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May 11, 2015

BRIDGEHOUSE IN THE NEWS


Special to The Globe and Mail

Charles Brandes: Value bond strategy can uncover hidden gems


Charles Brandes, CFA, is the founder and chairman of Brandes Investment Partners LP, and is also a member of
the firms Investment Oversight Committee.
The media noise surrounding interest rates and the bond market in the United States in general is sometimes
deafening. After six years of record low interest rates, its eye-opening how hyper sensitive the fixed-income
landscape has become to even the slightest hint of Fed action, or inaction, over the federal funds rate.
(This matters whether youre an American investor who owns a domestic fixed-income offering or a Canadian
investor who holds U.S. fixed-income products, because the United States is the largest bond market for
corporate and government issuers in the world. This earns it exceptional financial and regulatory influence in
other jurisdictions: inevitably, Canadian fixed-income issuers and investors are influenced by U.S. fixed-income
markets.)
It wasnt always this way. Yet, things changed significantly over the last decade. The fund industry rapidly
expanded its fixed-income offerings, and the individual and institutional world took a big liking to their
convenience and diversification benefits in the constant stretch for yield.
Corporate bonds and some other fixed-income strategies today are hardly plain-vanilla, and can actually provide
exciting insights into fundamentals. As I see it, whether youre looking at bonds or stocks, your compass should
always point you in the direction of intrinsic value.
Value investing equally applies to the stock and bond worlds and it makes no difference which side of the
Canada-U.S. border youre on. As with equities, the direction of the overall fixed-income market will have little
bearing on the value opportunities that present themselves on a company-by-company basis.
Bonds actually are what started it all for value investing; they are at its core alongside the principles of valueoriented equities in Ben Grahams Security Analysis of 1934. Mr. Graham devoted nine chapters to debt
investing, arguing that a companys intrinsic value can separate from its bond pricing just as it could its share
price.
The concept is relatively straightforward. Coupons are fixed, but the businesses that issue them are not. The
markets perception of a company can change, and this affects the perceived value (quality) of its bond issues,
just like its stock. Investors who see when this happens who examine the corporate balance sheet from all
angles can find opportunities. I believe the only discipline that can do this with any consistency and patience is
value investing.
Today, the market struggles to find income in corporate bonds, but it doesnt mean long-term opportunities
arent out there. If youre going to find the hidden gems, however, you need to look beyond the index average.
And, if you believe that lower credit quality always means higher return, then youre fishing in the wrong place.
Taking on more actual risk isnt always necessary for higher returns, especially in the non-investment grade
bond pool. Whereas value stocks represent companies whose value is greater than their stock price suggests,

value bonds represent companies whose quality is believed by the investor to be better than the higher interest
rates theyre forced to pay. It takes some searching to recognize these inefficiencies, but they do happen and
sometimes in striking patterns. Value bond investors look for these sweet spots constantly.
Also helping patient U.S. bond investors were new rules starting in 2005. This is when the U.S. Financial Industry
Regulatory Authority imposed requirements for bond trade reporting that evened the pricing playing field
among the big and smaller players in the market. Called Trade Reporting and Compliance Engine (TRACE), it
essentially required all bond dealers to report prices and whether they were buying or selling, which wasnt
even required before. (The Ontario Securities Commission published a comprehensive report on the Canadian
bond market in October, 2014. The Canadian Fixed Income Market identifies current transparency standards
and pending changes by the Investment Industry Regulatory Organization of Canada, or IIROC, to support
improvements.)
TRACE was a huge game changer for investors in U.S. bonds. It gave wider access to prices, which previously
were privy only to the select few involved with the transactions. With price, youre on your way to determine
value separation more effectively.
Another helping hand to value fixed-income investing was the U.S. Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank). As banks were forced to strengthen their capital requirements, many
dealers reined in their risk profiles by divesting much of their corporate bond inventory. Inventories shrank
dramatically, which flooded the market with corporate bonds. Yet, dealers didnt want them. Shrinking
inventory creates pricing volatility. When prices dip and yields spike in the short term, it creates buying
opportunities for long-term managers focused on fundamentals. Value bond pickers can take full advantage of
that.
You wont see value bond investing everywhere. Although it dates back to 1930s Graham & Dodd principles,
value fixed income is not your conventional bond fund strategy.
The value fixed income strategy is transparent, so investors typically know what they own. Its not an array of
5,000 bonds, swaps, currencies and other alternatives. Rather, it pursues its mandate with a select group of
about 70-90 undervalued corporate bonds.
Value fixed income doesnt make macro calls or bets either. So, like its value equities cousin, value fixed income
will take on its own appearance relative to the index. Moreover, the playing field is levelling through TRACE,
while the banking industrys general abhorrence of risk under Dodd-Frank keeps most U.S. bonds (other than
investment grade) off their books, so that they can get into the waiting hands of the market. Thats great for
value bond hunters in the United States, who are more than happy to take a look, and while theyre at it, the
other side of the issuers balance sheet too.
Bridgehouse Asset Managers is a trade name of Brandes Investment Partners & Co. (Bridgehouse). Brandes Investment Partners is a registered trademark of Brandes
Investment Partners, L.P. in the United States and Canada, used under license by Bridgehouse. Brandes Investment Partners & Co. is an affiliate of Brandes Investment Partners,
L.P., which is a portfolio sub-advisor to certain of the Bridgehouse Funds. Brandes Investment Partners & Co. operating as Bridgehouse Asset Managers (Bridgehouse) is the
manager of the Bridgehouse Funds. Bridgehouse has hired Brandes Investment Partners, L.P. (Brandes LP), Greystone Managed Investments Inc. (Greystone), Lazard Asset
Management (Canada), Inc. (Lazard) and Sionna Investment Managers Inc. (Sionna) as portfolio sub-advisors in respect of the Bridgehouse Funds.

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