Managing Director and Head of Dynamic Funds
Vice President & Senior 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 another edition of On the Money, I'm your host, Mark Brisley. Today's historically low traditional fixed income yields create several challenges for investors. At the top of the list are three in particular that investors and their advisors will want to consider. First, how can we effectively replace the income that investment-grade bonds used to provide? Second, how can we adopt portfolio construction to take into account the loss of protection that used to come from bonds when risky assets, like equities, go down? Third, how can we protect our portfolios from the risk of rising inflation and rising interest rates?
Each of these challenges is unique and requires an approach to effective fixed-income allocations to portfolios different than what we have used over the last 30 years. To help us understand these challenges, the current fixed-income environment, and discuss adapting portfolios going forward, I'm happy to be joined by portfolio manager, Marc-André Gaudreau, who heads the Specialized Credit Team here at Dynamic. Marc-André and team are responsible for managing approximately $6 billion in the credit-related assets classes, and apply their depth of decades of experience and disciplined process to managing assets in investment-grade corporate bonds, preferred shares, high-yield bonds and loans, in addition to floating rate and Credit Absolute Return strategies.
Marc-André, it's great to have you here. I'm going to jump right in. The title of this podcast today is Time to Diversify Your Fixed Income. How did we get to this title?
Marc-André Gaudreau: Well, Mark, as you pointed out earlier, when you look at most investors, having a good balance between offense and defense is obviously a great way to construct portfolios, which is why the 60/40 portfolio has been quite popular over the past few decades. When we look at the 40, which is your traditional fixed income, it really provides investors with two great investment benefits, I would say. The first one which is what I would call a reasonable level of income, over and above fees and inflation.
The second benefit has been basically portfolio hedge against, what I would call, economic disasters, where the 60s or equities will go down significantly. Basically, providing capital gains which are used to buy back or rebalance equities at lower levels.
Really, those have been the two main benefits of the 40 over the past few decades. When we look at the facts today, basically, today's environment, and we run scenarios about the future, and especially following the unexpected global pandemic recession of 2020, we believe that those two investment benefits have probably a low probability of delivering future returns similar to what they have done in the past. This is why, I guess, we came up with the title of today, which is, Time to Diversify Your Fixed Income.
Diversification going forward in our mind will be even more important than before, not just in your broad portfolio mix, but also within fixed income.
Mark Brisley: Marc, you talked in the previous answer to the challenges of the 60/40 portfolio. For our listeners, understanding that that represented a 60% weighting to equities traditionally and a 40% weighting to fixed income. Obviously, the fixed income provided what many people consider to be a more stable safety net of protection when the riskier assets and equity side would maybe go down and that would create that balanced portfolio. Why are we talking about 60/40 portfolio construction as much as we are? Maybe more simply, or as an extension to that, why do you think or why is the statement being made that bonds may no longer provide protection when risky assets go down?
Marc-André Gaudreau: Risky assets usually go down when there's a recession. This is when central bankers usually respond by bringing down overnight rates to basically give a break to companies, consumers, re-stimulate the economy, and also on the equity side, lower the discount rates of future cash flows, even though they're down, they're being offset by a lower discount rate.
When we look at what happened a year ago, or in March 2020, when the global pandemic hit, overnight rates in North America were not that high, but at least they were - I think they were at 1.75%, and central bankers, obviously reacted very strongly and cut rates almost to zero. Government bonds provided, or your traditional fixed income provided, some capital gains to offset the equity portion, which is what we were talking about the 60% here, which was down 30%. That provided a little bit of capital gain to offset the loss on the equity side.
When we look at March 2020, how traditional fixed income in countries where overnight rates were already at zero or even below zero, so Japan, Switzerland, and Germany, you actually did not see your capital gain on your traditional fixed income like we saw a bit in Canada and in the US.
We're sitting here today with overnight rates at again, pretty much zero, so it means that going forward, should anything occur that central bankers’ capacity to re-stimulate the economy, or at least for investors' expectations of capital gains for your traditional fixed income, we think they're quite low. That's why we're seeing that they may not provide this protection. I'd go even a step further, should a scenario occur where rates rise because the economy is reopening because of inflation, which actually brings a sell-off in equities, you actually could see both your equities and your fixed income or your traditional fixed income go down at the same time.
Again, back to the facts that looking at diversification is probably a good thing to do right now.
