Symmetry Perspectives - Q2 2010

Introducing Steve Locke, new fixed income manager on Symmetry Fixed Income

July 5, 2010 Since joining Mackenzie with the acquisition of Saxon Financial in 2008, Portfolio manager Steve Locke has been a key member of the Sentinel fixed income team for nearly two years. Recently named co-leader of the Sentinel team, Steve has assumed management responsibility for Sentinel Bond Fund and Sentinel Real Return bond Fund and the Mackenzie-managed universe bond and RRB components of Symmetry Registered Fixed Income Pool.

In the following interview with Karen Bleasby, Steve discusses his background and investment process, as well as the integration of the Sentinel and Saxon fixed income teams. He also comments on the management transition and its implications for Symmetry Fixed Income.

Karen: Steve, let’s start by talking about your background and work history prior to joining Mackenzie.

After I graduated from business school, I began my career at MetLife where I assumed various roles in credit analysis, bond trading and portfolio management. It was there that I developed my background in corporate credit which has influenced my style and focus to the present day. I eventually left MetLife to join Royal & Sun Alliance where I managed segregated and pension funds. I became more active in managing the risk and return relationship on an ongoing basis, a style I have maintained throughout the remainder of my career. Risk and valuation change all the time, requiring constant monitoring and active management in order to best take advantage of opportunities. Following Royal & Sun, I joined the Saxon Financial fixed income team in 2003 as a portfolio manager. My value-perrisk credit style proved to be a good fit for Saxon’s value-based equity culture. I remained with Saxon through the integration with Mackenzie in 2008.

How would you describe the integration of the Sentinel and Saxon fixed income teams?

Upon joining Mackenzie in 2008, the Saxon fixed income team merged with Mackenzie’s Sentinel team, so we have already been functioning as a unified group for some time. The teams have very complementary backgrounds, so the result of the integration is a very strong, well-rounded team with research expertise across the fixed income spectrum, from money market, governments and structured products to investment grade and high yield corporate credit. Thanks to our complementary skill sets and many similarities in our outlook and process, the transition was a Symmetry Perspectives 2 very smooth one. My background in investment grade corporate credit proved to be a valuable complement to Chris Kresic’s greater emphasis on structured products, with Dan Bastasic rounding out the team on the high yield side. The merger has been very productive for us, as our meetings and informal discussions have allowed us to foster new ideas and draw from each other’s experience.

With Chris Kresic’s departure, you were recently named co-leader of the Mackenzie Sentinel team, along with Dan Bastasic. You have also assumed management responsibility for a large component of the Symmetry Fixed Income Pool. Do you expect any significant changes to the process or structure of the portfolio as a result?

While Chris and I deviate slightly in terms of our asset focus (Chris on securitization and structured products, myself on corporate bonds), we share very similar views on portfolio construction style, duration management, and valuation. We have typically had very few disagreements and thus it has been generally easy to reach consensus. In fact, I have been involved in the analysis and selection of securities in Sentinel Bond Fund and Symmetry for the last year and a half. Chris and I have been executing as co-managers across our mandates, so apart from a slight shift in the composition of spread product, it is unlikely that the management and construction of the portfolio will change in a significant way.

Could you elaborate on some of the similarities and differences between your investment style and Chris Kresic’s?

Chris and I share similar views on duration, and we both share a focus on the front-end of the yield curve for spread product. While we both hold a variety of spread product, we tend to focus our efforts differently – a result of the influence of our respective backgrounds. I have emphasized corporate bonds as a source of yield within my portfolios. Chris, while also holding corporate bonds, generally prefers to add yield via structured products (assetbacked securities). Both types of assets are considered spread product within the context of a bond portfolio. In the end, it doesn’t matter where the spread comes from, given similar valuations and risk per return characteristics. For example, in 2009 both Chris and I began “barbelling” the portfolios - overweighting the short and long ends of the curve while underweighting the middle - in expectation of a flattening trend. While I weighted the back end with corporates, Chris focused the majority of his back end weight on asset-backed securities, but the end result was similar.

You have a definite emphasis on corporates and credit analysis, but tell me more about the factors that influence your decisions on duration, yield curve positioning, sector and security selection.

