yield on the Government of Canada benchmark ten-year bond fell to 1.81% from 2.77%. It was a similar story in the U.S., where the yield on the ten-year Treasury dropped to 2.17% from 3% at the start of the year. The FTSE TMX Universe Bond Index gained more than 9% on the year.

Where I was really wrong was with long bonds and real return bonds. In both cases, I had expected sharp declines as the upward pressure on yields, combined with the higher interest rate sensitivity would push prices down. With yields actually falling, these bonds shot higher, with long bonds gaining more than 18% and real return bonds rallying more than 13%.

While I have said this for the past few years, I don’t expect a strong year for bonds. Sorry if this sounds like a broken record, but I expect the FTSE TMX Universe Bond Index will be flat or lower this time next year, and both long and real return bonds will sell off sharply.

With this as the backdrop, I continue to favour fixed income investments with lower interest rate sensitivity. This includes short term bonds, and corporate bonds. I am also somewhat positive on global corporate bonds as well. I also like high yield bonds, but am a little concerned about valuations in the near term. Unless you are a gambler, I would try to avoid long term bonds and real return bonds in the short term. The risks to the downside are just too strong in my opinion.

Equities

As mentioned earlier, my outlook called for U.S. equities to lead the way higher, and I was right. The S&P 500 gained 13.7% in U.S. dollar terms, while the S&P/TSX Composite Index rose by 10.6%. The MSCI EAFE Index lost 4.5% on the year, thanks largely to continued weakness in Europe. This played out pretty much as expected.

Despite a few false starts over the year, emerging markets failed to make up any real ground, with the MSCI Emerging Markets Index losing nearly 2% in U.S. dollar terms. I had expected a rebound.
Another area where I was a bit off was with respect to small caps. I had expected both U.S. and global small cap stocks to have strong years. While they were both positive, they weren’t exactly what I would call “strong years”.

Looking ahead, I am going to once again say that the U.S. will be the best performing market, although I say this with less confidence than in the past couple years. Valuations are a bit rich, however, it is also one of the only countries in the world that appear to be on the road to recovery. I don’t see this as the best “opportunity” based on fundamentals, but more it is the least bad option in the equity space. From a return perspective, I’m expecting more modest, mid to high single digit returns.

I also expect a relatively decent year out of Canadian equities. While I see more volatility for oil, I do expect that the worst of the drop is behind us. That should help to put some floor under the energy sector. Another worry is the housing market, which continues to surprise with its resilience. If we see a blip there, the fallout may cause a significant market drop as the banks and others affected by the sector lick their wounds.

A wildcard in this is Europe. The European Central Bank has announced a number of different stimulus packages in an effort to turn things around. If one or more of these plans catches the favour of the markets, I would expect to see a liquidity driven rally. However, until things turn around in the troubled Eurozone, I expect more volatility and uncertainty.

Emerging markets is another wildcard as sentiment on EM has turned sharply negative thanks to the financial crisis in Russia. Many traders are selling their EM holdings indiscriminately. While this will prove to be a temporary selloff, when it will turnaround is anybody’s guess. A lot will depend on when we start to see a meaningful turnaround in Europe.

While the short term outlook is muddy, I wouldn’t be counting EM out for the medium to long term. Emerging markets now play a key role in the global economy, making up more than half the global GDP at the end of 2013 according to the IMF. Further, many EM countries have their fiscal houses in order, and their demographic pictures paint a very rosy medium to long term outlook, unlike a lot of more developed nations.

Another factor to consider is the valuation levels of the EM index compare very favourably to more developed indices. For example, Morningstar shows the P/E ratio of the MSCI Emerging Markets Index at 12.55 times. In comparison, the S&P 500 is 18.65 times and the S&P/TSX Composite Index is at more than 16 times. Other valuation metrics show a similar trend. While this may not be a predictor of shorter term performance, it is a good indicator of longer term returns. So while it is a coin toss of where the emerging markets will end up this year, longer term, the outlook certainly looks quite compelling.