Mark Brisley: The market seems almost impossible these days when we read about, or watch any news on the economy that there's not going to be talk about inflation, and that talk is often about higher inflation. What are your thoughts on this and why is inflation an important consideration when we're investing in fixed income?
Marc-André Gaudreau: The terminology, is it transitory or not is obviously very topical, and probably one of the largest risks in markets right now. When we look at the facts, it is obvious that some of the drivers which will bring inflation numbers year over year changes high in the next two, three months, some of them are obviously transitory. Talking about just energy costs a year ago, we were in shutdown, so you could fill up your car a lot cheaper than today, but there are, in our mind, potential for long-term implication of all of these stimulus that we're seeing out there from a monetary standpoint, fiscal standpoint, and also implication, or side effects, or long-term effects of the global pandemic that we've seen.
Bigger picture, I'd say that the odds of seeing, on the inflation side, the two tails - the two-tail risk, deflation versus high inflation, those two-tail risks, in my mind, they've gone up.
On the deflation side, I think we still have issues or very strong momentum from demographics, any technological advances, and the huge amount of debt in the system. Those are obviously bringing down or increasing the odds of deflation basically in the future. On the opposite side, on the hyperinflation side, again, you have there the unbelievable wartime physical stimulus, deficits that we have not seen in generations. There's the very weird phenomenon whereby you have a global recession but disposable income is actually up and there's huge pent-up demand. You've never really seen that. This will lead to very strong reopening economic activity.
Maybe one thing investors might not fully appreciate, but this kind of desire to focus on improving any environmental issues, if we're really true about it, this will increase inflation in the future, so there's a cost attached to it. Again, looking at the both tails, we think both have gone up. In reality, what is the probability that central bankers and government pull out all of the stimulus at the perfect timing such as the economy has a long-term growth trajectory, so not too hot, not too slow? We think the odds are that it might not play that way. The Fed basically wants investors to believe that it's going to be transitory, and that they have the tools available to be dealing with it, but, fine, we'll see. Only time will tell if that's going to play out.
I really like to try to compare the unbelievable size of the fiscal stimulus, at least in North America, and I'll focus here on the US. Larry Summers, not that long ago tried to compare the level of fiscal support in the US, comparing the last recession, so 2008 and 2009, and then 2020 and 2021. Basically, he looked at the output gap in the economy. Based on his work, there was an output gap that was negative in 2008 and 2009, about $80 billion a month. Basically, running $80 billion a month lower or below the long-term trends, so really tough time. The fiscal stimulus at that time from Obama was actually $40 billion a month, so roughly offsetting half of the shortfall.
Fast-forward today, in the US, the output gap is about $30 billion a month. Obviously, we're reopening, so this is shrinking every month, and we're probably going to be flat this summer, but the fiscal stimulus is $150 billion. It's basically five times more than the shortfall, which is why, as now facts have changed, we have the vaccine, it's highly effective, and then we're reopening, it might push the economy to really overheat, at least in the short run.
Those are the facts, and this is why the long-term impact of inflation is very, very important, especially obviously, for a fixed income.
Mark Brisley: Yes. Marc, there's not going to be a question or a conversation around inflation without a similar conversation around rates. I'm curious as to your thoughts on the impacts, short and medium-term, of a higher inflation environment on rates, and what might happen to traditional fixed-income investments if rates do in fact increase.
Marc-André Gaudreau: For fixed-income investors with a mid to long-term view, seeing the economy improving, seeing rates reacting to that, that'll be good longer-term because you'll be able to attract a long-term return that's going to be higher than today, and hopefully, higher than inflation, so you keep a purchasing power from that standpoint. That being said, in the short-term, it’s that transition which is very challenging when we look at the current state of the market whereby issuers issued a lot of bonds, issued longer dated bonds, and your income, as we talked about, is quite low.
A move up in rates, similar to what we've seen earlier this year, is obviously bringing your traditional fixed income in a negative total return where if you look at Canada, for example, a move higher in rates by 1% brings a mark-to-market loss of 8%. You have right now one point, less than 2% of return, minus your fees, and we just talked about inflation going up. So, you're losing, both on the mark-to-market, but also on the purchasing power.
This is why I think investors need to look at alternatives and be mindful of those risks. Again, longer-term, higher rates, and especially if rates are higher than the level of inflation, this is good for fixed income investors, but it's really that transition, which can be painful.