I like to start by examining the business cycle and the central bank’s position in terms of setting policy. I also consider extraneous elements, for example, the presence of risk-taking or risk-reducing behavior in the markets. These observations influence my position on duration and the yield curve in terms of managing maturity against a longer term outlook for inflation and economic growth. This approach can also drive my sector positioning to some extent. I first form a medium-term economic outlook, then check to see whether any short-term influences may supersede my medium-term view.

When setting duration, I examine Bank of Canada actions, and I also use flow-of-funds data and technical indicators to examine the relative degree of risk aversion versus risk seeking behavior in the market, to assist with timing. My “typical” duration position is within one year of the index, while being slightly short the majority of the time. I am currently neutral duration, as I expect a period of inflation rate and bond yield stability. My security selection process encompasses a combination of top-down and bottom-up influences. The team is focused on bottom-up fundamental credit analysis – the only way to accurately determine value relative to risk. An overlay of qualitative analysis and knowledge of our position in the cycle also influence our portfolio positioning.

You hold some positions in “maple bonds”. What exactly are maple bonds, and why do you own them?

“Maple bonds” are Canadian dollar-denominated debt issued in Canada by a foreign entity (either a government or corporation). The maple bond market opened in 2003 and quickly gained popularity in 2005 when foreign content restrictions were removed on registered investments in Canada. The market disappeared during the recent credit crisis as Canadian investors shunned foreign debt in favour of the perceived safety of issuers “close to home”, but it has recently picked up again.

Many maples are created as a result of foreign issuers looking for low-cost funding, and as such are not attractively priced. But maples sometimes offer good diversification opportunities with a yield advantage over similar debt. As an example, I purchased Commonwealth Bank of Australia maple bonds which offered a yield advantage over a Canadian bank. When investing in maples, I examine how the company is pricing its debt elsewhere, and check to see whether the foreign-denominated bonds of the same issuer offer a better value. If the foreign-pay bond is more attractive, I will purchase it instead, and hedge off the currency risk.

You manage Symmetry’s 7% allocation to real return bonds. How much experience do you have investing in RRBs? What role should they play in an investor’s portfolio?

I have held both Canada and provincial RRBs within Saxon portfolios as a tactical addition when they offer good value over nominal bond issues. Both Chris Kresic and I added RRBs to our portfolios in 2009 as they offered excellent value. Early last year, the perceived risk of deflation impacted the market and resulted in the underperformance of RRBs, setting them up to outperform for the 2nd half of 2009. RRBs typically trade on a breakeven basis with 2% to 2.5% implied inflation. In addition to their obvious place in real return portfolios, I have held RRBs in nominal portfolios due to their suitability as a yield enhancement tool. I expect to add to my position in RRBs should they become attractively priced again.

Given the current environment, what is your outlook for both fixed income and the general economy?

I expect a continued slow-growth environment with accommodative monetary policy. For the near-term I believe the Bank of Canada will continue to nudge higher in 25 basis point increments, but each move will be carefully on a case-by-case basis, considering the strength of the domestic economy as well as the impact of euro and global concerns on credit markets. Over the medium-term, the global policy rate setting should be stimulative for economies once the current deleveraging and deflationary forces currently limiting global growth begin to abate. Any concerns about inflation ramping up are premature at this point, so bond yields should remain relatively low, but may resume a small upward bias once European credit risk headlines cease to dominate the news. Corporate bonds continue to represent good value relative to government debt. While credit spreads narrowed significantly in 2009, both macro and bottom up analysis support an overweight in Canadian corporate bonds, and spreads should continue to narrow given the current, more stable yield environment. I also believe that investment-grade corporates will continue to outperform governments, as the strengthening economic environment is favourable to corporate credit.

What role should fixed income play in investor’s portfolios from an asset allocation perspective?

Fixed income represents a low risk asset class that offers a generally consistent rate of return through its yield. Bonds reduce volatility for equity investors, and the experience over the last cycle has taught us that high volatility has not correlated to high returns. Therefore, bonds have a place within a well-diversified portfolio. For Symmetry Fixed Income investors, my focus is to continue to seek out the best value and the lowest risk fixed income investments possible.

 

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