Bottom Line

To be brutally honest, I have no idea what the markets will do this year. I have a very good idea of what they should do, however as anyone who has followed the investment markets long enough knows, what should happen and what do are often times quite different, especially in the short term. As with any forecasts, I reserve the right to change my mind at any time, but only if things don’t go as I predict.

That said, I am expecting a positive year for the equity markets, with the U.S. again leading the charge. I like large caps over small caps, based more on liquidity and valuation metrics. I expect volatility levels to remain high in all areas, but especially in Europe and the Emerging Markets.
I am predicting a flat to negative year for the bond market, with higher duration bonds feeling the pain the most. I expect to see higher interest rates, as the U.S. Federal Reserve begins to increase rates by mid-year.

Still, I remain cautiously optimistic for the year ahead.

My current investment outlook is:

 

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Lots to consider as we head into the New Year?

Last year, for the first time, I did a feature highlighting the fund that I would own for the year, if I could only pick one. My pick was the Mawer Balanced Fund (MAW 104). That turned out to be a pretty good choice, gaining 12.1%, leaving most of its peers behind.

Turns out my honorable mentions weren’t too bad either. I also highlighted EdgePoint Global Growth & Income Portfolio (EDG 180) which gained 13.9%, and the Mawer Global Equity Fund (MAW 120) which gained 14.5%. Both of these picks outperformed and finished firmly in the top quartile.

My other honorable mention was the CI Black Creek Global Leaders Fund (CIG 11106), which disappointed, gaining a meagre 3.24% and trailing most of its peers. However, given the fund’s concentrated portfolio, heavy European exposure, and above average volatility, short term underperformance is not unexpected. Still, three out of four isn’t bad.

To find my one fund for 2015, I conducted a robust screening of the fund universe looking for those that I believe are best positioned for the coming year. My investment outlook favours equities over fixed income. While I am leaning towards equities, I believe that every portfolio should have some exposure to fixed income to act as a ballast in volatile times.

For the fixed income component, I looked for an emphasis on active management, a shorter duration, and a portfolio that favours corporate, global and high yield bonds over plain vanilla government bonds. Within the equity sleeve, I looked for significant exposure to U.S. and Canadian equities, with lesser exposure to international and emerging market equities.

After an extensive screening process, detailed analysis on a handful of candidates, and a consultation with the Magic 8-Ball, my one fund to own for 2015 is …

Manulife Monthly High Income Fund (MMF 583) – It was a very tough call to arrive at this choice. There were a number of strong candidates, including last year’s pick. What ultimately swayed me to this offering was its positioning. Of the funds considered, it had the lowest fixed income allocation, the highest cash balance, and the highest allocation to U.S. equities.

The fund is managed by the team of Alan Wicks and Jonathan Popper. The equity approach is rooted in a value philosophy that looks for high quality businesses that generate high and sustainable profits that are trading at attractive valuations. The fixed income sleeve is managed using a combination top down economic review combined with a bottom up credit analysis. The process looks to generate returns by focusing on sector allocation, credit quality and individual credit selection. They also emphasize risk management by actively managing the portfolios yield curve and duration exposure.

At the end of December the fund held 15% in cash, 35% in Canadian equities, 30% in U.S. equities and 20% in bonds. The equity sleeve was defensively positioned with consumer names making up 30%. It is dramatically underweight energy, materials, and financials which results in a portfolio that is dramatically different than the index.

Performance, particularly since 2011 has been excellent, posting an annualized three year return of 13.2% to the end of December. Perhaps even more impressive has been the volatility profile, which has been below both the benchmark and the category average. It has also done a great job at protecting capital in down markets.

Source: Fundata

Going into 2015, if my investment thesis plays out as expected, this fund should do an excellent job for investors. The lack of exposure to Europe and Asia is expected to help keep volatility in check. However, if a rally does take hold in Europe, it may lag some of its peers. The fixed income portion of the fund is defensively positioned and expected to hold up relatively well when rates do start to move higher.

