PARTICIPANTS
Rose Devli
Portfolio Manager
Romas Budd
Vice President & Senior Portfolio Manager
You're listening to On The Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected, active managers and thought leaders. From market commentaries and economic analysis to personal finance, investing, and beyond, On The Money covers it all because when it comes to your money, we're on it.
Rose Devli: Welcome to another edition of On the Money. I'm your guest host Rose Devli, Portfolio Manager at Dynamic Funds. Though we begin 2023 with fresh new resolutions, we find ourselves, as investors, facing the same problems that we saw in 2022. Record high inflation, rising interest rates, geopolitical concerns in Europe, perhaps a fresh start to the year can give us fresh perspective on these old problems. Is inflation beginning to wean? What will Central Banks do with yields in 2023? How will this affect our clients who hold fixed income in their accounts?
To help us navigate some of these questions, I'm joined by Vice President and Senior Portfolio Manager, Romas Budd. Romas has a widely recognized, successful long-term track record with over 30 years of extensive fixed income money management experience. As co-head of the core fixed-income team, he's responsible for directly managing approximately 22 billion in fixed-income assets for the retail, institutional, and private client channels. Romas, it's great to have you.
Romas Budd: Thanks, Rose. It's good to be here.
Rose: 2022 was obviously a very tough year for a number of different assets, especially bonds and stocks. Are we out of the woods yet? What do you think?
Romas: Here we go right into the tough questions, right? Let me just back up for a second on your point about tough year for bonds and stocks. Just to give people a sense of how unusual a year it was, the amount that bonds and stocks were down together, we've only seen that pairing three times in roughly the last a hundred years, if you can believe it. 1931, '69, and '22.
Now we had our performance relative outperformance, but certainly, on an absolute level bonds did have a tough year. Now, are we out of the woods? I think for the first half of the year, the bond market certainly looks like it's in a decent spot and I think we'll cover off in a minute about this idea of an inflation and growth downshift that we're going through in Canada, US, and globally.
Maybe China's a little bit the exception there, but we are looking at inflation and growth downshift and probably a pause from the central banks, especially the Fed, which is the most important. The yield levels have gone to the area now that you're starting to see some interest from the income side, certainly. We do think the bond market is in a decent place first half of the year. Now, second half, is still a lot of question marks, certainly, right now, especially for people that have been underweight bonds. It is not a bad place to put some money to work.
Rose: That's our second question. Should investors be adding to their fixed income exposure? Especially when you're looking at the running yield of the index, thinking about the darker days of COVID back in March 2020 and then you look at a running yield then and you look at vast difference. What do you think about that?
Romas: We often look at about four areas when we're looking at investing in bonds and we'd like to split it up into income component, capital gain potential to the diversification impact versus other risk assets on the portfolio, and the insurance aspect. Now, certainly, versus 2020, we know the rates have gone up a lot, so now they're competitive on an income basis.
Now, whether we get capital gains this year, I think it'll depend on the growth profile of the economy as the year goes along. We'd certainly look like we're going through a soft patch. If it ends up being a recession, you're probably going to see even better returns from bonds. Right now, our most likely scenario is more of a soft-landing scenario. We do think we're going to have decent returns. Well, especially investors that have been underinvested in bonds for various reasons the last couple years, we do think that they should get back to at least what they consider a comfortable proportion or their normal proportion in bonds in their portfolio.
The last few years, as we know, all the way back in 2020 when rates got to zero and negative in Europe, people were looking for alternatives to bonds. Now the yields are competitive. They've gotten on a forward basis; real yields are positive. We certainly think people should be raising their fixed income exposure to what they consider their normal exposure.
Rose: You mentioned inflation. The most Google hits I think in 2022 was a about inflation. Have we seen a shift in inflation indicators and what does this mean for central banks?
