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Funds of Note
Invesco 1 – 5 Year Laddered Corporate Bond (AIM 53203 – Front End Units, AIM 53207 – Fee Based Units
Heading into the second quarter, the consensus was that the next moves from global central banks was going to be a hike in interest rates. That changed about two-thirds of the way into the quarter as the friction caused by the trade wars started to have a real impact on the economic numbers, and with no end in sight, created real uncertainty about the future. This caused a complete 180 and the consensus shifted that the next move was going to be a cut by central banks, with the only real debate being how big of a cut. In this environment, we saw yields move lower. In Canada, the yield on the benchmark five year Government of Canada Bond fell from 1.52% to 1.39%, after peaking in mid-April at 1.66%.
This created a strong environment for fixed income, and this fund was one of the best performers in the Canadian Short-Term Fixed Income category. For the quarter, it gained 1.3%, outperforming the 0.9% rise of the FTSE/TMX Short-Term Bond Index. This outperformance was largely due to the fund’s overweight exposure to corporate bonds, which outperformed government issues in the quarter.
The portfolio uses a passive approach and is designed to replicate the performance of the FTSE TMX Canada Investment Grade 1 – 5 Year Laddered Corporate Bond Index. It invests in only investment grade corporate bonds, and only those rated BBB or better can be considered for inclusion in the index.
As the fund’s name suggests, the portfolio uses a laddered approach. It is divided into five equally weighted buckets with maturities from one to five years. Each of these buckets receives an equal 20% weight in the portfolio, and each holds 10 bonds.
Beyond the credit quality requirements, bonds must meet certain liquidity and issue size thresholds before they can be included in the index. Within each of the term buckets, the ten largest, most liquid issues make it into the fund.
Every June, the portfolio is re-run. When this happens, bonds that were in the one year term bucket are removed from the fund, while bonds in each of the other term buckets will roll down to the next bucket. For example, a bond that was in the three year bucket prior to June, will automatically roll into the two year bucket.
An interesting feature of the fund that results from this laddered approach is you will see the duration jump after each rebalancing. This occurs because new, longer dated bonds are added to the portfolio while the shortest dated bonds roll off. Over the year, the duration gradually falls, only to have the cycle repeat.
While not as exciting as some other short-term offerings available, I like it for a few reasons. It is fully transparent, helping you better understand what you are investing in. With its focus on corporate bonds, the portfolio yield will often be higher than other, more diversified short term funds. This is because investors typically demand a higher return to hold corporate bonds. As a result, it is expected to outperform in most market environments. One caveat is that if there is a sharp equity market selloff or a flight to safety that happens, this fund will likely lag as investors tend to favour government issues in such situations. It is also reasonably priced, with an MER of 0.99% for the full freight dealer sold units, and 0.39% for the fee based units. It’s also available as an ETF for those who wish to “do it yourself”.
IA Clarington Floating Rate Income Fund (CCM 9940 – Front End Units, CCM 9944 – Fee Based Units)
In a rising interest rate environment, floating rate bonds and leveraged loans tend to be popular with investors. Unlike traditional bonds that pay a set coupon, these floating rate investments pay a coupon that is linked to an underlying interest rate like LIBOR. As the reference interest rate rises, so too will the coupon payment on a floating rate bond. Coupon payments are adjusted regularly resulting in virtually no interest rate risk. Another attractive feature these instruments tend to be unrated or below investment grade in credit quality. Because of this, they offer coupon payments that are higher than what is available through traditional corporate bonds.
In the very low interest rate environment we have been experiencing, these types of funds have garnered a significant amount of investor interest. Prior to the financial crisis in 2008, there were only two floating rate funds widely available. Today, that number is more than 15, with this fund from IA Clarington being the largest at more than $1.2 billion in assets.
It is managed by a team headed by Jeff Sujitno that uses a very conservative credit analysis investment process that looks to find issues from high quality companies they believe have the ability to continue to deliver strong free cash flow, sustain or grow revenues, and keep their balance sheets fundamentally sound. The portfolio is well-diversified, holding between 100 and 125 loans. These loans are primarily issued in U.S. dollars, so all currency exposure is fully hedged.
Unlike some of the peers who are more active in their approach, the team is quite content holding what they believe to be higher quality issues and collecting a reasonable level of coupon income. Because of this patient approach, volatility of the fund has been well below the peer group over the past three and five year periods. Another byproduct of this patient approach is absolute performance has been middle of the pack. However, when you combine the average return with the below average volatility you get a fund that has delivered a risk adjusted return that leads the category.
