Market review
The story of 2020 in global bond markets was marked by the rise of COVID-19 colliding with a new risk-taking paradigm from global central banks. The Bank of Canada built out a balance sheet equivalent to $545 billion to support the economy through the pandemic. The figure is roughly 24% of Canadian gross domestic product and well above the pre-pandemic balance sheet assets of $100 to $125 billion.
Interest rates declined and yield curves steepened across North America as the spread of the virus accelerated through 2020. Canadian 10-year government rates fell just over 100 basis points in 2020, while the two- to-30 year yield curve steepened from seven basis points to 105 basis points. Thirty-year government of Canada rates continued to drift higher in the fourth quarter to 1.25%, after striking a new low of 0.74% in early March.
North American corporate bond markets benefitted more from verbal support than actual direct funding support in 2020. The Bank of Canada bolstered the corporate bond market with a new bond purchase scheme. But in the end, it bought only a mere $180 million¹ of corporate bonds. A record level of foreigners purchasing $40 billion² in Canadian corporate bonds in April and May lent more tangible support to our credit market. This strong demand for credit was met with increased supply of new corporate bond issuance, which surged in late spring, but only finished 6.5%³ above 2019 volumes as global funders found demand for credit product even stronger in markets outside of Canada.
If one only looked at the Bloomberg Barclays Canada aggregate corporate credit spreads, closing only seven basis points wider than they closed out 2019, they could have mistaken this for an average year and missed spreads spiking 170 basis points above their 2019 closing levels in mid-March. Since March, those Canadian corporate spreads have been on a steady rally lower and fell by another 25 basis points in the fourth quarter. The Canadian credit curve steepened out over the year with shorter-term credit spreads more supported by central bank purchase programs than longer- term corporate bonds.
Portfolio review
The fund closed the year strong from an active return perspective. For the fourth quarter, the active return helped the fund return more than double the total return of the index. The Fund’s overweight to credit and specifically to U.S. dollar corporate bonds drove nearly all of the active returns in the fourth quarter. The derivatives used to hedge the Fund’s foreign currency and foreign interest rate exposure also provided some tail wind to the active return, mostly due to favourable swap-spread movements. While Canadian yields moved higher and the yield curve steepened, the Fund remained very close to neutral in its exposure to changes in interest rates. And the net effect from changes in interest rates was minimal.
This was a solid year for this strategy as the portfolio manager effectively used fundamental credit research capabilities to choose wisely during the corporate bond sell off. Their broad perspective and hedging proficiency allowed the portfolio manager to take advantage of opportunities in the U.S. credit market, which had sold off more significantly than Canada earlier in the year, while keeping the Fund’s net foreign currency and foreign rates exposure minimal. As the credit opportunities in both the U.S. and Canada diminished toward the close of 2020, the strategy lowered its active credit and foreign content, while still retaining some of the foreign holdings for diversification and credit enhancement.
Portfolio positioning
Duration was slightly lower than the Fund’s benchmark, as the portfolio manager expects interest rate compression related to central bank bond purchases to gradually decline. Credit quality was similar to the benchmark. The portfolio continues to be underweight provincials as the portfolio manager expects relatively robust bond issuance programs from the provinces to continue. The weighting in corporate bonds was moved into federals over the quarter as the Fund realized gains from corporate bonds and positioned the portfolio higher in both credit quality and liquidity.
The Fund continued to be overweight inflation-linked Canada bonds. Inflation-linked bonds had outperformed nominal Canada bonds as inflation expectations embedded in these securities were rising. Canadian inflation-linked bonds may have further performance potential as their rise in value was less than the increase in value of similar inflation-linked securities in comparable countries.
The portfolio moved from overweight the 30-year term to underweight and reallocated some of that weighting to the seven-year term, consistent with the Fund’s reduction in duration in the quarter.
The portfolio’s overall credit quality was in line with its benchmark. Much of the portfolio’s increase in credit quality in the fourth quarter was driven by a decrease in the corporate bond weighting in favour of federal bonds.
The portfolio is overweight U.S. dollar corporate bonds, which are excluded from the benchmark. This overweight was driven by the potential for yield enhancement in addition to diversification benefits. The portfolio hedges its U.S. dollar bonds using a cash-flow swap to minimize the fund's exposure to changes in U.S. currency and U.S. interest rates. The U.S. dollar weighting in the portfolio decreased by 4.5% to end the fourth quarter at 12.4%. Much of the decrease came from selling U.S. dollar industrial corporate bonds and U.S. treasury bonds to purchase Canadian federals.
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