When we launched the Signature High Income Fund in 1996, the Signature team pounded the table with that simple premise. As interest rates fell starting in the early 1980s, yields in traditional parts of the bond market were, and continue to be, insufficient to generate an acceptable level of income. Nonetheless, government bond yields kept falling, generating capital gains in a defensive asset class, thereby perpetuating the illusion that bonds equal income.
We argued instead that if you need income, look to income asset classes that do well across different interest rate and growth environments—high yield bonds, real estate and infrastructure. The benefits of these asset classes are they have low or negative effective duration due to the cyclicality of credit spreads; predictable and growing cash flows; inflation protection; and they diversify overall risk as they are generally under-represented in client portfolios.
The inference then is to continue to rely on equities for higher returns and inflation protection, and on government bonds for diversification and deflation (i.e. recession) protection, but do not depend on asset classes that need capital gains to generate distributable income. Balanced portfolios built with equities and traditional fixed income can do well over the long term, but they still expose investors to equity volatility. Government bonds provide diversification as they are negatively correlated with economic growth and equities, but they can be volatile themselves. Case in point: Surprisingly hawkish language from Bank of Canada Governor Poloz and Senior Deputy Governor Wilkinson in late June set in motion a sell-off in the Canadian bond market, with government bond prices down about 2–3%. To put it another way, that is about 1–2 years’ worth of annual interest lost in three weeks as the yield on the Government of Canada 10-year bond moved from 1.46% in late June to 1.88% on July 12.
The Bank of Canada hiked overnight interest rates by 25 bps on July 12, the first increase since 2010, and also noted that future hikes will be guided by incoming data, as growth has been trending above expectations but inflation below. With new tightening biases by the Bank of Canada, the U.S. Federal Reserve, and other central banks, investors will be challenged to generate returns from their fixed income portfolios and from those halves of balanced funds allotted to government bonds. Given where yields are, return expectations for those assets should be relative, not absolute. An expectations reset is needed, and investors should view government bonds as insurance instead of a source of income.
This hawkish turn by the Bank of Canada and government bond sell-off has us focused on reassuring investors that the Signature High Income Fund and Signature Diversified Yield II Fund can perform well in a rising interest rate environment. The evidence is compelling. Looking at quarterly data over the past 15 years, in the 30 occurrences when the yield on the Government of Canada 10-year bond increased, the Signature High Income Fund (SHI) has:
- Posted an average return of 2.72% during those 3-month periods
- Generated a positive return in 24 of those occurrences (80% of the time)
- Outperformed a balanced portfolio1 23 times out of 30 (77% of the time) by an average of 90 bps
- Outperformed the Canadian bond market2 27 times out of 30 (90% of the time) by an average of 304 bps
The results of the Signature High Income Fund demonstrate the influence of the underlying asset classes combined with active management in the form of security and sector selection, asset allocation and dynamic currency hedging. These results are also decidedly the effects of dedication to the Signature model—fundamental global sector specialists, cross-asset intelligence, capital preservation mindset and our no client left behind policy. Nothing can replace high-octane brainpower working well together with a common goal.
While valuations are currently challenging, global growth does seem to have sufficient momentum to withstand higher interest rates. We feel that a reasonable intermediate-term expectation for the Signature High Income Fund and Signature Diversified Yield Fund II would be a return 2–3x above government bond yields (i.e. mid-single digit) with half the volatility of the equity market. Government bonds remain a conservative investment vehicle, but given low starting yields, they are more akin to an insurance policy that bleeds premium, with a trade-off of not being in riskier asset classes but is “in the money” and generating needed competitive returns when everything else is losing money. Growth equities are honestly better suited to participate in economic growth than the Funds’ target asset classes of high yield bonds, real estate and infrastructure—but with more volatility. However, that is the unique value proposition that the Signature High Income Fund and Signature Diversified Yield II Fund have, which is active management for predictable income without the volatility of the stock market.
Stay tuned for further commentary from Signature, including our weekly income fund podcast (soon to be in video) where we go into more detail on fund positioning and market outlook.
- A mix of 50% XBB (iShares Core Canadian Universe Bond Index ETF) and 50% XIU (iShares S&P/TSX 60 Index ETF) was used as a proxy for a typical balanced portfolio. XBB was used as a proxy for the Canadian bond market, while XIU was used as a proxy for the Canadian equity market.
- XBB was used as a proxy for the Canadian bond market.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.