* Bond bull market over, tough environment seen in 2014
* Asset managers favor emerging market debt, preferred
* Stay in short-duration debt to limit risks
By Andrea Hopkins
TORONTO, Dec 20 It's been years since fixed
income offered investors the "safe and stable" side of a
portfolio, but Canadian asset managers believe the waves created
by the Federal Reserve's tapering may make investing in bonds an
especially bumpy ride in 2014.
The year ahead has been billed as one in which interest
rates start creeping back to historical norms and the 30-year
bond bull market comes to an end. But with economic growth still
sub-par, Canadian money managers say there is money to be made
in fixed income if investors pick the right spots.
"Our forecast is not for a bear market for fixed income in
2014, but we are at the initial stages at a rate normalization
process, so I think it will be quite a challenging year," said
Ilias Lagopoulos, a fixed-income strategist at RBC Dominion
After years of record lows, the yields on U.S. and Canadian
10-year bonds are expected to climb to around 3.4 percent or 3.5
percent by the end of 2014, Lagopoulos said, high enough to hurt
investors who own government of Canada or Treasury bonds.
The bulk of the motion in fixed income in 2014 will come
from the Fed, as it tapers its asset purchase program and
removes stimulus from the economy. The U.S. central bank
announced the beginning of the process this week, and the
tapering could extend into 2015 as the U.S. economy improves.
As the biggest buyer in the Treasury market pulls back,
long-term rates are expected to rise and prices fall. Bond
prices will also come under pressure if U.S. and global
economic pick up speed, and the need for the safe haven of bonds
will decline as the crisis recedes - all of which may make for a
very rough year for bond investors.
Still, most observers believe rates will only rise
gradually, despite panicky headlines, and the Fed's pledge to
hold benchmark rates lower for longer was seen as an attempt to
reassure investors that low rates could persist for years, not
months, to keep the U.S. growth on track.
Sadiq Adatia, chief investment officer at Sun Life Global
Investments, said that while the end of the bonds bull market
means it will be hard to make money in "plain vanilla" fixed
income such as government bonds and high-grade corporate debt,
opportunities exist further away from the Fed's influence.
"There are still a lot of opportunities if you go abroad.
Emerging market debt offers great opportunities to get good
yields, positive returns and benefit from growing emerging
market nations," Adatia said.
"And people forget that bonds in these countries, about 60
percent are investment grade, so you're getting good returns and
the risk is lower than people expect."
Alfred Lee, portfolio manager and investment strategist at
BMO Global Asset Management, said some success in 2014 will be
from shortening debt duration to between zero and five years to
avoid being locked into low returns as rates rise. He also looks
to some U.S. high-yield debt to offset the shorter durations.
Diversification is also important, and a rising rate
environment is going to be one in which a good bond picker will
do better than a passive manager, Lee said.
"One way to play a rising interest rate environment is going
out and picking out bonds trading at a discount," he said,
noting that more and more bonds are going to trade at a discount
as rates rise.
"If you select those, and opportunistically pick off those
bonds trading at discount and hold to maturity or near maturity,
you're going to be able to mitigate your sensitivity to interest
Lee said that while funds with a broad exposure to the bond
market are unlikely to do well in 2014, an ETF like BMO's Ultra
Short-Term bond ETF, which begins trading Jan. 1 and targets
durations less than a year, should outperform.
NO CRYSTAL BALL
Darcy Briggs, co-lead manager for the Franklin Bissett
Corporate Bond Fund, said he's only expecting low single-digit
returns in fixed income as a whole in 2014. But he sees
corporate bond funds as a better bet than government debt. He
also likes some high-yield debt in industries such as oil and
gas, but warns it comes with higher risk.
"2014 is going to be more bond picking - you're going to
have to really do your homework in terms of what you expect
company balance sheets to look like," said Briggs.
Another piece of the fixed income market that both Sun
Life's Adatia and RBC's Lagopoulos like is preferred shares.
They have suffered deeply as the year draws to a close and
investors choose them for tax-loss selling, offloading them as
large losers to offset capital gains.
"The selling pressure has caused the preferred share selloff
to exacerbate and has resulted in very cheap valuations within
components of the preferred shares market, specifically the
perpetual preferred shares," Lagopoulos said.
While noting the risk of such an interest-rate sensitive
asset, Lagopoulos said the cheap valuations of perpetual
preferred shares combined with the tax benefits of preferreds,
which are eligible for the dividend tax credit, make them a good
option for risk-tolerant clients.
Above all, Franklin Templeton's Briggs said investors have
to have an appetite for experimentation in 2014, since the Fed's
actions and impact are just one big guessing game.
"Crystal balls and predictions are a mug's game in 2014,"
Briggs said with a laugh. "My advice is to stay short until
rates flatten out."