Episode 6: What’s up with bond yields? Wesley Blight explains.

What is fixed income yield? What is the relationship between a bonds price and its yield? And what can cause yields to go up and down?

Wesley [0:51] Sure, yea. So, for bonds, the most commonly quoted yield is yield to maturity, and that's the estimated annual return from holding an individual bond through until its maturity date. For a bond mutual fund, so as an example, our MD PIM Bond Pool, what you see when we're quoting the yield to maturity there, it's the average yield to maturity. It’s effectively the weighted average of all the yield to maturities of the underlying bonds that are held within the fund.

But before we get into the yield itself, stepping back a bit, I think it's important to set the stage for just how important the bond market is for the world. When you read the business pages, you might get the idea that the stock market is everything and that bonds, by comparison, are really just a sideline. And in fact, the bond market is much bigger. And that's because issuing bonds is a way of financing a wide range of economic activity.

Bonds are effectively a form of debt. They're issued not only by publicly traded companies, they're also issued by governments and they're issued by governments at all levels. So, in Canada, we've got government bonds that are issued by the Government of Canada itself, so that's the Canadian Government Treasury. The provinces have debt issuance. And then there's a number of municipalities across the country, that are also issuing debt. And every time that debt is being issued, it's being issued for a purpose. So, we have seen and heard that the Ontario government has a huge provincial debt. We have seen a massive fiscal stimulus coming out from governments around the world with stimulus packages to try and help get economies through the pandemic. The financing from that, as you may have guessed, is coming from issuing new bonds.

What is happening is essentially the government is saying that it will borrow money and pay the bond holder later, and in the meantime, it's obligated to pay interest for the use of that money. So, it kind of makes sense that the bond market, when you put all those different debt issuers together, is much bigger than the equity market and very powerful in how mechanics of the bond market really control capital markets globally. To give you a sense, the fixed income market is about $102 trillion, versus the equity market, at just $64 trillion, both big numbers, but you can see there's a sizable gap between the two.

Bond mechanics, so getting more into what is your yield question, and what's the relationship between its price and yield, a bond gets issued by a government or a corporation, it's effectively borrowing money for a specific term. When it's issued, it has a face value, for example, face value could be $100,000. And there is an interest rate which is called a coupon rate that is tied to that bond. So, let's say for example purposes, the Government of Canada is looking to issue a new bond that has a face value of $100,000, and it pays a coupon rate of say 5%. The coupon payment on that bond would be $5,000 a year. And at the end of 5 years, the bond reaches its maturity and the issuer repays the face value. The yield when the bond is priced at the same as its face value, is the same – so, it's 5%. So, if a bond gets issued, it's at its face value, the yield to maturity on that bond instrument would be 5%, which is identical to the coupon.

But it's different when the prevailing interest rates change, or another factor like credit risk comes into play and causes the bond’s price to change. Bonds are tradable securities, and their prices can go up and down. Generally, nowhere near as much as stocks but bond prices do fluctuate on the secondary market.

Bonds pay periodic coupon payments, which is what I mentioned earlier, and that's typically a percent that's relative to the bond’s principle value. So, if it's issued at $100,000, its par value, if it pays the coupon of $5000, then its yield to maturity is at 5%. And then as that price moves up and down, if for example, the price of the bond goes down and an investor is willing to pay less for that bond, at that time, the coupon would stay the same. So, your coupon for that government of Canada issue would stay the same at 5%. But it's over a smaller denominator, so the yield calculation would actually increase. So, when you hear yields on 10-year bonds went down, they're also saying that the value of that bond itself went up. So, they kind of move in opposite directions. And there's lots of different causes for that.

So, one would be, as I mentioned, when prevailing interest rates fall, older bonds of all types become more valuable, and that's because they were originally sold in an environment where higher rates were available. So, they have higher coupons. Investors holding those bonds can then sell them at a premium on the secondary market. So, if you continue with that same $100,000 par value bond and say interest rates fall, you still own that bond, it’s paying a higher rate. That means that your bond has become more valuable to other investors and your bond would now say be worth $110,000. The coupon payment is still the same, it's still $5,000, but that payment is now divided by a larger denominator, which means the yield has fallen down, in this specific example, to 4.54%. So, your bond price has gone up, yields come down, and as an investor, you could sell your bond for a gain. I hope that answers your question Alex.

