Episode 22: What is up with fixed income?

Why do we invest in fixed income? What is its purpose in client portfolios?

[Wesley Blight 01:03] That's a great idea. When I step back and think about the role that fixed income plays in the portfolio, there's really three things that sprang to the top of my mind. The first is it provides capital preservation. Second is it reduces volatility at the portfolio level. And it's used to generate income. Those are the three main objectives that I think about in positioning fixed income’s role within a portfolio. 

But I also appreciate that, that doesn't necessarily ring true with all investors. Some investors who are more fixed income oriented in their portfolio construction, they will also rely on fixed income as a source of capital appreciation as well as income. So, it's really delivering a lot of the return overall, that some clients expect from their investments. That can come from fixed income as well.

Why did we see fixed income investments perform so poorly? What about the current environment is causing this?

[Wesley Blight 02:15] Instances were fixed income draws down, while rare, it does definitively happen, and that, you can lose money in fixed income. The environment that we've been in for fixed income really, since the early 1980s, is that, it's provided steady positive return for most of the last long while going back to the 80s, because [the] bond yield environment, the interest rate environment that we were in from that point, all the way through to now, was really about starting yields being very high, and then migrating so low, and that we reached the all-time low in March 2020. And even through the middle of 2020, we were at the all-time low for interest rates. 

And that all time low was because monetary policy makers were stepping in and trying to make sure that financial conditions were going to be as easy as possible, while we went through the COVID pandemic. Provided that that low interest rate environment provided ample liquidity, it provided ample confidence to the market that we weren't going to be in a financial crisis. 

Now what's happening is the market is beginning to, or not beginning to, since the, since the beginning of the year, the markets really been pricing in the expectation that monetary policymakers are going to start to unwind that extreme policy accommodation. So, we've had inflation moving up as supply constraints have limited the ability to move goods back and forth to meet consumer demand. And on top of that, we had the Russian invasion of the Ukraine, which has really pushed energy prices up a lot higher. So those two factors have contributed to inflation being very strong. 

The other factor is, with consumers starting to return back to their normal spending habits, demand for goods and services, services in particular, more recently, has increased and all that serve to drive realised inflation a lot higher. Central banks around the world really started talking last year about starting to unwind their extreme policy accommodation and set the expectation that they were going to start raising rates. 

And even though we're now only at the beginning stages of interest rates moving up, the bond market has already anticipated that there's going to be a series of rate hikes through until early 2023. And because of how bonds work it's really a discounting mechanism in that they're already pricing in those higher interest rates into the market today, and that's pushed bond yields up. And as you know, when bond yields are rising, bond prices are falling. Well, that's what's happened most recently, and in particular, through the first four months of this year and even into May.

What's jarring about the situation is that recent fixed income performance is not what most investors expect. You mentioned in another call, that times when both equities and fixed income come down together is actually more common than one would think. Can you talk about that?

[Wesley Blight 05:54] Yeah, happy to do that. Now, if we, if we were all insensitive to how our investments are performing day-to-day, we would likely be better off just investing in equities, shutting the door, never looking at our portfolio, again, until our time horizon was up. Because over most periods, equities tend to outperform relative to fixed income. 

The reason why we don't do that is because it can easily create a loss of confidence when your investments are drawing down. And the instances where your portfolio is drawing down, are most typically caused by equities falling. We mentioned that a couple of reasons for having fixed income as part of the portfolio, in that two bigger instances where equities have fallen significantly, would be the dot com bubble. So early 2000s, equities fell by 30% between March 2002, all the way till November 2003, you had a significant drawdown in equities then, fixed income was up 23%. Then in the financial crisis, you had significant draw downs in 2008 - 2009, from an equity perspective, but fixed income again was up. 