Mark Brisley: You just mentioned alternative strategies in your last answer there. I wanted to go a little bit deeper on that one. It's my understanding that institutional investors are actually employing alternative fixed-income strategies in their portfolio. What are you talking about when you mentioned alternative?
Marc-André Gaudreau: Yes. You're totally right, Mark, that large pension plans have been basically diversifying over the past few decades, whereby, if you look at the balance, a balanced mandate, our 60/40, they've actually reduced both the 60 and the 40 and allocated more to alternatives in between. You have alternative asset classes, so that would be real estate, infrastructure, you would have credit there, but also alternative strategies. So more like the hedge funds. Strategies that have low correlation to both the 60 and the 40.
You're totally right. This is a great area for investors to look at. Over the past few years, there's been more solutions available, not just to institutional investors but also retail investors. I think the diversification in liquid alt, liquid alternatives, has a place in a balanced portfolio.
Mark Brisley: It's possible then when we think about the traditional 60/40, that we may start talking about a traditional portfolio that looks like 50/30/20?
Marc-André Gaudreau: Definitely. This is basically where the large pension plans are. That's their mix right now.
Mark Brisley: At the top of the podcast today, I introduced you as being Head of the Specialized Credit Team. I want to ask you, how do credit-related solutions, which is your focus, differ from traditional fixed income, and how do they provide diversification benefits in this current fixed income environment?
Marc-André Gaudreau: There are different types of credit. Your introduction talked about your return from traditional investment grade and where we're sitting today. Obviously, the return profile going forward is not as attractive as before. Both retail and pension plans have looked at credit for solutions, different type, whether it's private credit or public credit. We think that investors who decide to look at credit to improve diversification, to keep purchasing power, must also look at strategies and solutions that have low-interest rate sensitivity, as we talked about. Look for sectors, an allocation to sectors, which will benefit from a reopening of the economy and probably look at being active as well. Those are, I'd say, the items that investors who decide to look at credit should be focusing on when it's time to allocate to credit to improve diversification.
Mark Brisley: Well then, maybe the best way to apply some of the information that you've disseminated here for us today is to talk through some of the strategies that you currently think are particularly suited under your stewardship as a portfolio manager to address the need to diversify within the fixed income arena. Well, you're managing over $6 billion in credit-related assets, that's a big number. Let's talk about a couple of strategies that apply directly to what we've been talking about here.
Marc-André Gaudreau: Yes. The strategies that I'm going to talk to you about are obviously strategies that we think are very suited now, would have low interest rates activity while providing investors with a reasonable return profile.
The first one, which is actually an alternative strategy, the Dynamic Absolute Return Credit Strategy – a strategy that was launched over seven years ago with the objective of delivering a mid-single digit return through the entire business cycle with very low interest sensitivity, while remaining investment grade. Really well-suited for the current environment. When we look at how this strategy performed during periods of rising rates, since we launched in 2014, we see the fund actually having a positive return during those periods of above 2%, while your traditional fixed income would have had a negative return of almost 4% during those periods. This is obviously what we've seen so far, year to date, where your traditional fixed income has a negative return, while this strategy is positive.
When we look forward, this strategy has not benefited from lower rates, but it's not going to get penalized from potential higher rates in the future. When we look at the correlation of this fund to your traditional fixed income, it's extremely low. The return or the running yield right now, for example, we're running at 4.75% of running yield with a duration of 0.5 years, and a weighted average credit quality of BBB. It's pretty attractive. It's a great complement in a client portfolio.
The second solution that is a great place to invest today is what we call the crossover space. The crossover space means the lower bound of investment grades, so that would be BBB, and the higher quality of high yield, which will be BB. So this is very nichey, unique product. This is the sweet spot in my mind for fixed income investing. It's where you're getting the most bang for your buck, if you want. Where you get the most return per unit of volatility, whether it's interest rate volatility or credit spread volatility, and you're not taking on default risk, which would be the CCCs and single B. So, very sweet spot for investing. You can basically accomplish a high yield-like return, or equity-like return for that matter, with 1/3 less volatility. As we look forward, we think this is another place where investors can look at to improve diversification in portfolios.
The third solution, which basically going down further if you want, in the credit market, where you look at high yield and leveraged loans, those obviously benefit a lot more from the economic reopening, then from the interest rate sensitivity. When we look at the facts, we look at the quality of that market over the past few decades, we've never seen such strong credit quality underneath.
