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Investing in Corporate Bonds: The Compelling Case for Active Management

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The current environment presents an attractive opportunity for Canadian investors to implement a wide discretion, active approach to managing corporate bonds.

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Regarding the diversity of companies in a portfolio, Figure 4 demonstrates that Canada offers a very limited selection, with a paucity of options for investors in the higher spread categories.



In other words, if most of the value in the Canadian corporate market is provided by the exposure to the largest issuers, why pay active fees for managers to invest in the more challenging sector of less-indebted Canadian issuers?

Canadian corporates: tighter spreads, lower liquidity

As shown in Figure 5, the Canadian corporate market has for several years looked expensive relative to comparable US and global corporate credit. Measured by spread levels over duration-matched interest rate swaps, Canadian corporate index spreads, as measured by the Bank of America Merrill Lynch Canada Corporate Index, have remained well below their international counterparts, trading at 56 basis points (bps) below US dollar corporate spreads, shown in the Bank of America Merrill Lynch US Corporate index as of 31 July 2013.

This spread difference is partly due to the slightly lower average credit rating of the BofA Merrill Lynch US Corporate Index; because of the lower credit quality, the US Corporate Index therefore would have a higher potential for defaults. To estimate the difference in expected return arising from this spread difference, we should therefore adjust this comparison for the expected losses from default for each index. Using long-term default probabilities and expected losses in the event of default, based on average corporate debt recovery rates from Moody's Investors Service, we estimate that the US dollar index has an annual expected default loss approximately 17 bps higher than that of its Canadian counterpart. This still leaves a gap of some 39 bps of spread carry return between the two indices.

If default losses experienced in a corporate portfolio are in line with those of the regional or global benchmark indices, this would imply that the opportunities for carry, or additional return, from spreads in the Canadian market are inferior to those elsewhere. All things being equal, therefore, allocations to credit outside of Canada could serve to increase investment returns.



Figure 6 further demonstrates that Canadian spreads in many sectors and rating categories are narrower than those in three major bond markets. In particular, in the lower-rated, higher-spread and potentially most rewarding sector (securities rated BBB), Canadian corporates put investors at a disadvantage in terms of picking up spread.



The two most common Canadian corporate bond indices, DEX Corporate and DEX Corporate Long, are relatively small and much less diversified than global credit indices. For example, Figure 7 shows that the Barclays Global Aggregate Corporate Index is over 20 times larger in terms of notional amount outstanding and has more than eight times the number of unique issuers, 10 times the number of bond issues and an average issue size more than twice that of the DEX Corporate Bond Index. When comparing the DEX Corporate Long Index against various global indices, the differences in size and scope are even more dramatic.



It has been our experience at PIMCO that Canada's smaller corporate market translates into wider bid/offer spreads in the secondary market. Higher transaction costs make it more difficult for active managers to add value in the Canadian corporate market relative to larger corporate markets.

Recent outperformance of Canadian corporate bonds: Look to global opportunities

Between 1 May and 31 August this year, the BofA Merrill Lynch Canada Corporate Index tightened 5 bps, while the BofA ML Global Corporate Index widened 2 bps and the BofA ML US Corporate Index widened 5 bps, as Figure 8 illustrates. We believe this environment presents an attractive opportunity for Canadian investors to implement a wide-discretion, active approach to managing corporate bonds.



Jeremy Rosten contributed research and analysis to this article.

This article originally appeared on Pimco.
No positions in stocks mentioned.
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