Last Thursday, the Macdonald-Laurier Institute released a report warning Canadians that several provinces have a high probability of defaulting on their debt payments over the next 20 years (although they acknowledged that the risk of default for all provinces over the next 5 to 10 years was essentially zero).
Although this Greece-like crisis is only one possible outcome over many, it is still recommended that investors take the time to understand the underlying risks of their fixed income investments. We can start by popping the hood on the DFA Investment Grade Fixed Income Fund (DFA449).
Long Term Provincial Bonds
The fund is underweight long term provincial bonds and overweight long term federal bonds (relative to the iShares DEX Universe Bond Index Fund (XBB)). For investors who are concerned with the long term sustainability of our provincial finances, this fund may be more suitable than a broad market ETF.
Short Term and Long Term Corporate Bonds
Adding short term corporate bonds to a portfolio has historically resulted in higher returns and higher risk-adjusted returns, relative to an all short term federal bond portfolio. Adding long term corporate bonds to a portfolio has actually resulted in lower returns and lower risk-adjusted returns, relative to an all long term federal bond portfolio. DFA has a significant overweight to short term corporate bonds and an underweight to long term corporate bonds – I doubt this allocation is merely by accident.
The DFA fund uses the variable credit approach to fixed income investing. When credit spreads (the difference between corporate bond yields and government bond yields) are wide (narrow), the fund will overweight (underweight) corporate bonds, relative to the DEX Universe Bond Index. When intra-corporate spreads (the difference between lower quality A/BBB bonds and higher quality AAA/AA bonds) are wide (narrow), DFA will also overweight (underweight) these credits within their corporate bond allocation.
The DFA fund includes a number of issuer and credit quality constraints that control the risk of the variable credit strategy.
Credit Quality Constraints:
For example, if the DEX Universe Bond Index has 22% exposure to A-rated issuers and 8% exposure to BBB-rated issuers, the DFA fund can have a maximum of:
As with all fixed income investments, it helps to understand the underlying risks inherent in any strategy. As longer term provincial, municipal and corporate bonds are riskier than longer term federal bonds, I prefer to favour products that have a low allocation to these issuers.