While some of the other funds in the category have done an excellent job at delivering outsized absolute returns, I’m not sure those are sustainable going forward. While there are many positives to floating rate instruments, there are also many risks that are often overlooked. Investors will often only look at an investment’s volatility level when assessing its risk. This can be misleading. For example, many believe that floating rate instruments, with their low level of volatility are a great short term parking spot for their cash like money market or short term bonds. This is an incorrect assumption. Remember, these instruments are often unrated or below investment grade, meaning they carry a significant amount of credit risk. Looking back to the financial crisis, the BMO Floating Rate Income Fund fell by nearly 50% in 2008 and the Invesco Floating Rate Income Fund was now nearly 30%. Yes, both funds bounced back sharply in 2009, recovering a substantial portion of their losses, but this potential volatility make these types of funds unsuitable parking spots for cash. This is particularly true as we are very late cycle, and there is much uncertainty in the markets.
Adding to the risk is the estimate that 80% of leveraged loan debt is “covenant lite”. This means many of the investor protections built into earlier issues are no longer included. That increases the risk for investors and will make it more difficult to fully recover capital in the event of a default. With economic growth starting to show, it is expected we may see default rates increase.
In the event default rates move higher, I believe the conservative, credit focused investment style of this fund will help to better protect capital compared to some of the more aggressive peers. As a result, this remains my top pick in the Floating Rate Fixed Income category.
Mackenzie Canadian Growth Fund (MFC 650 – Front End Units, MFC 090 – Fee Based Units)
Back in March, I added this fund to the Mutual Fund Focus List and with a category leading second quarter return of 6.1%, it did not disappoint. Managed by the team of Dina DeGeer and David Arpin, it is a concentrated portfolio of well-managed, niche companies with sustainable competitive advantages, a history of strong free cash flow generation, and growth rates that exceed both the economy and their peers. Unlike some other growth focused managers, valuation is considered in the security selection process. To make sure they don’t overpay, the team builds out a valuation model based on a company’s free cash flow to provide them with an idea of what the company is truly worth. Only those companies trading at a meaningful discount to what they believe a company is worth are added to the portfolio.
Not surprisingly, the portfolio has a growth tilt to it with an overweight to technology, industrials, healthcare, and consumer names. As result, valuation levels are well above the broader market. With interest rates likely to remain flat or move lower, it is expected that growth focused investments will continue to benefit compare with more value focused names, which is a positive for this fund.
While I don’t expect the recent outperformance to continue indefinitely, the skilled management team and their disciplined investment process should allow the fund to continue to perform better than average in the near to medium term.
Given its growth tilt and current valuation levels, I would suggest being very active in taking profits in this fund. If you experience a reasonable level of growth, take some profits and bring the allocation back to a level that is in line with your investment objectives and risk tolerance. This will help to increase your overall returns over the long-term and help preserve capital in the event of a meaningful selloff in the markets.
Capital Group U.S. Equity Fund (CIF 847 – Front End Units, CIF 827 – Fee Based Units)
The Capital Group U.S. Equity Canada Fund is modelled after the firm’s oldest portfolio, the Investment Company of America, a fund that was launched in 1933, and boasts a strong track record of performance. Like all Capital Group funds, it is managed using a multi-manager approach, divided into different sleeves that are managed independently by managers of different backgrounds and styles. There is also a portion of the fund that is made up of the top picks from the firm’s analyst teams. The result is a portfolio that tends to be style agnostic.
Overseeing the portfolio is the firm’s Portfolio Coordinating Group, who monitor it in real time. They are responsible for setting the manager mix, based on their outlook for the environment. While there is this top down overview, the security selection is very much bottom up, resulting in a sector mix is much different than its index. The portfolio has a growth tilt to it, with an overweight to technology and healthcare. Despite this growth tilt, valuation levels are roughly in line with the broader market. It holds 70 names, with the top ten making up just over a third of the fund.
The managers take a longer-term outlook to investing, which is reflected by their very modest 23% average annual portfolio turnover. Capital Group is well known for its high level of manager co-investment in the funds. Nearly all of the firm’s managers had more than $1 million invested in their mandates, aligning their interests with their investors.
Costs are very reasonable, with an MER of 2.05%, which is well below the category average.
Despite the very solid long-term history of the U.S. based version of the fund, it has struggled recently. In second quarter, performance lagged as a result of a poor showing from holdings in the consumer staples and healthcare sector. An overweight to energy, which trailed in Q2 was also a headwind.
To be honest, I was a little surprised at the poor showing in the second quarter but am watching to ensure a turnaround occurs with the fund. Given the well-staffed management team, the disciplined investment process, the alignment of manager interests with investors, and the long-term track record of the firm and the fund, I remain confident performance will normalize.
Looking ahead, with its emphasis on risk management, I expect it will deliver index like or better returns with volatility levels that are slightly better than the broader market over the long-term.