Managing Director and Head of Dynamic Funds
Vice President & Portfolio Manager
Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions to find out their insights on the market environment and navigating the investment landscape.
Welcome to On the Money. I'm your host, Mark Brisley. Fixed income investing often takes a back seat in an investor's thoughts to the perceptively more exciting world of equities.
This is magnified by the recency of bull market conditions, which many will argue has been running since 2009. As populations or more importantly investors age, fixed income increases in importance as you near retirement and portfolio construction to effectively address the preservation of capital while providing a targeted income stream becomes a driver's seat conversation. This asset class elicits so many questions. Are there particular areas where investors should be cautious?
Where are the opportunities to find yield in this environment? How will fixed income markets fair as major central banks reduce monetary easing? The big one, is the 60/40 portfolio still relevant? Fixed income, or to simplify the discussion for today's purposes, bonds, remain a relative and critical component of any portfolio to address income and capital preservation needs. Historically, this has always been the case. Masters like Benjamin Graham, the great economist and the father of value investing suggested a long time ago that a portfolio mix of stocks and bonds for later-stage investors is appropriate.
To unpack more of the intricacies around this important discussion, I'm happy to be joined today by portfolio manager Dominic Bellissimo who is a key part of our core fixed income team here at Dynamic, and leads our Toronto-based credit team, which is responsible for managing approximately $5 billion in assets. He has 25 years of investment experience and brings in-depth knowledge and a disciplined process to the analysis of North American corporate credits, but equally important, he's a passionate educator on this particular asset class. Dom, it's great to have you here. I'm going to jump right in. Let's break down the basics of what an investor needs to know about bonds.
Dominic Bellissimo: Bonds are very large part of the investment universe, and it really doesn't receive nearly as much attention as equity yet it is vital to the proper functioning of financial markets. In fact, most people would be surprised if I told them that the bond market is larger on a global basis than the equity market is. Now, simply put, bonds are an obligation to repay borrowed funds with interest. Now, for any of our listeners that have had the opportunity to borrow money from a bank, let's say they've held a mortgage, it's very much a similar idea.
Unlike equities, where we have often as the case, one share one class of shares per company. In the case of bonds, you will have many or could have many bonds issued by the same company, by the same issuer. They may vary by a number of factors like maturity date, coupon payments, and covenants, these being the conditions to repay. Also, the issuers can vary. We could have governments such as federal or provincial governments across the globe, as well as companies, firms across the globe as well.
Mark Brisley: What makes bonds attractive then to investors?
Domenic Bellissimo: Well, there are a couple of things that stand out. First being it's a steady stream of income. It's the cashflow that the bond itself generates from the coupon payments. Also, they generally tend to represent less volatile securities than equities, for example, and there are a couple of reasons for that. The first is that bonds have a fixed maturity date. You know if all goes well, when you're expected to receive your principal back unlike an equity which is an ownership in a long-term cash flow stream on the company. In the event of bankruptcy, also bond investors are repaid before the shareholders of a company. You're higher up on the capital structure so that priority also has a value to it.
Mark Brisley: On the other side of that, what potentially makes them less attractive to investors?
Domenic Bellissimo: The one thing that stands out is the asymmetric risk. By that, we're referring to the upside versus the downside possibilities. When you're looking at a bond in exchange for more stable cashflow stream and that promise and obligation to repay the coupon and the principal on a timely basis, investors effectively receive less upside. If you buy a bond, a new issue and you hold it until maturity, the best you will do is the return of that coupon and the principal, so that is your return.
The upside is somewhat limited. That said, if a company or any issuer, government, were to file for bankruptcy and have trouble repaying, then bond investors would have to run the risk of actually losing some of their principal in that scenario.
Mark Brisley: Then Dom, let's unpack this in a little bit more detail. Let's discuss a bond in the context of the capital structure and maybe define what I mean, even by that question in your answer.
Domenic Bellissimo: When we're looking at the capital structure, it's really to understand the priority of payment. In any company, you have an ownership class, which would be represented by equities, and then you have creditors and those that the company owes money to. That would include bond investors and the bank, for example. In the case of a bankruptcy, so an extreme scenario where the company has to be closed down and the assets sold off and so forth, those entities that are higher up on the capital structure receive priority of payments before the owners of the company.
In the case of bondholders, they stand ahead of the equity holders on the company. If there's a wind-down scenario, the bondholder would receive a priority of payment commensurate to the value of the assets that were left over after all the obligations, the equity holders would be after that. That is a definitely a positive for bondholders and that for longer-term that has provided them with in a sense a greater degree of comfort that they'll receive prior to payment over the equity holders.
Mark Brisley: It's interesting when we're considering this asset class, Dominic. I think for most people when they think of bonds, they think of safety or maybe less risk, but there are risks associated with investing in this particular asset class area. The risks often seem more complex to people. Can we talk a little bit more about the considerations that a bond investor has to take into account?
