Passively investing in corporate bonds in Canada has been an unattractive proposition for many years: Historical risk-adjusted returns for corporate bonds have generally been only slightly higher than those for comparable government bonds. Structural reasons that involve how corporate bond indices are constructed, as well as factors unique to the Canadian corporate bond market, can generally explain why corporate bond returns have been less than impressive for passive investors.
Unconstrained by the structural limitations of corporate bond indices, active management may provide superior returns to passive management within corporate bond portfolios. Our belief is that active managers with global reach are best positioned to outperform the Canadian corporate bond indices. The recent widening in global corporate credit spreads has increased the attractiveness of a global investment style for Canadian investors.
Structural shortcomings of corporate bond indices
It is an increasingly recognised reality in investment circles that passive investing has been a sub-optimal strategy for credit investors. Over the last 15 years (from December 1997 through July 2013), for example, the Bank of America Merrill Lynch Global Corporate USD-Hedged Index has delivered annualised returns in excess of duration-matched government bond returns of approximately 0.48%, with a volatility of 3.8% per annum. To put this in perspective, the corporate index’s Sharpe ratio, a widely-used measure of risk-adjusted return that takes volatility into account, is just 0.13, indicating very modest value. The BofA Merrill Lynch U.S. dollar-denominated corporate index showed similar shortcomings, with an average annual excess return over government bonds of 0.53% and a Sharpe ratio of 0.10 across the same time period.
These results are disappointing and somewhat counter-intuitive. After all, given the cyclical nature of credit risk (credit generally performs well in good economic times and poorly in bad times, similar to equities), corporate bonds should reward investors for taking added risk over time. Why don’t they? Our research indicates that there are at least two major factors behind the less-than-impressive performance of corporate bond indices, both of which relate to the rules that lie behind the makeup of traditional indices.
First, there is the issue of “fallen angels.” To reflect different levels of credit risk, standard credit indices have strict rules regarding the credit ratings of the underlying constituent securities. In particular, investment grade indices stipulate that only bonds rated at or above BBB-/Baa3 can remain in the indices. This means that, should an issuer be downgraded below investment grade and into high yield, it would be forced out of the index at the end of the month of downgrade. Such “fallen angels,” however, often bounce back; losses initially experienced upon, or in the lead-up to, the credit rating downgrade are often at least partially recouped in the following months. For the passive investor, however, the initial losses are locked in as the bond falls out of the index and subsequent gains are not captured.
Second, many mainstream bond indices, including the widely followed suite of DEX indices in Canada, are restricted by maturity and include only bonds of at least one year in remaining term. As bonds slip below this maturity, they fall out of the index and must therefore be sold by holders of index-tracking portfolios. However, our empirical analysis of historical returns shows that shorter-dated credit has outperformed longer-dated credit. Such exclusions therefore force passive investors to relinquish potentially superior returns arising from this sub-asset class of short-term bonds.
Figure 1 shows realised historical return-per-unit-risk measures (Sharpe ratios) for these categories, using widely tracked indices. While Canadian corporates (0.34) have outperformed their global counterparts, they still lag both fallen angels (0.43) and short-dated credit. Due to lack of data for longer-term corporates, we have used the one- to three-year sector of the standard index as a proxy (0.85). Since 2004, we find that the less-than-one-year sector shows the strongest performance, delivering a Sharpe ratio of 0.95. This historical evidence indicates that any investment strategy that precludes allocations to the more rewarding subsectors of credit, such as index-tracking, is prone to lower returns than one that allows participation in them.
Another weakness of typical bond indices is they tend to be market-capitalization weighted. This means that passive investors must make higher allocations to the most indebted companies. The Canadian corporate market is especially problematic in this regard. As of 31 July 2013, the largest 10 issuers in the DEX All Corporate Bond Index accounted for 44.4% of its total market value. The DEX Corporate Bond Long Index is similarly concentrated, with the top 10 issuers making up 46.7% of its total. By comparison, other global credit indices are considerably less top heavy, as shown in Figure 2.
In addition to this high concentration, the relatively healthy performance of the Canadian Corporate Bond Index has been largely due to a small collection of highly indebted companies (mainly financials, utilities and resource companies). This is clear in the historical performance figures, shown in Figure 3, for the large-cap sector of the Canadian corporate universe. (Here, we use the Bank of America Merrill Lynch Canada Corporate and Canada Corporate Large-Cap Indices.)
This lack of diversification poses the risk of exaggerated losses from idiosyncratic, company-specific events. It also shows that active managers of corporate bond portfolios that are restricted to investing in credits within the index would be challenged to add value by allocating capital beyond the largest issuers in the index.
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 U.S. 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 U.S. 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 U.S. 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 U.S. Corporate Index widened 5 bps, as Figure 8 illustrates.
Jeremy Rosten contributed research and analysis to this article.