Compass: Fixed Income Fixes


By Paul Rietkerk, CIM, FMA

View this edition of Compass in PDF version.

With interest rates on the rise from near all-time lows; along with credit markets expanding to all-time highs; there is a real risk of losing money in a typical bond portfolio. In this issue of Compass, we answer investors who find themselves asking, “why should I be investing in Fixed Income or Bonds?” We will do this first by reviewing why fixed income is still important and then highlighting a few ways in which Nicola Wealth Management looks at fixed income differently.

Fixed income is a mainstay of any balanced portfolio. When yields were higher and falling, returns were good, liquidity was great for portfolio withdrawals, and it typically served as a counter balance to equities (a general rule of thumb – when stock markets fell, the bond market rallied). Although a typical bond portfolio that consists of mostly government and investment grade bonds of varying maturities can still serve as a means of liquidity for portfolio withdrawals and a counter-balance to equities, there is very little return potential remaining in the current environment (unless interest rates go negative).

Although it may seem hard to believe that one could lose money on a typical bond portfolio that would have been considered a “conservative investment”, in today’s market environment it is a real risk . This is because we’ve reached a point where interest rates have stopped falling and have begun to increase.

All else being equal, investors tend to choose a bond with the higher interest rate. When new bonds come to market and offer higher rates, investors sell their current bonds in order to buy the bonds with the higher rates. This is where you can lose money. The value of your current bond portfolio will be worth less if interest rates increase. One may ask “how much could I lose?” There are calculations that use the “duration” of a bond portfolio to answer this question, let’s use a simple example. Supposing you have a typical bond portfolio and the average maturity of your portfolio of bonds is 10 years (very close to the actual average in the market today). If interest rates were to increase by 1%, the value of your bond portfolio would drop by 10%. Not so conservative anymore…

So what do we do? Abandon fixed income investments? Re-allocate bonds into other parts of the portfolio? Add more equities or real estate? These options may provide some of the solution, but at Nicola Wealth Management, we take a different approach to fixed income.

We still have a bond portfolio, in the form of our NWM Bond Fund, in order to provide our clients with a very liquid pool of capital with minimal volatility and a better return than cash. However, it is structured with more short-term bonds than a “typical” bond portfolio. Part of the NWM Bond Fund is also allocated to strategies that hedge out interest rate exposure while still capturing yield from fixed income credit spreads. This strategy has worked well historically. For example, despite rising interest rates, the NWM Bond Fund performed  well, returning +3.3% vs. comparable iShares Universe Bond Index ETF return of +2.4% in 2017. Please see chart below of the longer-term performance and how the NWM Bond Fund has continued to perform despite raising rates in the last couple years:

Source: Morningstar Direct
Time Period: 09/01/2011 to 04/30/2018

The differentiators in our fixed income strategy do not stop there. Instead, we continue to look for different areas of the fixed income universe that are historically accessible only by institutional investors. These kinds of private markets are more challenging to access but can offer better return characteristics (with some trade-offs which we will discuss later on).

Commercial Mortgages

Commercial Mortgages have been a part of Nicola Wealth Management Portfolios since the 1990’s. These are not “high-risk” mortgages on residential homes where the borrowers cannot get traditional financing from banks (like many of the “Mortgage Investment Corporations” advertising these days).

Our approach is far more conservative. The NWM Balanced Mortgage Fund and the NWM Primary Mortgage Fund are comprised of mortgages on commercial properties with stable monthly rental income like professionally managed multi-unit apartment buildings, office buildings, and shopping centers across Canada.

Not only do we ensure that the rental income less operating expenses is more than enough to make the monthly mortgage payments, but the invested capital is secured by investment grade assets with values far in excess of the loan amount. The historical returns have been very consistent and have averaged between 4.0%-7.5% (after fees) per year since November 2009 (inception).

Private Debt

Private debt is another attractive asset class which is, traditionally, far more exclusive. There are many companies in North America that will pay higher interest rates to investors for private loans, for various reasons (here are a few):

  • Traditional lenders may not understand their business, be slow to underwrite or outright refuse to lend.
  • The borrowers may appreciate keeping their financial statements private (which they would not be able to do when accessing public markets) in order to keep information from their competitors.
  • A company may want to work with one lender (or a small group of lenders) instead of a public issuance with far more end borrowers where making changes to the structure of the debt is far more challenging down the road.

Nicola Wealth Management’s NWM Private Debt Fund partners with several third party private debt managers (and lends directly) in order to provide this asset class to our clients. Although, still new (launched in October 2017) the NWM Private Debt Fund has been investing well and we target 7-8% per year returns to our unitholders in this investment.**

So what’s the catch?  Why isn’t everyone allocating capital into mortgages and private debt? Here are a few answers to these questions:

Liquidity Risk

We would be remiss in mentioning that both the Commercial Mortgage and Private Debt asset classes have another type of risk that is not generally associated with fixed income, and that is liquidity risk.

Commercial Mortgage and Private Debt funds typically hold loans that have an agreed term of several years, which can restrict the ability of the fund to meet its short-term cash needs.

To mitigate these liquidity issues, both our NWM Primary Mortgage Fund and NWM Balanced Mortgage Fund have a large and diversified pool of mortgages with many borrowers and loans with various maturity profiles. This diversification of maturities allows us to provide weekly liquidity (unless we experience an extreme event, where the Canadian financial system experiences a lack of liquidity in the commercial mortgage market and there are a large number of redemptions from our funds) to our unit holders.

Private Debt has higher liquidity constraints. These are also loans that on average have an agreed term of several years. However, because this investment is newer to us, it does not have as much diversification built in and is not yet regularly receiving capital back from matured loans. Once the Private Debt Fund has a few years of investing behind it, the liquidity should theoretically improve.

Neither Commercial Mortgages nor Private Debt are investments that we recommend if your time horizon is less than a year.

Private Debt is a complex product

Private Debt remains a complex investment offering, it has grown tremendously over a short period of time and lacks the track record of more established investments. Additionally, the opportunities that are available in the market often have high investment deposit minimums with very restrictive liquidity constraints.

Through the NWM Private Debt Fund, however, our clients can access several attractive areas of private debt investing in a cost-efficient and diversified way. With a larger pool of capital, the NWM Private Debt Fund negotiates for lower institutional-type manager fees as well as further diluting these fees by asking managers for no-fee co-investment opportunities.

Not all Mortgages are created equal

There are other organizations offering mortgage investments; many offering higher returns than our own. However, not all mortgage investments are the same. Be very careful when investing in these kinds of products. Be sure to ask questions like: what kinds of properties are being used as collateral? Do they produce monthly income? Where are they located? Who are the borrowers?

Mortgages held in the NWM Balanced Mortgage Fund and NWM Primary Mortgage Fund are sourced and underwritten by some of the most respected companies in the Canadian commercial mortgage industry, with deep technical expertise, diverse borrower relationships and almost 110 combined years of management experience. We are able to leverage our relationships with these firms because of our large institutional sized mortgage pools, which would otherwise be unavailable to smaller investors.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is generally intended for tax residents of Canada who are accredited investors. Past performance is not indicative of future results. All investments contain risk and may gain or lose value. Returns are net of fund expenses charged to date. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. All investments contain risk and may gain or lose value. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Please speak to your NWM advisor for advice based on your unique circumstances.

*The returns for NWM Balanced Mortgage Fund, as reported on March 31, 2018  are as follows: 5.2% 1 year, 5.3% 3 year, 5.9% 5 year, and 6.0% since inception, 

**This summary contains forward-looking information and actual results may vary materially in respect of the investment described in this summary. This summary is not an offering document or an offering of securities in any jurisdiction.