The active edge with Dynamic's crossover bond ETF

09-05-2019
The active edge with Dynamic's crossover bond ETF

Moves to the head of the performance queue

The Dynamic iShares Active Crossover Bond ETF (TSX: DXO) is a relatively new entrant to the high-yield fixed-income fund category – it was launched in January 2017 – but has moved quickly to the head of the performance queue. The one-year return through July 31 was an impressive 9.6% (compared with the category average of 4.3%); the 2019 year-to-date return to the end of July was an even more stellar 11.1%. That’s given it a FundGrade A rating for July.

The fund’s manager, Marc-André Gaudreau, vice-president and senior portfolio manager at 1832 Asset Management, attributes the fund’s outperformance (and its name) to its focus on the “crossover” – an industry term denoting the rating zone where “investment grade” and “high yield” bond issues intersect (between BB and BBB).

“That’s the sweet spot,” says Gaudreau. “That is the zone that offers the best risk/return profile, where the return per unit of volatility is highest. We’re far enough from defaults, and we’re away from interest-sensitive credit like AAA bonds.” Gaudreau adds that while focusing on the crossover is not a new investment concept, this fund is unique in investing there almost exclusively (a few outliers are permitted if the numbers warrant). “We have some names below BB that we find attractive.

“Our overall weighing is BB+,” Gaudreau adds. “The bulk of our exposure is in the U.S., but we’re fully hedged for currency. We are looking purely at credit selection, not duration or currency.”

This focus on credit is made possible by the fund’s internal team of credit analysts. “We don’t rely on credit rating agencies, although we do need to look at them,” Gaudreau says. “They affect the market because a lot of players outsource 100% of their risk evaluation.

“A lot of fixed-income traders are passive investors, and there are passive benchmarks that trigger selling points,” says Gaudreau, adding that “when you cross the line” the result is a lot of selling and buying. “When rating agencies and passive managers downgrade it’s often for good reasons, but sometimes it’s for bad reasons. We define the risk, and we can play the spread, or wait for a selloff.

As for whether the fund’s exceptional performance can be sustained in the evolving interest rate climate, Gaudreau is unsure but optimistic. “It depends on whether you’re looking at short- or long-term rates. Short-term rates had been going up in the U.S. and Canada, but [the U.S. Federal Reserve] recently lowered theirs.

“Long-term rates are driven by global growth and expectations have been falling, but some countries don’t have a positive yield, so they try to manipulate the market with quantitative easing (QE),” says Gaudreau. “The yield curve is now inverted, and there are some very weird things taking place. For example, there are now 15 European high-yields bonds with negative yields – that’s hard to believe.”

Given current circumstances, Gaudreau acknowledges some caution may be in order. “We are later in the business cycle, and so we need to look more at risk. It makes sense from a risk-rewards standpoint to switch to a more defensive position,” he adds, suggesting perhaps a move from BB to BBB. “But as we progress to the next phase of the business cycle, where there’s some risk of recession, there will be tremendous opportunities for independent active managers.”

Meanwhile for investors. it’s worth noting that as with most ETFs, the Dynamic iShares Active Crossover Bond ETF’s management expense ratio (MER) is a relatively low (for an actively-managed investment) 0.56%, and it trades on the Toronto Stock Exchange just like common shares.

Olev Edur is an experienced financial and business journalist and a frequent contributor to the Fund Library.

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