Domenic Bellissimo: Sure. There definitely are risks and every investor has to be aware of what they are and how they could impact their investment. I'll keen on two main risks, that being interest rate and the second being credit risk. In the case of interest rate risk, it does really relate to the value of a bond changing whenever interest rates or market yields change. When a yield will rise, then ultimately the value of a bond will fall, and the opposite is true as well.
When yields will fall, bond prices will rise and investors need to be aware of that risk and how it is changing over time. With respect to credit risk, it really focuses on the borrower's ability to repay in a timely manner. How creditworthy is the borrower? Now, generally, when we think about governments, it's almost taken as an automatic that a government will repay, but if you work your way through to all the types of investors and issuers out there and get into corporations.
The creditworthiness of each individual company in organization will vary and change drastically from one entity to another and also will change over time. It's important to understand is the creditworthiness of that borrower becoming better or worse. How is it changing and where is it likely to go?
Mark Brisley: Dom, as we think then about these two risks, as you mentioned, interest rate and credit risk, how have each of these manifested themselves in the market in particular over the past decade or so?
Domenic Bellissimo: A lot has changed over the past decade. In fact, since the global financial crisis in 2008, and we've seen risks both interest rate credit risks grow substantially in that time. Investors need to be aware and understand what's going on. Understanding the past will give them a better perspective of how to work forward. Really you can identify how these risks have manifested themselves by looking at the bond benchmarks, this being a proxy for the aggregate market.
I'll break it down first with interest rates risk. We've seen yields or interest rates decline steadily since the early 1980s, and since the financial crisis, they've hit all-time lows. In fact, actually, since last year we touched the all-time low during the pandemic. What has happened during this period is as yields have declined, interest rates have declined, companies and governments, all borrowers have taken advantage of the lower borrowing costs.
As maturities have come due, they've replaced those maturities originally let's say 5 and 10 year terms with longer-dated bonds. Their coupons, their payments are actually lower, but they're able to extend the term for 10 years and in many cases, 30 years. In doing so, the interest rate risk within the market has actually grown because now you have that many more 10 year, 20 year, 30 year bonds, even longer terms. As an investor, you need to be aware that there's more interest rates risk out there.
In the case of credit risk, it has also grown substantially since the global financial crisis. What we've seen is more of everything. More companies borrowing in the public markets. Part of the reason, a big part is that the banks have curtailed their lending to companies today to a greater degree than they did prior to the global financial crisis. They're actually lending a little less and encouraging these companies to go out into the public markets and borrow. We're seeing more companies, a broader suite of companies, and in many cases, lower rated companies, companies with a higher degree of credit risk, not that they're necessarily bad or bad risks, it's just that there's more risk than what would have traditionally been the case prior to the global financial crisis. Now, if we were to look at one example in the investment-grade market in Canada, the lowest-rated companies within the investment-grade market fall into a category called BBB. That's three Bs. Now, prior to the global financial crisis, that category was approximately 18% of the overall corporate market in Canada.
Today it's over 40%. So we've seen more companies issue, more companies that are lower-rated issue, and even companies that were once higher rated that have allowed themselves to fall into a lower rating category. Ultimately, that means more credit risks that you have to be able to understand handled and manage.,
Mark Brisley: All right. That's a great overview of, as you say, where investors have to be aware of how these risks are unfolding in the market. When I think about an investor saying, "I need to have fixed-income portfolio, I understand the awareness I have to have around these two particular risk metrics." What are the actual implications then to me as a bond investor?
Domenic Bellissimo: There are a few for sure. One is that for investors, they cannot assume that what has happened in the past will continue to occur going forward indefinitely, so will government yields, will interest rates stay low, and will they continue to fall as we've seen over the last 40 years or so? You can make a strong argument that on both sides of the ledger, whether they'll actually stay low or in fact could rise in materially and, or we could see periods like we've seen this year where you see a significant move in a very short period of time.
Investors need to understand that you could have a very large outsize move that would not have been the case in prior periods. With respect to credit risks, you need to be able to better manage these risks because of the change in the market composition. You need to understand, you have to analyze a company, you have to be able to monitor and follow through with that company and understand is their creditworthiness improving, or worsening, and be able to take advantage of let's say an opportunity or just simply get out of the way if you think things are getting worse and becoming uncontrollable.
I think ultimately with more risk comes more responsibility and as investors, we need to be aware of that. The last point that I think investors need to be cognizant of is to understand the normal relationship between equities and bonds and how that might change. Traditionally when equities rise, and equity valuations rise, bond valuations will decline, and then the opposite would be true. When equities would fall, bond prices would rise. That inverse relationship has by and large held true throughout the decades.