Honorable Mentions

Mawer Balanced Fund (MAW 104) – This was my pick last year, and to be honest, could very well have been my pick again this year. The deciding factor was that I feel the duration of the fixed income sleeve is a little too “indexy” for a rising rate environment. Still, make no mistake, this is an excellent fund, and if you are looking for a more diversified portfolio than the Manulife offering, this is a great choice. It invests in a handful of mutual funds offered by Mawer, providing exposure to fixed income, Canadian, U.S., and International equities. It also provides exposure to Canadian and global small cap. To top it all off, it is offered with an MER of 0.96%, which is great for do it yourself investors.

Fidelity Global Monthly Income Fund (FID 1222) – I have been a fan of this and the more domestic focused Fidelity Monthly Income Fund (FID 269) since just after Geoff Stein took responsibility for setting the asset mix of the funds in 2011. The recent addition of David Wolf, formerly of the Bank of Canada certainly won’t hurt going forward either. Similar to the Mawer offering, it invests in a mix of Fidelity managed pools run by some of the firm’s top managers, including one of my favourites, Daniel Dupont. In addition to the main asset classes, Mr. Stein also has access to a number of other mandates, such as high yield, convertible debt, and floating rate notes, thanks to Fidelity’s massive global reach and impressive bench strength. The main reason that this isn’t my top pick is the fixed income allocation is higher than my other picks, coming in at 40% at the end of the year. Another modest concern is it only has a modest 2% allocation to Canada and 20% invested internationally. Still, if you are looking for a very well diversified portfolio, this is a great option. If you want something with more domestic exposure, the Fidelity Monthly Income Fund is also a great pick.

Name	3 Mth	1 Yr.	3 Yr.	5 Yr.	10 Yr.	MER
Manulife Monthly High Income	5.5%	16.5%	13.2%	9.8%	6.8%	2.11%
Mawer Balanced	4.5%	12.1%	14.5%	11.2%	7.9%	0.96%
Fidelity Global Monthly Income	4.3%	12.3%	12.1%	8.8%	–	2.32%
Fidelity Monthly Income	2.6%	8.2%	9.0%	9.0%	8.1%	2.10%

Source: Morningstar

 

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Updated approach simplifies process and allows for expanded factor coverage

When I first started providing a rating on mutual funds back in 2002, I developed a formula that considered a number of key performance and risk metrics. It looked at absolute return, relative return, volatility and relative volatility. It also took into account the length of track record of a fund when determining the final rating.

It seemed to work very well over the years, but its biggest drawback was that it was complicated to explain. Whenever an advisor or investor would ask about my rating system, I could never easily explain how I arrived at my ratings in a clear, concise way.

Another challenge would often arise when someone would ask why two funds with rather similar returns would have differing ratings. With the formula approach, there was no quick way to look at the two funds to find out why the difference. Instead, I would have to having to deconstruct the factors and look at each on its own to find the discrepancy, which could at times be rather time consuming.

After having gone through that exercise a few times in the past year, I thought it might be better to create a rating system that simply scored the various factors under consideration, weighted them based on importance and determined a rating based on the final score. So that’s what I did. I looked at the key factors in my current formula and then looked for any gaps in coverage. This resulted in six key metrics that are now rated and scored in my new process.

Each factor is give a score between one and five. The scores are then averaged, with a final grade ranging from A to F being assigned. The grading system is very much like in school, Those receiving less than 50% are rated an F, those scoring more than 80% are an A, and the B’s, C’s, and D’s distributed accordingly.