If you look at what happened last year is with the unexpected global recession, you've seen the weaker credits defaulting. You've also seen some BBBs; companies being downgraded to high yield. Those companies, as the economy reopens, are restarting to improve their margins, we call them fallen angels. The quality today is very, very high, defaults will continue, or should continue, to remain low and to go down. As the economy reopens, rates remain low, companies are having access to capital markets, so we expect the default risk to remain quite low for the foreseeable future; we're seeing the odds of a recession quite low. That's another area for investors to look at. Obviously, valuations are reflecting a reopening but there are still great sectors, issuers, that provide a pretty good return profile over and above inflation, so we do think that this is another area that investors should be looking at.
The fourth strategy is Canadian preferred shares. There are three main drivers that in our mind dictate the asset class returns, the credit risks, the subordination risk, the odds of seeing a recession, which we think the odds are quite low right now.
The second driver of the asset class is basically short-term interest rates. As I mentioned before, rates are already at very low levels, the fact that we have the vaccine, the economy's reopening, we think that the odds are that the central bankers look at increasing overnight rates over the next few years, so the asset class like to see higher rates because your coupon is resetting every five years, so if the overnight rates and short term rates are higher, your cash flow is going to go up.
The third driver of the asset classes is what we call technicals, so basically the supply and demand. This is where we're experiencing something that's unique to Canada in preferred shares, which we think that the supply of product is actually going to go down. Companies that are issuing preferred shares are able to recapitalize themselves, or issue capital in other sectors cheaper than the Canadian preferred share market, so we expect to see the asset class supply to go down, which should support Canadian preferred shares as we look forward.
Mark Brisley: Well, Marc, you have certainly unpacked a lot of the considerations that an investor needs to think about when considering diversifying their fixed-income allocations. There is another consideration I'd like to talk about. That's how to choose what type of allocation you're making within your fixed-income portfolio. That's whether we're looking at a more passive overlay or an active management approach. Of course, passive where we're just trying to follow indices and match those returns, versus active, where a portfolio manager like yourself is trying to outperform those benchmarks.
Why do you think investors should favour an active approach when we're thinking about everything you've talked about today?
Marc-André Gaudreau: Again, we've been doing this for a number of decades now. I think in less liquid markets, so i.e. not equities, or S&P 500, the odds of active managers to outperform passive strategies are just higher. Investing is all about risk and reward. In fixed income, when you decide to go passive, you outsource 100% of the risk evaluation to, one; the rating agencies, they're the ones paid by the issuers dictating if it's going to be in the benchmark or not. Two; the risk is not necessarily taken into account. I mentioned earlier, the experience that we've seen in 2020, where you had a huge amount of basically bonds or issuers being downgraded from investment grade to high yield, well, that brings a lot of forced sellers. Whether you're a more passive manager, an insurance company that needs to look at ratings because of capital reasons, all of those are bringing forced sellers.
Basically, taking the other side of that, doing your own fundamental credit work, has proven to be a great strategy. When we look at what's in front of us, we think that the other thing's going to happen next year, whereby, a number of companies, now that the economy is reopening, a number of companies will get upgraded back up to investment grade, so there will be forced buyers over the next year. Being active and knowing those kind of flows and doing your own credit work, I think increases your odds of outperforming.
Even closer to Canada, just looking at, for example, the preferred share market, currently as we speak, we're able to sell some preferred shares with a negative yield-to-call return. We believe, based on our analysis, that some of those buyers are basically passive, not because they're at, fault, it's just that they're following the way the indices are constructed. They're buying some preferreds which will basically get redeemed over the next two or three months with a negative return.
Knowing the various players, the various rules again I think this is why the odds of outperforming by being active in fixed income is high.
Mark Brisley: Marc, those are really appreciated insights, and this is such a big subject and it requires a lot of due diligence, and it requires advice. I know you stand with me when I say, for everything we've talked about here today, the next step for an investor is to really sit down and talk to their advisor about how their portfolio construction will evolve over the coming days.
I want to thank you for those insights and giving us all something to think about. I appreciate your time today, and to our listeners for joining us. Of course, we always think that you should seek more advice on any of information that we've covered today or on investing in general from a qualified financial advisor. On behalf of all of us here at Dynamic, we wish you continued good health and safety. Thanks again for joining us.
You've been listening to another edition of On The Money with Dynamic Funds. For more information on Dynamic, and our complete fund lineup, contact your financial advisor or visit our website at dynamic.ca.
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