Canada May Be the "Cleanest Shirt in the Hamper," but It Still Faces Some Unsettling Secular Trends, Says Pimco's Ed Devlin

When it comes to fixed income, Canada is the cleanest shirt in the hamper.

The reason, says Ed Devlin, executive vice president and head of Canadian portfolio management at Pacific Investment Management Company, is that Canada engages in less "financial repression" than the country's G7 counterparts.

This term, first coined by two Stanford University economists, Edward S. Shaw and Ronald I. McKinnon, was recently reintroduced into the financial lexicon by economists Carmen M. Reinhart and M. Belen Sbrancia in a 2011 National Bureau of Economic Research Working Paper. Financial repression refers to a strategy used by governments to keep interest rates artificially low in order to reduce the real value of debt, which has skyrocketed in many developed countries in the wake of the global financial crisis. In response, governments have been keeping nominal interest rates lower than would otherwise be possible. That, in turn, has not only reduced debt service costs, but also resulted in negative real rates of return, reducing the real value of debt.

Devlin told delegates at the Global Fixed-Income Management Conference in Toronto last week that there is less financial repression in Canada because the country's economy, financial institutions, and real estate markets have been relatively immune from the financial crisis that swept through the U.S., the U.K., and the eurozone.

However, Canada still faces some unsettling secular trends, Devlin said. A strengthening Canadian dollar has resulted in a steady decline in exports to the U.S. (its largest trading partner) and greater imports from China and other emerging market countries. Household debt as a percentage of personal disposable income has also been rising — which does not bode well for future consumer spending — and is currently equal to that of the U.S. at 140%.

From an investment perspective, Devlin thinks that the Canadian corporate bond market is one of the most expensive and the least diversified. Option-adjusted credit spreads are approximately 132 basis points in Canada versus 160 in the U.S., 178 in the eurozone, and 230 in the U.K. Devlin also noted that 59% of Canada’s bond index is concentrated in ten issuers; the equivalent figure for the U.S., the U.K., and the eurozone is much lower: 20%, 26%, and 35%, respectively.

The upshot: Devlin recommends that Canadian bond investors become more active and look to increase yield through high-quality spread and high real yields. Although bonds have been a good hedge in the past against bear markets, he expects future bond returns will be in the mid- to low-single-digits and thus unlikely to offset future equity bear markets.

In this environment, Devlin asserted, 1% to 2% in alpha matters more than ever.