You know, that balanced portfolio still rings true over most environments and you still see fixed income acting as an offset. But over most instances, both fixed income and equity are positively correlated. And that if you look at periods over the last 20 years, and you just take each quarter over the last 20 years, over 50% of the time, both equities and fixed income were positive. Just under 40% of the time, one of the two was up and the other one was down. So that's that negative correlation in, between the two asset classes that causes a smoother portfolio outcome when you have both asset classes in the portfolio. 

But less, just under 10% of the time, you see both equities and fixed income drawing down. And that's the environment that we've been in year-to-date. And part of the reason why I wanted to have this conversation with you is that in those environments, it's easy for investors to lose confidence in the ability for their investment portfolio to realise the objective. And I think from my perspective, recognising that these types of environments do occur, they do not last for a very long period of time. And I think that's critically important to helping investors stay on the portfolio plan that's right for them.

I appreciate this type of environment is jarring. The drawdown that we've experienced in fixed income, year-to-date is the worst drawdown that we've seen for Canadian investment grade bonds since 1994. It's the second worst that we've seen since 1981. And if you look at long bonds, it's the worst drawdown that we have seen since the early 80s.

The objectives of our fixed income mandates are to achieve income, reduce volatility at the portfolio level and preserve capital for our clients. Let's talk about our positioning and how it achieves these objectives.

[Wesley Blight 09:34] So the vast majority of the exposure that we have in the MD portfolios, from a fixed income perspective, is within Canada. Over the last several years in order to try and enhance the income that's being generated, so really looking at higher yielding opportunities, we introduced the strategic yield fund, as well as the strategic yield pool. 

Within those vehicles we look to take advantage of foreign, both investment grade and non-investment grade exposures to try and drive the yield a little bit higher. We also use those allocations to further diversify the fixed income exposure itself. 

Then, within the domestic funds, we also have exposure to what we call our opportunistic fixed income allocation. It's very similar to strategic yield. But it's more dynamic in the sense that when we think that interest rates are going to rise, as an example, we increase our allocation to the opportunistic exposure within the domestic funds. And in the early part of 2020, we did just that. So we actually reduced the allocation we had to domestic fixed income, increase the allocation to foreign fixed income, where we were attempting to add more yield from higher yielding investment grade credit, as well as non-investment grade credit to try and boost the income in a period where income was going to be very low. 

And at the same time, when interest rates started to move up, and bond yields, more importantly, started to move up, we use that allocation to try and cushion the increase a little bit more. Then that cushion is coming not just from the yield advantage, but also coming from other areas of the world where interest rates weren't expected to move up by as much as they were in Canada. 

So that decision helped to reduce volatility within the fixed income allocation itself. And because fixed income typically operates differently than equity, it also helped to reduce the overall volatility at the portfolio level so far this year, which I think is a nice value add, around retaining confidence in the ability for the fixed income allocation to continue to add value. 

And then the last objective we have is around preservation of capital. And what we do there is we are proactive in managing, I think the main two tools that we use, are around managing interest rate risk, and managing credit risk. And then there are a series of other decisions that we're able to make, like managing the currency risk, all trying to add incremental value. And over the long term, when you think about our fixed income and what we're trying to achieve, that's how we're driving that preservation of capital.

How has all this translated into portfolio performance?

[Wesley Blight 12:51] Fantastic. So, the absolute return from fixed income has detracted value from portfolios. Entering the year, we believe that interest rates were going to move higher, we further believe that bond yields were going to move higher. And we proactively took advantage of that active risk management that I was describing earlier, and reduced our interest rate risk across the domestic bond mandates within our portfolio. 

What's interesting about that is, the benchmark duration has roughly eight years of interest rate risk in it. Our positioning at the beginning of the year had six years. So, what that is similar to is like taking 25% out of the fixed income market and moving into cash. And as interest rates move up, and bond yields move up because bond prices are moving down, that reduced the sensitivity of bond prices falling and reduced the negative impact of the bond market on our client portfolios. 

