Breaking the home bias

Aside from a few blips along the way, fixed-income investors have enjoyed the luxury of a rising tide over the past several years. As credit spreads compressed across virtually every sector, the broader market (or beta) did the heavy lifting, generating most excess returns. Simply owning credit, regardless of the specific security, was handsomely rewarded.

For Canadian pension plans and institutional investors in particular, this period reinforced a set-it-and-forget-it approach to credit allocation—one that is becoming increasingly difficult to justify. Today, however, conditions have changed. As we survey the current landscape, we see limited room for capital appreciation from further spread tightening.

Priced for perfection

Credit spreads are very tight. From investment grade to high yield, the margin for error has narrowed significantly. Spreads across many sectors now offer far less compensation for downside risk than they have historically, leaving little cushion should economic or geopolitical conditions deteriorate.

For Canadian fixed-income investors, who are often concentrated in domestic banks, energy, and a highly correlated market, the risk of complacency is real. Risks are aplenty—geopolitical instability, shifting central bank policies, and simmering trade tensions—yet credit markets continue to reflect an optimistic outlook that leaves little room for disappointment.

As Howard Marks observed: "Investment success doesn't come from 'buying good things,' but rather from 'buying things well." At current spread levels, the broad market is certainly not priced to be bought well. We are at a juncture where we can no longer rely on broad-based tightening that lifts all boats. To generate alpha today, we must move beyond the index – seeking out mispriced risks in individual securities, expanding the opportunity set, and applying rigorous fundamental analysis to avoid blindly reaching for yield.

Breaking the home bias

The Canadian fixed-income market, while stable, is notoriously concentrated. Relying solely on domestic credit can create vulnerabilities within portfolios. When spreads are this tight, managing risk is not about defaulting to cash, but about looking to structural and geographical diversification. Prudent investing is not about avoiding risk, but about being appropriately compensated for it. Achieving this often requires looking beyond our borders and across the capital structure to uncover opportunities that a constrained investment strategy may overlook or be unable to access.

Broadening the opportunity set

By expanding the toolkit to include Global Investment Grade (IG), Global High Yield (HY), Unrated Bonds, and Collateralized Loan Obligations (CLOs), we can build a more diversified, higher-yield portfolio, with more levers to pull.

Global IG & HY: While spreads are tight everywhere, the sheer breadth of the global market means that opportunities still exist beneath the surface. Overlooked credits, turnaround stories, and rating migrations can provide diversification away from broad market beta. Differences in credit cycles across North America, Europe, and emerging markets further expand the opportunity set. When the rising tide stops, success depends on picking the right bonds issued by the right companies.

Unrated Bonds: This is where independent, bottom-up research adds value. Many high-quality issuers choose to remain unrated to avoid the costs and scrutiny of the major agencies. Because these bonds often fall outside the purview of many large institutional mandates, they can offer an attractive complexity premium. Identifying them requires a boots-on-the-ground approach, independently vetting issuers and going far beyond a credit rating.

CLOs: For investors with the governance frameworks and analytical resources to evaluate structured credit, CLOs can offer differentiated diversification and enhanced yield potential. They provide floating-rate exposure to the broadly syndicated loan market and benefit from unique structural protections against defaults, particularly in senior tranches, that help mitigate default risk. When properly understood and sized within a portfolio, these features can result in attractive risk-adjusted returns relative to similarly rated corporate bonds.

A credit picker’s market

We view the current environment as a credit picker's market. Since no one is benefitting from market-wide spread compression, we expect alpha to be generated through rigorous, bottom-up fundamental analysis—selecting the right securities issued by the right companies, with a balanced focus on both upside and downside risks.

At Burgundy, by diversifying globally and structurally, we aim to build a portfolio that is resilient in the face of significant macroeconomic risks. We seek to identify credit opportunities that can withstand broad market weakness while ensuring that exposure to unrated securities and structured products is backed by an intimate understanding of the underlying businesses and cash flows.

We believe the era of easy wins in fixed income is coming to an end for Canadian investors. The path forward requires a transition from Canadian-centric mandates to a flexible global approach. By diversifying across markets and embracing selective complexity, investors can navigate a tight-spread environment with greater confidence. At Burgundy, we believe our long-term approach and disciplined research process positions us to deliver durable long-term outcomes for clients, regardless of where spreads sit across market indices.

James Arnold, CFA, is a senior vice president and portfolio manager at Burgundy Asset Management. He joined the firm in 2017 and has held roles at DBRS Ltd., Morningstar Research Ltd. and was formerly a senior portfolio manager of fixed income investments at Canada Post Corp.