You see a relationship between interest rates, currencies, stock markets and yield. This is opening a pretty big can of worms, how does all that work?

Wesley [6:30] Great question. I don't think you're opening that big a can. Everything is tied together. And I think interest rates are really the key here and that they specifically represent borrowing costs. And the implication of interest rate changes are really profound.

You just think of a person's mortgage and their ability to spend money on other projects around the house or, not that we can go out for dinner now, but down the road, when we can go for dinner, you may go out for dinner more if the interest payment that you have on your mortgage is less. And it's the same mechanism that occurs for governments, businesses, individuals. Given those entities have a requirement to borrow, the interest rate level has a direct impact on that entity's ability to meet its debt obligations, grow, spend money on new projects.

A good example, the health and fiscal policy response to the virus has been enormous. Stimulus packages have been provided around the world. The U.S. has a $2 trillion stimulus package that needs to be paid for. And as I mentioned earlier, this is done by bond issuance. If interest rates are high, it makes it more expensive to finance those costs. And normally, the issuance of new bond supply, so if the market is getting flooded with more and more bonds, it makes it more difficult for the borrower to repay.

Normally what that means is you would have – interest rates will rise because the lender, the investor in those bonds, would demand more compensation because there's a perception that the willingness and ability for the borrower to repay their debt obligations is worse because they've got more debt out there. What's happened more recently, and we'll get into this a little bit later, I suspect, is that the demand for the safe haven bonds that don't have as much volatility as equity markets, has more than offset that increase supply, and that's helped kind of push interest rates down more than they had been at the outset of the crisis.

Borrowing rates really aren't the same for all individuals, for countries and companies as it does reflect the perceived willingness and ability to repay their debt. But interest rates are incredibly important from the sense that the lower the interest rate, the easier it is for companies to make their earnings forecasts, it's easier for them to start new projects, it's easier for them to grow. And it also, from a business perspective, corporations are better able to meet their growth objectives when interest rates are low. Governments are able to better finance their activities when interest rates are low.

From a currency perspective, the interest rate differential from one country's currency to another are a factor in helping to identify price of that currency pair. You can earn positive carry by investing in currencies that have a higher interest rate. So, if you think of two pairs, the difference between two similar debt instruments in two different countries is the interest rate differential. So if you take Canada and the U.S. as an example, if Canada has a higher interest rate than the U.S. dollar, there's an incentive to earn that positive carry, which is coming from the higher interest rate by holding the Canadian dollar as opposed to the U.S. dollar. There's lots of other factors that go into currency pairs and what happens with their valuation but the interest rate differential between the two is usually positive for the currency that has the higher interest rate underneath it.

Really, I think at the end of the day, interest rates have a profound impact on all capital market instruments with a direct reflection on borrowing rates. Interest rates are a direct reflection of borrowing rates and as a result of that, lower interest rates mean the ability for asset prices to grow.

Longer term bond yields, certainly in Canada and the U.S. have been trending downwards. Why is that happening?

Wesley [10:24] There's an interesting chart that was put together by the Bank of England a couple years ago, and it tracked interest rates going back 3000 years. And what this showed is that we are currently at or below the all-time historic low for interest rates, but the difference between where we are now and previous lows is not as profound as how high interest rates were in the late 1970s and 1980s.

The path from those heights in the early 1980s through until today is the anomaly. It's not where we're at today. Yes, interest rates are incredibly low right now, but from the height where we were at up over 17% interest rates back in the early 80s, through until now, that's the anomaly. That normalisation from that very high period is what's different from the past. And that's partially why we've had interest rates trending downwards back towards and now through normal.

And I'd say factors that have influenced that decline has been an ageing demographic. So, you think about what happens as you get older, you tend not to save as much, so in aggregate, there's a reduced savings rate and the potential output from an ageing population from an economic productivity perspective is coming down.

We've had increased technologies. Coming with that increased use of technology has been a reduction of capital-intensive businesses. If you look at the difference between, say a car manufacturer and WhatsApp, the capital intensity that's required to get a factory up and running, get a production line up and running – buy the inputs, hire the staff to actually produce the vehicle – is a lot higher than say, a social media application that earns a lot of money, but doesn't necessarily have to spend as much capital to make it happen.

