The right time For fixed income

There is a renaissance underway and it is happening in fixed income. Adrienne Young and Brian Calder join us to take a closer look at what is driving change, the themes influencing their thinking and how they are generating positive performance for investors. 

“On a risk-adjusted basis, fixed income is once again able to offer attractive returns and a reasonable income.”

Q: How would you describe the current Canadian bond market landscape?

Brian Calder: On a risk-adjusted basis, we are more excited now about the Canadian fixed income market than we have been since the Great Financial Crisis of 2008. The repricing of fixed income is now in the past, and yields are very appealing. Heading into a well-telegraphed recession, fixed income returns are attractive on an absolute basis and relative to higher risk equities.

Q: Investors’ memories of fixed income’s dramatic 2022 decline may linger. How do you view that period?

Adrienne Young: We believe 2022 was a once-in-a-generation situation. We have never seen central banks raise rates as hard and as fast as they have since 2022, nor have we ever seen fixed income sell off as quickly. Keep in mind, it has been over a decade since the 2008 financial crisis when central banks—facing the real potential of institutional collapse—chopped interest rates. Since then, interest rates have remained low, and people have grown used to cheap credit. A generation has grown up assuming such conditions would remain the same. For example, in 2021, we regularly saw yields below 1% for strong investment grade bonds. That reality made fixed income unappealing to investors.

Brian Calder: As of June 2023, we are earning 4.75% for two years on AAA Government of Canada bonds.1 This has not happened since 2001. Given where we are currently sitting in terms of interest rates, you could say it is nearly impossible for 2022 to repeat itself. Central banks started hiking rates from a near-zero base, which demanded a magnitude of increases that we believe will not be repeated.

Q: With talk of central banks pausing rate hikes and eventually easing rates, should investors revisit expectations?

Brian Calder: Looking at the balance of 2023, we expect approximately 25-50 basis points of further hikes are possible, followed by a pause of at least a few quarters, with easing to follow in Canada and the United States. However, easing does not mean a return to ultra-low rates. No one should wish for that as it would signal central banks were once again forced to implement extreme measures.

Q: Inflation rates are directly tied to the interest rate watch. We in a period where inflation rates may decline, but not to the lows of previous years? 

Adrienne Young: While inflation has fallen rapidly through the middle of 2023, central banks have clearly stated that reaching their 2% target is driving their approach to interest rates. We believe the problem is inflation may struggle to hit that mark. The economist community is divergent in its opinion, with some agreeing that 2% is achievable while others suggest, for various reasons, central banks are going to have to rethink their 2% target level. 

Brian Calder: The problem with hitting the 2% target is that some elements are stickier than others. Unemployment and therefore wage inflation, for example, have been very difficult to manage. Housing costs have also been slower to react to higher rates than expected.

Q: What broader themes are on your mind?

Adrienne Young: We see macro uncertainties that could further complicate matters. For example, the Russia/Ukraine war could result in more aggressive food price inflation. Trade hostilities with China could increase spending on reshoring/friendshoring/nearshoring of manufacturing, which could also push manufacturing inflation higher. And, of course, leverage is high in Canada: the Organisation for Economic Co-operation and Development (OECD) reports that Canadian households are almost twice as financially levered as US households.2 Add the combination of higher inflation and higher borrowing rates than pre-COVID to this reality and Canada’s recession could be longer and deeper than the anticipated US recession.

Q: How does this environment affect your decision-making?

Brian Calder: Two themes are key to our approach: managing risk and returns by focusing on quality assets, and actively managing diversified portfolios. 

Q: Can you elaborate? 

Adrienne Young: For instance, looking at our Core Plus strategy, with its focus on Canadian fixed income and ability to invest beyond our borders, we are maintaining our overweight position in Investment Grade Corporate bonds. That said, over the past 12 months, we have increasingly shifted to better quality credit and more liquid bonds that we can trade in and out of easily, taking advantage of market opportunities.

Given our focus on quality and liquidity, we are also taking advantage of our access to the breadth and diversity of names in the United States, which enhances diversification and helps us manage risk. In this space, we have been preferring Industrials and Noncyclical assets. While we can access emerging market fixed income assets, we prefer to invest in such names through the US market, given its highly liquid and efficient characteristics.

Over the past year, as quality Canadian Investment Grade Corporate bonds became increasingly expensive, we decreased our overweight commitment to these assets, reallocating funds to less expensive high-quality government credit that is generating positive returns, with less risk attached.

Q: What should investors be mindful of in terms of a diversified fixed income portfolio?

Brian Calder: This year is a period of tremendous uncertainty. Within this context, we believe an actively managed portfolio, aggressively diversified across sectors, asset types and currencies is critical to achieving attractive risk-adjusted returns.

Q: Looking ahead, what should investors consider?

Brian Calder: For over a decade, investors, particularly those seeking sustainable income, have lived with the all too familiar acronym TINA (there is no alternative), prompting investors’ increasing exposure to equity markets in search of yield. If acronyms reflect change, then there is a shift underway. Goldman Sachs was recently quoted as focusing on TARA: There are reasonable alternatives.3 Deutsche Bank has added its two cents with TAPAS: There are plenty of alternatives.4 In other words, as a viable source of yield, fixed income is back. And as we move closer to a likely recession, we believe fixed income is an asset class that will continue its tradition of preserving capital. On a risk-adjusted basis, it is once again able to offer attractive returns and a reasonable income. It has been a long road since the Great Financial Crisis of 2008, the resulting drastic central bank measures and a generation of low interest rates and inflation. Times are changing and with that, there is a warranted renewed interest in fixed income as an asset class that can serve investors well.