Signature Corporate Bond Fund (Class A) had a strong return of 3.4% for the first quarter of 2014.
Simply put, we scored four out of four in terms of success with the levers we can pull to add value in the fund. The investment-grade component of the fund significantly beat its benchmark in the quarter while the high-yield component matched the index. Both components of the fund benefited from an overweight position in the subordinated debt of financials, as that sector dramatically outperformed. We have been talking about this trade for nine months and we continue to have high conviction in our thesis of the cheapness of these securities, especially given the ongoing de-leveraging (de-risking) of the banks.
This is how we expect to generate returns in Signature Corporate Bond Fund, in order:
- Credit – Most important to how we intend to add value in the fund. Credit "worked" in the first quarter with tightening in both high-yield spreads (-30 basis points) and investment-grade spreads (-13 bp). This was largely due to additional inflows into the asset class and diminished supply on a year-over-year basis.
- Asset allocation - While we were slightly overweight high yield in the quarter – about 55% of fund – this only added value after the effect of currency, as the high yield and Canadian corporate bond indexes generated essentially the same return in their native currency.
- Rates – Government bond yields rallied, pulling the yield on the Government of Canada 10-year bond from 2.75% at the start of the year to 2.46% at quarter-end (worth almost 4.5 points of price appreciation on a duration of 8.8 years) and the yield on the U.S. 10-year from 3.03% to 2.72%. In both cases, rates rallied as economic data weakened throughout the quarter, probably due to the impact of severe weather across the continent. The rally in U.S. rates was surprisingly strong in light of the Fed beginning to taper quantitative easing. Both components of the fund were shorter duration than their benchmarks (3.1 years for high yield, 5.4 years for investment grade), so we only picked up a partial benefit there.
- Currency – The approximately four cent depreciation of the Canadian dollar against the U.S. dollar helped the fund as about 55% of the positions are denominated in U.S. dollars and the average hedge ratio was about 70%. This implies we picked up about 66 bp of performance from not being fully hedged. We are bullish on the U.S. dollar as bond yields creep higher as the taper continues and slightly bearish on the Canadian dollar as softer data have likely delayed Governor Poloz from raising rates.
There are tailwinds and headwinds for credit investors as we progress through 2014. The tailwind is improving economic growth in Canada and the U.S. that should translate into credit quality improvement of the bonds in the fund, which in turn should result in spread tightening (valuation). The headwinds are twofold. First, starting valuations are stretched, as we are in the fifth year of this rally. Second, improving economic growth is also a headwind, as it is accompanied by less stimulative monetary policy and, eventually, restrictive policy when the Fed raises short-term interest rates, which is possible in the first half of 2015. We are more comfortable with credit risk than rate risk at this point and believe we can generate a low single-digit return over the next nine months despite the headwinds noted above. That may not seem overly optimistic but it could be the best return in all of fixed income as rising interest rate expectations re-price government yield curves higher. This will impact traditional fixed-income product more than it will credit funds, and we are additionally conservative by keeping duration short and maintaining a modest cash balance.
– Geof Marshall and John Shaw