The other difficulty, in my view with technology, is it's more difficult to measure the productivity that's coming from it. You think back like a few years when we are all using phones and we had to buy different phones for our homes, there was a cost to buying that phone, but it was kind of hard to measure – measure the economic benefit of having a conversation. Now you can have lots of different conversations with people all around the world without having to spend the same amount of money to do it. So, the productivity function of the increased technology is declining, in that it's harder to measure the productivity with our increased use of technology. Maybe a better way of saying that is you used to have to pay – pay for your phone, you pay your phone bill, you had to pay for long distance charges, you had to buy a calling card to call across the globe. Now you just click a few buttons and you're able to do that pretty quickly without having any cost or very, very low cost to make that happen.

And then the last thing is just low population growth. Those three factors have combined to a less capital-intensive economy, which requires less debt to kind of keep the economy's growing.

Those factors have combined to move rates down towards their all time low. And that, from an application perspective means the historic returns that were realised over the last 30, actually 40 years now, have been higher than what we should expect going forward. So, when the starting place for yields was up north of 15%, the forward-looking return expectation from bonds was comparable to that 15%. And the way to look at that, it's kind of getting back to that yield to maturity concept, if you buy an instrument that has a yield to maturity of 5%, you should expect, on an annual basis, that you're going to earn roughly 5%. So if you think about interest rates being significantly higher in the late 80s, the forward-looking return from holding those bond instruments is a lot higher than what you should expect to earn from fixed income today. And that's because interest rates are so low.

We saw some spikes in yields earlier in the year in March and now to kick off the month of June. What happened there?

Wesley [14:54] Part of what happened is interest rates moved so low. So, when the Coronavirus came, the pandemic came, lockdowns were starting to roll in, they had a massive negative impact on the expectation for global economic growth. And it served to increase volatility within all financial markets. It's hard to fathom what the current environment was. So, going into lockdown, nobody really knew what to expect. It was also really hard to project and forecast what was going to happen as a result of economies effectively closing.

And that uncertainty is bad for capital markets, in that it creates more volatility. And people are more reactive to news, they're looking to move into more safe haven instruments. So, we saw investors generally moving out of risk assets and moving out of stocks, moving into bonds, moving into U.S. government bonds specifically. That causes interest rates to fall dramatically. That's really interest rates generally, and bond yields are coming down a lot as well.

The slope of the yield curve, the yield curve is a measure of the yield on different bonds with different maturity levels. And normally, the yield curve is positively sloping in the sense that short term bonds usually have a lower yield than longer term bonds. That's a positively sloping yield curve. The yield curve itself is a projection of what investors expect the economy to look like in the future. So, when it's positively sloping, it means that economic growth is likely going to be better down the road than it is today. And with a lack of certainty around what future economic growth was going to look like, as well as a shrinking economy in the immediate future, we saw the entire yield curve shift down with the long end of the curve shifting down by a greater magnitude.

Then we started to get more news about, economies starting to, well this is more recent, we started to see news about the economies opening back up so we're getting out of lock down in some regions. Obviously, the pace of those lock downs being removed is going to change and it's going to not be consistently deployed across countries and across regions. But the massive policy stimulus that has come from governments, from a fiscal perspective and from central banks from a monetary policy perspective, has served to drive yields very low, but it also supported future economic growth.

And last Friday, we saw a pretty significant spike in yields at the long end of the curve, because the jobs market was better in May, then what economic consensus was, so that meant that, hey, if we are at the bottom of this economic trough coming out of lockdown, and maybe things are going to get a little bit better, then perhaps bond yields that have been so suppressed over the last couple of months should better reflect that future economic growth by moving up.

Can you explain our current fixed income positioning?

Wesley [18:11] Strategically, bond exposure in client portfolios provide three things. They provide capital preservation, they reduce volatility at the portfolio level, and they provide elevated income. What we have done from a bond portfolio construction perspective is make sure that those three objectives are met.