Now from portfolio perspective, fixed income might not actually behave quite the same way going forward as it did historically. That has significant implications to a portfolio. In a traditional balanced portfolio where you have equities and bonds, they would look at, let's say a normal split would be 60/40, 60% equities, 40% bonds. They would be tied in part to the expectations that equities would give you longer-term growth perspective and opportunities, and that the bonds would provide some pretty decent downside protection in the case that we went into a rocky period for the markets, but does that make sense today?
With government yields as low as they are, with negative correlations between the bonds and the equities, will they remain in place? It's not quite so simple, it's not quite as obvious. I don't think you can expect that a relationship between the two will behave today or going forward as they did in the past, and so investors need to better understand that the choices for investors have grown and become more challenging when you're looking at fixed income, especially when you're combining in a portfolio with equities.
Mark Brisley: If we think about, the diversity probably of our listenership right now, some already being invested in this space, some thinking about having to be at some point in the near future, what should they be doing differently or thinking about differently? I'll preface that question with, we're going to assume that they are going to seek out the services of a qualified financial advisor because this is a difficult space to do on your own.
Domenic Bellissimo: Absolutely, investors going forward really need to broaden their perspective. Historically, an investment in fixed income was seen as a ballast. It's an anchor against a choppy market. You have that steady cash flow stream. They provide you nice downside protection when risk assets are selling off but today, the choices have grown and it includes, not just the ballast perspective, but also opportunities in credit-related as well as alternative investments as well.
Mark Brisley: Well then Don, let's unpack that a little bit more. You mentioned ballast and you talk a little bit about bonds with credit risk and alternatives. Can we dive a little bit deeper into exactly what you mean by that?
Domenic Bellissimo: Sure. It's complicated. It has grown. I think it's a point worth highlighting. In the case of ballast, we're really focusing in on how fixed income has been viewed on a more traditional sense that being a long-only investment, that is an allocation let's say in a bond fund is an allocation to both government securities as well as corporate securities. Traditionally, there's been a heavy reliance on managing the interest rate risk, so to protect some downside there and the proper asset allocation, so how many government and how many corporate securities you should be holding and moving and toggling between the two.
As the name states, it's really a ballast and it was it's meant to be a ballast and provide protection in a down market, with some income, and even potentially some upside capture if yields were to fall but it is a ballast. Now over time, and over the last decade or so we've seen a growth of opportunities in both the credit and alternative side within the fixed income markets. Looking at credit opportunities, the credit universe has grown, and in Canada, in the US, and globally.
With that, there are more credit-focused mandates that would be long-only, but that they would need and focus on managing of credit risk and trying to capture additional income and potential for capital gains that come with that. You would be looking at, focusing in on different markets, for example, you could focus on the investment-grade market, or the high yield market, or both, whether an investment is in the Canadian credit markets, or if there's geographic diversification, like the United States or even beyond on a global basis.
I think that the proliferation within the credit environment has created opportunities that have given investors now options that even 10 years ago weren't there. On that same theme, looking at alternatives. This area has also grown over the last number of years. When we mention alternatives, what we were referring to, it could be a couple of things. The first is the asset type itself. Is it an alternative type of fixed income instruments such as private debt, not to be confused with the public debt markets, which is what we've been talking about today, or is it in fact related more to the investment strategies that are allowed within the fund or the investment vehicle? The investment strategies would vary materially from, let's say, a more traditional long-only mandate.
It can vary a few ways. Looking at as an example, the use of leverage to augment returns or unique trading strategies such as shorting bonds, and the benefits that one might be able to capture either downside protection or on upside as well.
Mark Brisley: Dominic, equity investors have been hearing a lot about alternatives on that side of the equation and the fact that alternatives are really starting to become a legitimate third asset class when we think about the 60/40 portfolio and the challenges around there. Should we be thinking the same then about fixed income as well?
Domenic Bellissimo: Absolutely. With the growth of alternatives over the last decade, I think investors should consider them as a legitimate allocation to fixed income within their portfolios. Of course, if it makes sense, but it has grown, and it is worth looking into for sure.
Mark Brisley: With the better awareness now of some of these strategies and alternatives that you're talking about, bonds with credit risks, alternatives, this use of ballast, how does an investor then consider allocation into these particular buckets within a fixed income portfolio?
Domenic Bellissimo: There's a few things. First, I'm a big proponent, and I know the company has always been a big proponent of getting the right advice. I think it's important that investors today understand that the options available to them are broader. We talked about ballast, we talked about credit, we talked about alternatives. That is a great starting point when they speak to their advisor and using that as an opportunity to understand what options are available and then what options make sense for every investor. It will vary, obviously, life cycle and risk tolerances and so forth.