The metrics I’m following are:

• Alpha – This is the excess return that a manager has been able to generate. The higher the Alpha, the higher the score.
• Sharpe Ratio – This measures how much return an investment has delivered for each unit of risk assumed. The higher the Sharpe Ratio, the more return the investment has delivered for each unit of risk, and the higher the score a fund receives in my ratings model.
• Standard Deviation – this is a measure of volatility or risk. It measures the fluctuation that an investment has exhibited. The higher the standard deviation, the more fluctuation the fund has shown, so the lower the score it receives in my new ratings model.
• Information Ratio – is a measure of how consistently a manager has outperformed its benchmark. It is basically the Sharpe Ratio of the monthly excess returns. Like with the Sharpe Ratio, the higher the better.
• Batting Average – this is another measure of how consistently the fund has outperformed. The batting average is just a measure of how frequently a fund has outperformed. It’s like the win/loss percentage in baseball. A batting average of 500 means it has outperformed as often as it has underperformed. I like funds that win more than they lose. The higher the batting average, the better the score.
• R-Squared – finally, I like to look at the R-Squared of an investment. This is a statistical measure that shows how much of the return of an investment is the result of the benchmark. The higher the R-Squared, the more the fund behaves like the benchmark. And as we know, if you want to beat the benchmark, you can’t be the benchmark, so my model favours those funds that have a lower R-Squared.

While these six factors are the ones I am starting with when the new ratings system goes live in the next few days, this new scoring system allows me the flexibility to bring additional metrics into the mix as they become available. For example, I am currently testing what effect bringing Downside Deviation into the process would have on improving the ratings results. Other metrics I hope to be able to incorporate in the future include upside and downside capture ratios and manager tenure.

My hope is that the increased transparency will make it easier for you to understand why funds are rated as they are, helping to reduce the amount of guesswork required. Watch for the new ratings with the December 31 Investment Fund Ranking Report, due to be released on January 15.

If you have any questions, please do not hesitate to contact me at info@paterson-associates.ca

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Let’s be honest, nobody expected that bonds would have the type of year that they did in 2014. I know I didn’t. I believe my exact words were:

“… While the economy is on the right track and showing sustained signs of growth, I expect it will be much later in the year or even next year before policy rates move higher. I do however expect that we will see upward pressure on bond yields which will make it very difficult to see any meaningful returns from fixed income investments this year. I favour high yield and corporate bonds over government bonds, and shorter duration over longer duration.”

I can admit that I got it wrong last year. But, fast forward a year, and my thoughts are pretty much the same. The massive bond buying program that the U.S. Federal Reserve has now been fully wound down. The Fed has now said they will remain “patient” in raising rates, however recent economic data points to a slight acceleration in the pace of economic growth.

Closer to home, with the economy now showing signs of a slowdown, there is less pressure on the Bank of Canada to push rates higher. However, with the Canadian dollar losing some ground to the U.S. greenback, the BoC has some additional flexibility that it didn’t have when the dollar was trading near par.

No matter how you slice it, 2015 looks to be the year that interest rates finally start to move higher. Obviously the timing remains a big question mark, but all signs point to the first rate rise sometime in late spring or early summer.

With rates likely to be on the rise, it will become increasingly difficult for fixed income investments to generate any meaningful returns. In fact, it is highly likely we will see losses from bonds, depending on the speed and magnitude of any rate rises.

A great way to estimate the interest rate sensitivity of a fixed income investment is to look at its duration. The higher the duration of an investment, the more sensitive it is to movements in interest rates. Because bond prices move in the opposite direction of interest rates, you will want to have a shorter duration if you expect that rates will move higher. This shorter duration will help to protect your capital better.

To get an idea of how duration can affect the value of an investment, the table below shows the expected losses of various investments based on interest rate increases.

		Expected Loss if Rates increase by:
Index	Duration (yrs)	0.25%	0.50%	1.00%	1.50%	2.00%
FTSE TMX Canada Universe Bond Index	7.37	-1.84%	-3.69%	-7.37%	-11.06%	-14.74%
FTSE TMX Canada Short Term Bond Index	2.78	-0.70%	-1.39%	-2.78%	-4.17%	-5.56%
FTSE TMX Canada Long Term Bond Index	14.36	-3.59%	-7.18%	-14.36%	-21.54%	-28.72%
Markit iBoxx USD Liquid High Yield Index	4.24	-1.06%	-2.12%	-4.24%	-6.36%	-8.48%
FTSE TMX Canada FRN Index	0.18	-0.05%	-0.09%	-0.18%	-0.27%	-0.36%

Source: BlackRock

The point is that even modest increases in rates can create losses for investors, particularly those invested in longer term investments.

