Positioning Fixed-Income Portfolios

Featuring

Aaron Young

From

Related Article

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Aaron Young, vice president global fixed income, CIBC Asset Management.  

The upcoming bank announcement from the Bank of Canada is a closely watched one, especially here in Canada, but also from market participants globally.  

We’re looking at kind of the all clear from the market for the Bank of Canada to start cutting. We recently had on May 21 some more CPI inflation data come out, and it showed a continuing trend lower. So, we view that as kind of the green light for the central bank to begin cutting rates, we’re talking smaller amounts, maybe one or two cuts. But they do have the data to back the argument that rates could start to be cut here in Canada.  

If they do cut, the market has priced a good chunk of it in, in terms of government bond yields on the short end, but there is still room for those yields to go lower. If we see a continued pause from the Bank of Canada, likely see more of the same of what we’ve really gotten used to over the last few months or even years is further inversion of the curve. Short end rates remain high, longer tenure bonds, Government of Canada bond yields, remain lower. And we kind of sit in that unusual position of having an inverted curve where I can actually get more yield being shorter in the curve versus taking more term risk.  

The U.S. quickly I’ll touch on, we think there’s a bit of divergence happening now. Unlike the picture I painted for Canada, we actually think the U.S. and the Federal Reserve has more runway to keep rates where they are. Consensus is still now for, call it one to two or two to three cuts, from the Fed by the end of the year. But we think they have much less pressure to start cutting rates as quickly as the Bank of Canada. And this is for a lot of the same reasons we think the Bank of Canada feels more pressure to cut rates. Thirty-year mortgage terms, the U.S. consumer continues to chug along, the macro economic data coming out of the U.S. is persistently strong. We think the Fed has more runway to stay at these current levels before pivoting to cuts. 

With rates where they are, whether we start to see cuts or not, what we’re really excited about, in general for the asset class, is the level of yield that is in the market right now. And I think as all the listeners will know, we have not seen these levels of yields in quite some time. So, if yield is your baseline of returns upon which you build an active fixed-income portfolio, right now, we’re starting at very attractive levels. And to be honest, that makes our jobs a bit easier, because we’re starting from that great base.  

But then when you go beyond that, some of the elements that we really find exciting are what we would call backwards opportunities, opportunities that in a highly efficient market, you should not be able to take advantage of, but we’re actually seeing quite a bit of them.  

And I’ll give you a few examples quickly. These are positions that, you know, we’re doing within the portfolios that we manage, something as simple as the inversion of the curve. Right now, I don’t need to take a lot of term risk, and I can still generate a healthy call it four, four and a half percent yield in government bonds. Technically, that shouldn’t exist, I should get paid more yield for taking more term risk. If I’m locking in a bond for 30 years, I should get paid more than my three-month or one-year or two-year bond. That’s not the case right now. 

For us, that environment’s not bad because we like the short-end yield, we’re happy to clip that coupon as kind of a baseline return for our portfolios. And because we can remain in the short end, that gives us a lot of what I would call dry powder or ready capital. As those bonds mature, we get those proceeds, and we can redeploy it at periods of time where maybe other elements of the market are more interesting. Really, it shouldn’t be that way, but that’s the backdrop we have right now.  

Other elements I’ll mention — owning non-Canadian government or quasi-government securities. And this really has only come about because of the interest rate divergence between say Canada U.S. So, for us, for example, in the shorter end, we do own a bit of U.S. agency MBS. These are bonds backed by the U.S. government. And people would be surprised to know that the size of the U.S. agency MBS market eclipses the size of the entire Canadian government bond market. So even though we get caught in home bias and think Canadian government bonds are the place to be, there’s actually a much more liquid market out there. And again, against this backdrop, we can actually own those bonds at a higher yield than we get in Canada.  

Another element I’ll mention is more on the long end. Thirty-year bonds in Canada are the most expensive amongst developed markets. For us, a similar type of trade is to own U.S. Treasuries for that small percentage of long-end bonds that we do own and portfolios. And again, we get a yield pickup going into a much more liquid, larger market. And the same factors are also being applied in the corporate bond exposures that we have across funds. Again, we own a lot of the Canadian banks, we think they’re solid names, we’re rotated up to the most senior debt, but we’re also seeing opportunities to own non-Canadian banks, they’re called GSIBs. They’re globally, systemically important banks, they are very, very large, well regulated, have gone through the deleveraging of the great financial crisis, and now offer, you know, really attractive yields that can compete with what we can get here in Canada. 

The key things that should be on the radar for people as they’re allocating private debt against this interest rate backdrop, is, again, the majority of private debt that you probably come across in the market is floating-rate debt. It’s performed very well in 2022, 21, when rates were going up, because it had near zero duration risk versus traditional fixed income. But investors need to remember that the eye-popping yields they’re getting in private debt, the flip side of the coin is higher financing costs for those underlying companies. So, especially in the U.S., if rates are to remain at these levels for a more extended period of time, there’s no doubt that this will put pressures on the underlying companies to which you are lending in a private debt fund, because their financing costs essentially went from call it four or five hundred basis points up to now the base rate on offer is around 5% plus the spread that private debt lenders add on top of that.  

Now, that’s not to say we think there’s a day of reckoning for private debt or that it’s an asset class you should avoid based on that. What we do think is it places a premium on partnering with private debt managers and private debt originators that have shown the resilience through cycles; have been around a long time and have helped manage their funds through the great financial crisis, through the pandemic, etc. That kind of experience and tenure will pay dividends in the current backdrop.  

And we would also argue partnering with private debt providers who have the infrastructure, the underwriting capabilities, the portfolio management and analytics teams who are spending all of their day making sure when they originate a private debt loan that is underwritten well, it’s stress tested for different environments, including this one where we are facing higher rates and possibly for longer, especially in the U.S., and also have experience. You can’t help but have companies that are going to hit rough patches, are going to need help and sometimes even the worst case where you have to liquidate an asset and go through a workout period. Again, managers who have been doing this a long time, who have that long-tenured experience, who have built up the teams to work through these periods, we think are the managers to go with, are the funds to go with. And when we allocate to private debt within our kind of fixed-income strategies that we run, those are the key elements that we’re looking for to give us the comfort to hold those loans through bit of a higher for longer period.  

So, our long-term outlook for fixed income is actually quite healthy. Because again, we think, the near zero interest rate policy, the lack of yield punishing savers at the cost of spending and expenditure that came during really post the great financial crisis through to the pandemic, where rates really hit zero and we saw nearly, you know, trillions upon trillions of dollars of negative yielding debt. With that behind us now, we think long-term fixed income kind of rises back to the role it has in the past, to play as an income generator for clients, as a lower volatility asset class, and as a place to add value through active management.