Romas: We are definitely going through a downshift in inflation, especially on the goods-producing side, we're going to see it in autos, we're seeing it in housing. A lot of areas have been impacted quite dramatically by the increase in interest rates. That does mean we're going to see a lot of negative inflation or lower inflation coming out of a lot of sectors. Look, there's still some question marks on the service side, on the wage side, but we do feel that the over-year numbers will be falling over the first six months, and probably enough that the central banks can at least pause in their rate hike cycle, and combining with a slowdown and growth, this downshift that we talk about, we probably are going to see that translating to lower bond yields as well.
In fact, since about October of last year when we saw a lot of things starting to break, whether it was in the UK in the pension fund side, whether it was volatility in the treasury market, since that time, we've actually seen yields come down a bit already since October. In fact, the peak in bond yields, never mind short-term yields, which are still going up, but in bond yields, the peak was already back in October. We do think that trend is likely to continue, at least for the first half of this year. We do think this downshift on inflation is very important and consistent with this idea that yields have peaked at least on a shorter-term basis.
Rose: Let's talk about the other most Googled term in 2022, recession. Recession is the top of mind for many people and a lot of our clients. How does fixed income do during recession, in general, and why is it so important at this time to have it in a diversified portfolio?
Romas: Recession still is not the most likely scenario this year, but how do bonds do? Government bonds especially do very well. When I talk about a year this year where we could potentially see positive returns versus last year in bonds, but let's say we're in the area of 3%, 4%, 5%, 6% returns for bonds in 2023. If there's a recession, those returns could even be higher. Now, it's important to split which part of the bond market you're talking about when you're talking about a recession because government bonds will do better than corporate bonds, which, of course, get impacted by the slowdown.
Our funds do traditionally do better in a risk-off environment. Now we keep up when it's risk-on. In fact, if you break out the periods over multiple years and our funds, generally speaking, we've kept up in the return side in risk-on periods. In risk-off periods we've done especially well. We have that asymmetric return profile. In fact, a recession, the way we manage money, is actually a net positive as far as the unit holders are concerned.
Rose: What benefits does fixed income have over owning a GIC? I just got this question yesterday as, "GICs look fabulous at 5%. Why would I hold anything else at this point?" I guess we could tie that question into a passive versus active, and how important it is, especially at this point of the economic cycle.
Romas: To me, GICs are more of a long-duration cash asset. What I mean by that, they don't fluctuate in price. The income is there. Right now it's competitive, and bond yields are actually competitive with GIC rates and people should be aware of that. Sometimes they're not. I would think of GICs where I would think about my cash proportion in the portfolio because it doesn't give you that optionality and it doesn't give you the diversification aspect. Sure, we had both go down last year, as in, stocks and bonds. Normally, if stocks have a bad year, bonds actually perform well. Now GICs wouldn't give you that. They wouldn't give you the diversification impact of a negative correlation against the equity returns.
That's important to note. Also the insurance aspect of a bond portfolio. If things really go badly, whether it's through policy, whether who knows what happens and we end up in a serious recession, then, of course, your bonds are there meant to offset some of the negative returns elsewhere in the portfolio and actually improve the performance of the portfolio overall. Again, a GIC doesn't give you that. A GIC more to me is a long-duration cash asset. It's a very different place for most investors. Now, Rose, you're a manager in the fixed income area as well and maybe you have a couple of words that you can add as far as active versus passive goes.
Rose: Before the financial crisis, that 2008/2009 period, there wasn't as much leverage in the system. Since the financial crisis, we've had relatively low rates, corporations have had a tough time finding that real growth factor, so have had the tendency to lever up the balance sheet, so basically, sacrificing leverage, issuing a lot of debt to try to get to that growth factor for their investors.
We've seen in the index duration really being 50% more than before the financial crisis. I think a lot of investors don't really realize when they purchase a passive fund how risky it is, especially when you look at it 10 years ago. It's pretty dramatic. Not only that, when you drill down on the corporate area of the index before the financial crisis, it was easy to say an average credit rating in there would be that A to AA-plus in the index.