And those objectives have varying degrees of importance depending on the risk tolerance of our clients and the risk of, more specifically, the risk objective of our clients. So, for clients that have a lower risk objective, their willingness and capacity to take additional or less risk in their portfolio leads them to have a higher allocation to bonds than clients that have a higher risk tolerance. So that risk objective for clients is tied directly to the amount of bonds that are strategically held in our client portfolios. That's the first step in the portfolio construction that we have with bonds.

The second is from a tactical asset allocation perspective, we will look to make modest adjustments to the allocation we have across bonds and stocks to try and add incremental value in the shorter term. The second thing we'll do from a tactical perspective is we will look to make minor adjustments in our fixed income position itself.

And then the last thing that we're doing within our bond positioning in our portfolios is from a fulfilment perspective. So that's the selection of the individual bonds that are held within our bond pools and bond funds to try and make the expected contribution to portfolio performance from the bonds as well as make sure that we're showing up competitively with the bond benchmarks themselves.

So strategically, we don't really change what we're doing all that often. We will make incremental changes, and we'll definitely be reviewing the strategic allocation to our bond positions on an annual basis. But the change would be modest and incremental.

Tactically, we had entered into 2020 with an expectation that we were going to be in a world of low growth, low inflation, historically low interest rates. And we were cautious with risk in our fixed income portfolios. We had an expectation that the yield curve would steepen from where it was, and we had a position where we were slightly short duration with an expectation that interest rates will start to move up.

Since that time, we have seen interest rates fall and the reason for that is directly aligned with what we were talking about earlier about the pandemic, the lockdown, monetary and fiscal policy stimulus, stepping in and providing support to individuals, to companies, to help them continue to spend money and keep the economy going.

And then from a monetary policy perspective, central banks around the world reduced interest rates all the way down to rock bottom levels. In some areas of the world, those interest rates are below zero, so they're negative. And then they've also taken unprecedented measures to try and provide liquidity and confidence into the bond market by buying up bonds across the yield curve and keeping interest rates and bond yields low. And what that does is it ensures that capital markets and the financial system doesn't add to the difficulty the economy was going to have to continue growing amidst the pandemic. So, providing confidence into capital markets.

As that occurred, we changed our fixed income positioning. We move back to a neutral duration perspective position and as we were adding value from the yield curve steepening because the short end of the yield curve had been originally moving down, by a greater magnitude than the long end, we close out that position as well. That's what we had done tactically.

And then from an underlying fulfilment perspective, so within the bond funds and pools, we've got lots of different tools at our disposal. We can, similar to what I described in the tactical position, we can change our yield curve position, we can change our duration, which is really two measures of interest rate risk. We also have the ability to use corporate bonds.

Entering into 2020, as I mentioned, we felt that interest rates, we were in a low growth, low inflation, low interest rate environment, but from a corporate credit perspective, valuations were really high. And what that means is corporate bond prices were very high. Difference between corporate bond yields and government bond yields with very low as corporate bond prices were very high. The valuation had been bid up. And part of that is because of the low interest rate environment holistically. Investors are stretching for yield, they're taking more risks to try and get more income into their portfolios.

Then as we fast forward to the lockdown, there was initially some panic before monetary policy came in and help to support capital markets that caused corporate bond yields to widen out materially from where they were. And that presented an opportunity for us within our funds and pools to add corporate bond exposure. Do it in a measured way, keeping our risk low, keeping it appropriately balanced with our objective being capital preservation but taking advantage of that spread widening, allowing us to generate additional income into our bond pools and making sure that we were well set up to take advantage of a prospective narrowing and pick up the additional income by having a greater exposure to higher yielding corporate bonds.

Putting all that together, strategically, we haven't really changed our fixed income positioning. Tactically, we had entered into a position where we were neutral, we're actively reviewing that position, as we believe that economic growth is set to rebound, as we get out of lockdown, economies start to reopen back up, monetary policy stimulus and fiscal policy stimulus remains, it's going to be supportive for future economic growth. And we think as a result of that, the long end of the yield curve should move up. So there's an opportunity for us from a tactical position to try and take advantage of that and put that steep inner trade back on. And then, from underlying fulfilment perspective, we're trying to add value by having more spread risk embedded within our pools and our bond funds.

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