Conservative investors can hedge bonds

When bonds do poorly, all traditional bond investors have been able to do, is decrease bond duration and increase cash, says Philip Mesman, a portfolio manager at Picton Mahoney Asset Management in Toronto.

“That results in mediocre returns; or, as we saw [in 2013], negative returns.”

This doesn’t mean you should flee fixed income and load up on stocks. Instead, consider alternative strategies for the fixed-income portion of your portfolio.

Long and short

Mesman’s approach uses long and short positions to capitalize on good buys and hedge the risks that stymie typical strategies. His long positions focus on the middle of the North American corporate bond market — firms rated B to BBB. Familiar names include Bombardier, BCE, Telus and TransCanada. Mesman says such companies are often worth more than they’re priced.

Within this set, he sees the best value in shorter-duration high-yield and lower-quality investment grade bonds. He specifically goes after bonds issued post-credit crisis, between 2009 and 2012. “They have some of the best structures and coupons I’ve seen,” Mesman says. “Coming out of the crisis, these companies were forced to offer attractive covenants to get their deals done.”

The short side of the portfolio hedges three key risks:

• Interest rate risk – the bond’s price falls when rates rise
• Price risk – the bond costs too much
• Credit risk – the issuer may default or go bankrupt

The severity of each factor varies over the investment cycle. Currently, interest rate and price risk dominate, he says. To hedge interest rate risk, Mesman shorts government bonds. Just like shorting stocks, you’re betting bonds will lose value.

But how does that happen? Say you hold 10-year government bonds with $100 face values, issued at a rate of 1.5%. If the rate jumps to 2%, newly issued bonds are more attractive.

To match that 2% coupon, your price would have to dip below $100. Your bonds’ current effective value, in other words, has gone down even though you don’t intend to sell. To hedge price risk, Mesman shorts expensive bonds with weak credit profiles. “A high-yield company at 5% for 10 years is too expensive.” The asset class has historically commanded close to 8% and with shorter durations.

When Mesman sees signs of credit risk, he adjusts accordingly, adding positions to short against it. For instance, his firm thought a mid-sized oil and gas company’s balance sheet was over-levered and the bonds mispriced. When the company reported Q4 earnings, the numbers reflected his firm’s concerns: the company’s bonds went from $100 to the mid-to-low $80s.