In addition to shortening the duration of your fixed income holdings, there are a few other options to help protect capital in a rising rate environment. Things that I look for in a bond fund include:

1. Low Fees – With bond returns expected to be low for the near to mid-term, you will want to reduce the impact of costs, keeping more money in your portfolio.
2. Active Management – With an active fund, the manager can do things such as increase the yield, shorten the duration and take advantage of other opportunities as they arise. They may also be able to invest in other strategies such as high yield, derivatives and currency, which can not only provide additional return, but also help protect you against major drops in value. Look for managers not afraid to take bets.
3. Higher Yields – With yields expected to be the main driver of return for the near term, you will want to maximize them. As well, a higher yield can provide a better buffer against rising interest rates than lower yields.
4. Global Bonds – Global bonds trade off of a different set of economic and yield factors than Canadian bonds. By bringing some exposure into your portfolio, you can provide an extra layer of diversification than what you can get with only investing in Canadian bonds.

Bottom Line – Yes, the return outlook for bonds is muted at best, and downright depressing at worst. It is highly likely that most investors will see their bond investments post losses in the next little while. But that doesn’t mean you should move out of bonds. On the contrary. Bonds have been and should continue to be an integral part of your portfolio. They can provide a tremendous safe haven in periods of uncertainty, and can help preserve the value of your portfolio when equity markets drop. However, as we move forward from here, bonds can no longer be counted on as a key driver of portfolio returns. Instead, their main role will be to help to reduce overall portfolio volatility in periods of uncertainty.

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Mutual funds are now required to provide investors with a risk rating on the Fund Fact documents and in the Simplified Prospectus. The goal is to provide investors with an understanding of the potential risks of an investment.

To determine the risk rating, fund companies calculate the historic standard deviations of each fund over a variety of time periods, and then slot it into one of five risk ratings based on the results. The risk bands are as follows:

Standard Deviation	CSA Fund Facts Investment Risk Scale
0% – 6%	Low
6% – 11%	Low To Medium
11% – 16%	Medium
16% – 20%	Medium to High
> 20%	High

Source: IFIC

On the surface, this seems to make a lot of sense. I am a big fan of providing advisors and investors with the tools and information they need to make informed decisions about the risk of their investment portfolio. However, digging deeper, you will quickly see that this methodology is flawed.

The main reason for this is that the historic volatility is not necessarily indicative of the future volatility. Let’s take a look at the current historic volatility numbers for the key market indices.

	3 Yr. Standard Deviation	Risk Rating	5 Yr. Standard Deviation	Risk Rating
S&P/TSX Composite	8.43%	Low to Medium	10.28%	Low to Medium
S&P 500	7.02%	Low to Medium	8.43%	Low to Medium
MSCI EAFE	9.27%	Low to Medium	11.23%	Medium
MSCI World	6.96%	Low to Medium	8.89%	Low to Medium
FTSE TMX Universe  Bond Index	3.20%	Low	3.29%	Low

Source: Fundata

So based on these recent historic numbers, the main equity indices could be rated as Low to Medium. Umm. NO!! For one thing, the longer term volatility numbers are about 50% to 75% higher. Despite the recent volatility numbers, there is no way in hell that I would ever consider a pure equity fund to be considered Low to Medium risk. Obviously following this methodology we would have all but forgotten about 2008, where the S&P/TSX Composite fell by 33%, the S&P 500 dropped by 37%, MSCI EAFE was down by 43% and the MSIC World Index dropped by more than 40%. In what world is that Low to Medium Risk???

