The Cambridge Approach to Fixed Income

Grant Connor's picture

In today’s interest rate environment, fixed income investing is no easy task. The yield on U.S. Treasury notes is only 2.47%, not far off the recent lows of the past half-century. Meanwhile, reaching for yield is not attractive either. For example, the yield on high-yield bonds is only 5.55%, nearly 400 bps below its 20-year average. This hardly seems like fair compensation considering a typical high-yield bond has historically defaulted at a rate of 16% over a five-year period. These unattractive yields and potential for capital losses from rising interest rates means the fixed-income returns enjoyed during the bond bull market over the past 30 years will be far more difficult to achieve going forward.

At Cambridge, we apply similar principles to investing in fixed-income as we do to income-oriented equities. For the core of our fixed-income portfolios, we target higher-quality businesses or industry leaders with strong management teams and a good history of allocating capital and balance sheet management. However, in the current ultra-low interest rate environment, finding these companies at an attractive yield (i.e. price) is difficult. As a result, our target fixed-income allocation will change materially with yields. At a high level, our bond allocation strategy is outlined below.

What is our benchmark bond allocation? Our bond allocation strategy is influenced by our target total return of 6% on our income funds. At the historical average U.S. 10-year Treasury note interest rate of 5%, we can achieve a weighted average 6% yield on bonds by allocating 50% to investment grade bonds, 25% to Treasuries and 25% to high-yield bonds. We then weight income funds 60%/40% between bonds/equities thereby deriving the majority of our targeted return from bonds.

Where are we today? Investment grade bonds and Treasuries yield half, or less, of our targeted 6% return and high-yield bonds fall just shy of our targeted return at a 5.55% yield. The low yields combined with the elevated risk of capital loss from rising interest rates mitigates in favour of significantly underweighting bonds in our portfolios. Thus, we target today a minimum bond/equity weight of 15%/85%. Meaning, we only need to find 10-15 attractively priced bonds that meet our principles, a reasonable amount.  We will look to increase our bond allocation when the yield on the U.S. 10-year Treasury note crosses 3.0%.

What is our full appetite for bonds? In a high interest rate environment, our maximum bond allocation is 85%. For example, a scenario where the U.S. 10-year Treasury yield rises to over 6.5% and the yield on high-yield bonds more than doubles. In such a scenario, we could achieve a 9.5%+ yield on the vast majority of the portfolio, well exceeding our targeted return of 6.0%.

For every 1% increase in the U.S. 10-year Treasury note yield we target a 15%-20% increase in our bond allocation. In our view, this flexible fixed-income allocation is one of our best risk management tools. Today, it means significantly underweighting bonds to avoid unduly exposing our clients’ savings to elevated credit risk or rising interest rates. To compensate, we overweight income-oriented equities (see our blog, “Approaching Income Differently” for our approach to income-oriented equities). This should reduce portfolio volatility in a rising rate environment while generating a more attractive combination of income and returns.

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Grant Connor's picture
Submitted by Grant Connor on

The approach outlined above primarily applies to the Cambridge High Income Fund and the Cambridge Income Fund. However, we use a similar approach for Cambridge Canadian Asset Allocation Corporate Class. The key difference is that rather than targeting a 60/40 split between debt/equity in a normal interest rate environment, for Asset Allocation we target a 40/60 split of debt/equity. We adjust the approach for Asset Allocation accordingly, which, in rough numbers, means that for every 1% increase in the 10-year U.S. Treasury note we will increase our bond allocation in Asset Allocation by about 10%-13%.

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