We have seen a substantial change in Canada’s interest rate landscape beginning in 2017 and continuing into 2018. During this period, the following developments occurred:
- The Bank of Canada raised the overnight lending rate to 1.0% from 0.5%;
- Canadian 2-year bond yields moved from 0.75% to 1.7%; and
- Canadian 10-year bond yields moved from 1.75% to 2%.
Despite the shifting rate environment, the fixed-income component of Cambridge Asset Allocation Corporate Class returned 1.6%. (The fixed-income component, which makes up 45% of the fund as of March 31, 2018, consists of Cambridge Canadian Short-Term Bond Pool and Cambridge Bond Fund, which are not currently available for individual purchase).
Against a backdrop of rising rates, how did the fixed-income assets within Cambridge Asset Allocation Corporate Class generate a positive return?
With regards to fixed-income returns, there are more factors than simply short-term interest rates that determine returns. For example, in 2017 the change of the shape of the Canadian yield curve significantly impacted our fixed-income returns. Why? 30-year Canada bonds started the year 1.2% higher than Canada 5-year bonds, but ended the year only 0.4% higher. This flattening of the yield curve resulted in the 5-year Canada bond returning -1.1% in 2017 while the 30-year Canada bond returned 3.3% in 2017.
Source: Bloomberg April 24, 2018
Source: Bloomberg April 24, 2018
A second factor impacting returns is spreads. Canadian investment-grade corporate bonds traded at a 1.3% spread above Government of Canada bonds to start 2017, but ended the year 1.05% higher. This spread compression allowed the FTSE TMX Canada Corporate Bond Index to return 3.4% in 2017. In contrast, the FTSE Canada Federal Bond Index returned only 0.1%.
In this environment, the Cambridge Bond Fund, which is an underlying component of Cambridge Asset Allocation Corporate Class, returned 3.7% in 2017 compared with 2.5% for the overall FTSE TMX Canada Universe Bond Index. The strategy benefited from its overweight positioning in corporate bonds, as well as the curve positioning mentioned above.
As risk assets rallied through 2017, valuations became more expensive and short-term interest rates continued to rise. The Asset Allocation Committee decided to position Cambridge Asset Allocation Corporate Class conservatively. This included moving equities to an underweight position and fixed income to an overweight position relative to the fund’s blended benchmark. We also modified our positioning within the fixed-income portion, with an overweight to Cambridge Canadian Short-Term Bond Pool, to maintain a lower sensitivity to interest rates. This defensive positioning detracted from relative performance in 2017; however, given elevated valuations in risk assets and the elevated sentiment towards global growth expectations, we feel the conservative positioning is appropriate for this fund. As we always tell our clients, our first priority is always to protect client capital.
The upward momentum that markets enjoyed in 2017 has not carried forward into 2018. As I write this article before the opening bell (April 24, 2018), the S&P/TSX Composite has returned -4.5% in the first quarter of 2018, while the FTSE TMX Canada Universe Bond Index had a slight positive return of 0.1%. The conservative positioning of Cambridge Asset Allocation Corporate Class provided downside protection and was -1.4% in the first quarter of 2018 compared with the benchmark return of -2.7%. Although the Asset Allocation Committee took the opportunity to slightly increase the fund’s allocation to equities, we have maintained a relatively conservative positioning.
In closing, I thank you for your support and remind you that we remain focused on applying Cambridge’s bottom-up investment process across asset classes and around the globe.
Cambridge Asset Allocation Corporate Class – Asset Mix as at March 31, 2018
“Please note that this blog post has been corrected. In the prior version it stated that the yield curve inverted in 2017. This statement was not part of the PMs original script and has been corrected.”