Another thing to consider, which is key is active management. We've established that the fixed income market is riskier today, and has a lot more going on today than it did at any point in the past, especially since the financial crisis. With that, investors need to be aligned with managers that are willing to add and subtract risk in a thoughtful manner, thoughtful process, and in a very deliberate way. If you are focused on a benchmark, my belief has always been if you're focused on a benchmark, you will not beat the benchmark, but you also run the risk of being exposed to the inherent risks that have only grown within the benchmark. Active management needs to be a cornerstone going forward.
Mark Brisley: Dominic, we've talked a lot about the historical background of how this particular market, this asset class has evolved and how it's changed. Believe it or not, not everybody wakes up in the morning and looks at how overnight markets did or turns on CNBC or picks up the financial side of the newspaper. If we think about some of the news and what people may have read about or paid some attention to, they would have heard things like taper tantrum 2.0. Can you talk a little bit about what it means when we hear the word taper tantrum as an example, and if it's the same as what we've seen historically, like back in 2013?
Domenic Bellissimo: The taper tantrum that you referred to is really referencing a period back in the second half of 2013. At that time, the federal reserve chairman Ben Bernanke had announced that the fed was planning on tapering its asset purchases. With that announcement, it really caused a huge negative impact on the bond markets, in the markets across the globe, also the risk markets and equities. What happened was bond yields rose materially and when that happens, as we know, bond yields rise and the value of the bonds fell, but it didn't just focus on government bonds.
It also impacted corporate bonds and investors were selling fixed income indiscriminately fearing that the yields would continue to rise over an extended period of time. As we entered 2021, we heard a lot of talk and a lot of comparison to the 2013 taper tantrum. It's understandable if you use yields and government yields and interest rates as your main reference point because back then they were very low and today they're very low.
The expectation is today that as the world normalizes and we get back on our feet, that yields would have to rise. As they would expect to rise from a very low point that we run the risk of a repeat of what happened in 2013. It's not uncommon within the markets to look at prior periods and to try to establish a comparison, but the risk with that is what happens if it's different, what happens if it doesn't actually occur? That's really what we're seeing today.
Earlier this year, government yield started to rise materially and the concern would be that we'd see a selloff in the credit markets, but in fact, the credit markets have not actually sold off. They've remained very strong and buoyant. We've seen money entering the credit markets on a consistent basis week after week, and there's a few reasons for that. Today, the federal reserve is much more cautious in their communications to the markets than they were in 2013.
They've been reassuring the markets, it seems almost on a daily basis, that any actions they have will take a long time to play out and they will be very careful and reiterating a patient message at every opportunity. The next factor to consider is that credit investors have continued to support the market. As I mentioned, we've seen a steady stream of inflows and that's really been supported by the view that the economy, global economy will continue to improve and that provides a tailwind to risk assets, the credit markets, and so forth.
If you think about, when would you like to be investing in a corporate bond to simplistically, it's when the economy is getting better, not worse and that's where we are today. Then lastly is that despite the rise in government yields so far, they are still close to their all-time pre-pandemic lows. The incremental yield that you have from a corporate security actually is substantial, relatively speaking. It gives you that incremental return that many investors are looking for. We really haven't seen a taper tantrum 2, we've seen a selloff in the government markets, but it's been contained to that market
Mark Brisley: Taking into account then this continued support you mentioned that credit investors have shown to the market and the fact that you still believe incremental returns and investor can earn are substantial, where do you see then the biggest opportunities in credit unfolding and as a portfolio manager, how are you positioning around these beliefs and opportunities?
Domenic Bellissimo: We're really focusing in on a few themes, the first being looking at reopening credits, so companies that are in industries that were most hurt by the pandemic and that are now bouncing back. The auto industry is a very good example of that. They should benefit from a stronger tailwind and have the greatest bounce back. Then the next would be, and specifically within the investment-grade space, lower-rated companies that have larger risk premiums that are now better able to strengthen their balance sheets and get back on their feet and move forward in a more normal fashion.
That might be companies within the BBB space, for example. I mentioned that BBB is the lowest-rated category. There are still opportunities, we find them, companies that need to borrow we will lend at the right price. I think that as the world normalizes, these opportunities will prove fruitful from a return perspective.
Mark Brisley: Dominic, this has been a great overview today. Fixed income investing, as we mentioned at the top, it's a complex subject but a critical component of portfolios and portfolio construction, especially for investors that are either nearing retirement or already in retirement. I really appreciate these insights. Thank you to all of our listeners that joined us today and listened to this particular podcast. It is not one that generally gets the same attention as its equities counterpart, but it's no less important. If you would like any more information about some of the subjects that we discussed, please visit us at dynamic.ca.
As we've already mentioned, seek out the services of a qualified financial advisor to make sure that you're comfortable and that your portfolios are positioned effectively when we're thinking about fixed income investing. On behalf of all of us at Dynamic Funds, we continue to wish you good health and safety. Once again, thanks for joining us.
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