So that was the single most significant decision that we made to preserve capital year-to-date. And as time has gone on, we've started to unwind that lowering of interest rate risk positioning, and that is based on our expectation that going forward, we don't think that bond yields are going to continue to move up by a material amount. And we don't believe they're going to move up on a sustainable basis. So, we've unwound that position. 

The other decision that we made, and this was a decision that we had, we introduced back in the beginning of 2020 or early 2020. And increased it as time went on, was what I was mentioning earlier, where we move some of our allocation out of domestic bonds and into foreign bonds with an expectation that that would help us to preserve capital. And as that did help preserve capital year-to-date, we've started to unwind a bit of that position as well. 

We still have the exposure to foreign fixed income, but we don't have as much as we did at the beginning of the year, because part of the value that we were expecting to extract was realised in that credit spreads, so the difference in yield between corporate bonds and government bonds, had contracted. So, there wasn't a lot of added value to be left outstanding there. And also, the interest rate risk in the foreign allocations is a lot lower than in the domestic side. So, recognising that we didn't think that interest rates or bond yields, bond yields, in particular, were not going to continue to move up by such a significant amount, we reduced some of that foreign exposure and brought it back into Canada.

How do we expect things to play out? 

[Wesley Blight 16:02] I didn't mention this earlier, but there certainly is good news. And from our perspective, bond yields are really a great indication of future return. And when we were in March 2020, through till the middle of 2020, and even kind of a little bit, towards the end of 2020, we were at the all-time low for bond yields. And what that meant is the forward-looking projection for fixed income return was a lot lower. 

Since that point, as bond yields have gradually migrated higher, the forward-looking return for fixed income has gotten a lot better. And what that means is, the contribution that you should expect from fixed income at the portfolio level is a higher performance for a similar level of risk to what you have been used to having over a longer period of time. 

In the short term, we do expect that there's going to continue to be some volatility around bond yields, as the market continues to try and figure out exactly what monetary policymakers are going to do, that's going to promote continued volatility. However, over the longer term, we appreciate that the forward-looking return is a lot stronger than it was a year ago. So that means the contribution to portfolio outcomes is a lot better. 

One of the ways that I heard this described and it really resonated with me is that from a risk perspective, we still need to have fixed income as part of our portfolios. And that's because of the benefit of capital preservation and reduced volatility from having fixed income as part of a portfolio. Back in 2020, because the return expectation was so low, if you think about it as having insurance as part of your portfolio, the cost of insurance back in 2020, was very high, because the return expectation for fixed income was so low relative to the equities you held in your portfolio. Now, because the starting yield is so much higher, that cost of insurance has just gone down. And I think that's something that really will resonate with diversified investors.

Any last thoughts you'd like to relay to our clients and listeners?

[Wesley Blight 18:33] Thanks, Alex. As we digest information coming at us from news sources, so in the headlines, we're still going to see a lot of information around bond yields moving up and interest rates moving up. And I think it's very important to separate the two and that as we continue to see news about interest rates moving up and we see the Bank of Canada and the U.S. Federal Reserve actually raising their rates, don't believe that we're going to see bond yields continue to move up by a similar amount. 

A great example of that is on May 3rd, when the U.S. Federal Reserve made its first 50 basis point hike since year 2000, bond yields actually declined. And the reason for that was they were expecting that there was a chance of a 75 basis point hike. So that didn't quite meet the market's expectation. 

So, we kind of take that into account and what we're really getting at is that even though there's going to be headlines and more information and interest rates are actually going to move up, bond yields, we believe have already peaked. And that on a forward-looking basis, the return that you should expect from fixed income just got a whole lot better. And while there may be some short-term volatility, the income that you're going to be able to generate from fixed income is going to be more significantly positive than what it has been over the last several years. And you're still going to be able to realise the benefit of its capital preservation and reduced volatility properties. 

So, I think from that perspective, though, the last message that I would leave folks with is, even though interest rates are going to move higher from where they are now, the bond market and bond yields have already taken that into account.

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