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January 2010

After four consecutive quarters of gains, the DEX Universe Bond Index lost ground in the fourth quarter, sliding a modest 0.2%. The S&P/TSX Composite Index, on the other hand, continued on its upward trend, rising 3.9%. Over the past year, the two indices were up 5.4% and 35.1%, respectively.

The Income Fund gained 3.0% in the quarter, and was up 22.5% over the past 12 months.

With improving economic conditions and the repayment of government loans by several U.S. financial institutions (issued under the TARP program), the bond market shifted its attention to the recovery at hand. Interest rates on medium and longer-term bonds began to rise in the wake of positive economic growth and signs of stabilization within the U.S. housing and labour markets.

Government bonds lost ground due to the rise in rates, but corporate bonds continued to produce positive returns as credit spreads (the difference in yield between corporate and government bonds) compressed further.

Early in the year, 5-year bank bonds had yields that were over 4% higher than their government counterparts. By the end of 2009, the difference was less than 1%. This narrowing of spreads led to large price gains in many of the fund’s corporate holdings. Indeed, as we suggested in past reports, 2009 proved to be a once-in-a-generation opportunity in the corporate market.

A subset of this market, maple bonds (Canadian dollar-denominated bonds issued by foreign institutions), has also seen a revival, leading to attractive gains in holdings such as Morgan Stanley, Goldman Sachs and Merrill Lynch.

The fund’s 2009 return was a reflection of both the events that played out in the fixed income market and the manager’s positioning. CC&L made few changes to the portfolio, maintaining a significant weighting in corporate bonds, which comprised 50% of the fund at year-end, and a healthy allocation to income-equities (31%). Government bonds, at 19%, made up the balance of the fund.

The fund’s income-equities (dividend-paying stocks, income trusts and REITs) have enjoyed a solid rebound, with business trusts turning in a particularly strong fourth quarter. That said, their weight in the fund is at the higher end of where the manager would like it to be, and some positions may be trimmed in 2010.

While bank bonds still comprise the greatest weight in the fixed income portion of the fund, the manager likes the value they are seeing in insurance bonds. In our June report, we highlighted that CC&L was shifting some assets out of the banks and into these bonds. The transition has been modest (as the fundamentals of bank bonds are still attractive), but CC&L continues to like the outlook for bonds issued by companies such as Sun Life and Manulife.

The fund’s pre-fee yield at year-end was 5.5%. This represents a yield advantage of roughly 1.9% over the Government of Canada benchmark 10-year bond.

Along with the asset class and security selection decisions that we have highlighted, the manager pursues a number of other strategies to add value. These include duration and yield curve strategies, among others. An explanation of all these tactics is beyond the scope of this report, but suffice to say, the manager has been hitting on all cylinders. Yet, this will not always be the case. Investors should expect more modest annual returns which are more in line with the fund’s objective of providing stable income and modest capital growth.