While most companies are doing the right thing and keeping their equity funds rated at least Medium risk despite lower standard deviation numbers, I have seen a few come across my desk touting that they were lowering the risk ratings on some of their equity funds to Low to Medium. To those companies doing this, I beg you to please stop. To advisors and investors, please understand that equity funds, despite the recent low volatility period can be prone to periods of extreme volatility.

By focusing only on standard deviation, some funds may be understating their true risk profile and misleading investors. Let’s hope this practice stops before somebody gets seriously hurt.

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Q – Could you please provide an overview of the different PH&N Bond Funds?

A – Certainly! When it comes to bond funds in Canada, PH&N is easily one of the best shops in the country. Their funds are run by a very skilled, well-staffed management team with expertise in both government and corporate bonds. Risk management is a key pillar to their approach, which will certainly help when we see an uptick in volatility in the bond markets.

Regardless of the mandate, PH&N fixed income funds tend to be above average. Their process is the main reason for it, but their rock bottom pricing, particularly for their do it yourself focused D-series units also helps the cause. Even with the higher MERs of the advisor series units, these funds tend to be at or near the top of my list of favourites.

	Average Credit Quality	Term to Maturity (yrs.)	Duration (yrs.)	Yield to Maturity
PH&N Short Term Bond & Mortgage	AA	2.7	2.5	1.9%
PH&N Bond	A	9.9	7.0	2.5%
PH&N Total Return Bond	AA	9.9	7.0	2.5%
PH&N High Yield Bond	<BBB	5.7	2.6	4.9%

Source: RBC Global Asset Management

PH&N Short Term Bond & Mortgage Fund (RBF 1250) – As the name suggests, this fund invests in a mix of short term bonds and mortgages. It is defensively positioned with a duration that is shorter than the FTSE TMX Canadian Short Term Bond Index. This positioning will help it when rates do move higher. Using this as part of a well-diversified portfolio is a great way to reduce the risk exposure of your fixed income holdings. While it has outperformed most of its peers, the low rate environment has resulted in absolute returns that have been pretty uninspiring. For the past three years, it has earned an annualized 2.2%. In a rising rate environment, expect even less than that until the portfolio yield starts to rise.

PH&N Bond Fund (RBF 1280) – When it comes to bond funds, this is about as plain vanilla as it gets. Don’t get me wrong, this is some of the best vanilla you can get! It invests in a mix of Canadian government and corporate bonds. It is currently overweight in provincial and corporate bonds, and has a duration that is slightly less than the FTSE TMX Canada Universe Bond Index. Still, with a duration of 7, it is likely to experience losses as rates move higher.

PH&N Total Return Bond Fund (RBF 1340) – This fund is very similar to the PH&N Bond Fund, except the managers can invest a portion of the fund, generally no more than 20%, in other investments such as mortgages, derivatives and high yield bonds. This gives the managers a few more tools in their toolbox to help protect against rising rates. Because of this ability, this has been one of my top bond picks for more than a year. With a duration of roughly 7, it is still likely to experience a short term loss if we see a spike in rates.

PH&N High Yield Bond Fund (RBF 1280) – This invests in a mix of non-investment grade Canadian and U.S. corporate bonds. High yield bonds are generally higher risk than more traditional bonds, as there is a greater risk that the company may default on its obligations. Because of this higher risk, high yield tends to offer greater return potential. At the end of November, the yield to maturity of the underlying portfolio was listed at 4.9%, nearly double the more traditional bond funds. This will go a long way in helping to protect capital once interest rates rise, particularly if rates are rising because of a strengthening economic picture. Because of the higher risk, I would be very reluctant to suggest using this as a core fund. Instead, it can be a great compliment to the more traditional bond funds. But, unless you already own this highly rated fund, you are out of luck. RBC has capped it to new investors and I don’t expect it to reopen anytime soon.

As far as a comparison of the funds goes, it isn’t a case of which fund is better. Instead, each serves a different purpose and all can work together nicely to help build a well-diversified fixed income portfolio. In addition to these offerings, you may also want to look for other complimentary funds focusing on tactically managed global bonds, and possibly floating rate investments.