However, now you have a large percentage of these companies being Triple B, which is basically one notch above high yield. Why is that a problem? Well, we see a drastic difference in price. You have a very big price drop when a corporation is a triple B versus a high yield which is only a double B. We say this to clients all the time. We go to where the data takes us. If we see trouble in the economic numbers, we can shift the risks in the portfolio very quickly by use of trading the cash bonds.
Sometimes when liquidity is very gruesome out there, when I think about March 2020, in particular, cash bonds really froze up. We, at least, have other levers in the portfolio to shift around the risk, especially on the derivative side, using futures, using things like CDX, and other tools. We aren't like sitting ducks out there versus a lot of our competitors. To me, I feel like that fee does make up the peace of mind and active management can give you versus a passive fund.
Romas: Just so people are aware, you might be inclined to believe that a passive index or passive portfolio is low risk. In fact, nowadays the way it's constructed actually is quite a risky portfolio, whether it's duration or the credit quality. An active management, as you say goes to where the data takes us and we're able to actually reduce risk even versus a passive portfolio.
Rose: We talked about the first half of 2022. You made some comments into the second half and what we could see the risks around the corner.
Romas: We've got short-term issues and long-term issues. The short term we've got the growth and inflation downshift. That's the first half of the year. The second half of the year, I've become a little more concerned about some of these longer-term issues that we're going to have and the central banks are going to have as far as getting inflation down to 2% in a steady manner that we've had for 20 years approximately where we had inflation really just moving around that 2% target.
If we look currently, we've got a lot of reasons whether it's demographics, shift in the supply chain, how labor markets have changed, how the goods markets have changed. That's a big one since 1980, of course, in China, entering the WTO goods have been really a deflationary force in the economy, and they probably will be at least for the first half of this year.
Going forward, the supply chain shifts we're going to have where we perhaps will be losing this idea that we're constantly have access to cheap goods and same thing cost of capital. That goes into the cost structure for companies. We were in an environment where rates were falling all the way from September 1981, if you can believe it in a secular sense even though we had cycles up and down. Generally, rates have been falling since September of 81 all the way into the summer of 2020 where they really got down to very close to zero. Since then, we've, of course, moved up quite dramatically.
That's another shift that I'm concerned about as we get into the second half of the year, that with all these cost pressures that are not really going to go away that easily and in a secular manner we might be looking at an upshift in the general cost basis of companies and corporations and of labor and of interest rates and those combined together will probably put us into a slightly more inflationary environment than we've had.
For people that are interested, certainly, you would see we do post these articles as well on the Twitter feed for those that are interested at Alpha dynamic. that's the idea. First half of the year is very traditional slowdown inflation and growth. As we get into the second half and into 2024, we have to deal with some of these longer-term problems which could cause a little bit more issues in the financial markets. Again, that's probably a story for another day.
[music]
Rose: Thanks so much, Romas. Really insightful discussion that we've had today. Thanks again to all our listeners. This is another edition of On The Money. Thanks for joining us.
Operator: You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website @dynamic.ca. Thanks for joining us.
Announcer: This audio has been prepared by 1832 Asset Management L.P. and is provided for information purposes only. Views expressed regarding a particular investment economy, industry, or market sector should not be considered an indication of trading intent of any of the mutual funds managed by 1832 Asset Management L.P.. These views are not to be relied upon as investment advice nor should they be considered a recommendation to buy or sell.
These views are subject to change at any time based upon markets and other conditions and we disclaim any responsibility to update such views. To the extent this audio contains information or data obtained from third-party sources, it is believed to be accurate and reliable as of the date of publication, but 1832 Asset Management L.P. does not guarantee its accuracy or reliability. Nothing in this document is or should be relied upon as a promise or representation as to the future.
Commissions, trailing commissions, management fees, and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return or the historical annual compound total returns including changes in unit values and reinvestment of all distributions does not take into account sales, redemption or option changes, or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed. Their values change frequently and past performance may not be repeated.
[music]
[00:16:01] [END OF AUDIO]
