How liquid alternatives fit into fixed income allocations

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In 2022, a relatively new crop of bond funds only made available to the majority of Canadian investors a few years earlier proved their worth. Conventional fixed income was getting crushed as interest rates skyrocketed, yet several of these “alternative” fixed income funds managed to post positive returns.
“In a year during which almost everything – including bonds – was down by double digits, that felt like a big victory to a lot of our investors,” says Darren Cooper, senior investment advisor with Baun & Pate Investment Group at Wellington-Altus Private Wealth Inc. in Calgary.
Since their introduction in 2019, so-called “liquid alternative” funds have grown into a $32-billion corner of the market, according to the Investment Funds Institute of Canada.
The funds use a range of strategies designed to enhance returns or provide downside protection while offering the liquidity of a standard mutual fund or exchange-traded fund. While many liquid alts are focused on equities, some are aimed at complementing and, in some instances, replacing core fixed income holdings.
“It does represent a fairly core positioning for our client bond portfolios,” Mr. Cooper says.
Bond markets are no longer roiling like they were when ultra-hawkish monetary policy sent interest rates spiking, but there’s still uncertainty regarding where rates are headed, he says, which makes hedging against that volatility warranted.
“Liquid alts solve for the fact that, in a short period of time, there can be extreme changes in market interest rates,” Mr. Cooper says. “A traditional bond portfolio simply can’t eliminate the price risk that comes with changes in interest rates. Even very high-quality fixed income baskets can still see big reactions.”
Ongoing volatility in the bond market combined with the fact many bonds are still below their face value has created fertile ground for liquid alt fixed income strategies, says Kevin Headland, co-chief investment strategist at Manulife Investment Management, which launched Manulife Alternative Opportunities Fund and Manulife Strategic Income Plus Fund in May.
Manulife Strategic Income Plus Fund, a global multi-sector bond fund, is designed to maximize returns through income and capital appreciation. The fund uses currency hedging and derivatives to manage risks or seek higher returns, and employs futures to adjust the fund’s duration.
Manulife Alternative Opportunities Fund is more focused on income generation and managing volatility, Mr. Headland says. Focused on North America, the fund uses credit default swaps and options strategies as it aims to provide higher yields with less volatility than a typical bond fund.
Yet, some investors and advisors question the need for alternative strategies for fixed income now that yields on plain vanilla bonds and guaranteed investment certificates are more generous than they’ve been in years. Also, conventional bond exposures are simpler and generally cheaper than alternatives.
“My investment philosophy is, a bond is a bond is a bond,” says Jane Alm, senior wealth advisor with the Angus Watt Advisory Group at National Bank Financial Wealth Management in Edmonton. “It has very specific characteristics – an issuer you can identify, a coupon that’s readily knowable, a set maturity date and yield. That’s very different than a liquid alt.”
She says the investment strategies are too “opaque” to consider an alts product as a core fixed income investment.
“From my perspective, one does not replace the other,” the Edmonton-based wealth professional says. “If you look at some other similar assets, liquid alts have some of the same challenges that private alternatives have, whether it’s credit or equity.”
Phil Mesman, portfolio manager and co-head of fixed income at Picton Mahoney Asset Management in Toronto, says liquid alt funds like the pair his firm offers – Picton Mahoney Fortified Income Alternative Fund and Picton Mahoney Fortified Special Situations Alternative Fund – can represent core portfolio holdings.
“That’s where a quality credit analyst can add value,” he says.
Alternative funds can also be used for a “core plus” approach, in which conventional bonds are complemented by alternative funds that boost returns, smooth out volatility – or both.
“To me, alternative thinking is to use the tools available to improve the return experience [and] the quality of those returns,” Mr. Mesman says.
Advisors may favour the front end of the yield curve now, he says, where yields on short and ultra-short-term bonds are the highest they’ve been in years.
“Great prices, great yields, many of those bonds below par so earning some capital gains – there are lots of benefits,” he says. “The idea is to add in strategies that can complement that.”
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