On the Money with Dynamic Funds

PARTICIPANTS

Roger Rouleau
Vice President and Portfolio Manager

Lloyd Perruzza
Head of National Accounts

Lloyd Perruzza: Welcome to our podcast. I'm your host, Lloyd Perruzza, Head of National Accounts, VP Managed Assets and Fixed Income Strategy for Dynamic Funds. In today's episode, we hope to help Canadians keep more after-tax from their bond investments.

Announcer: 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.

Lloyd: Today's podcast is strictly about helping all fixed-income investors better understand the generational change in bonds and how they can actually keep more of the money they earn in bonds. What's more, they can likely make more money with less drama than was possible just a mere 26 months ago. To do this, I'm thrilled to be joined by Roger Rouleau, VP and Portfolio Manager from Dynamic's $7 billion Specialized Credit Team. Roger has more than two decades of such experience and has a remarkable way of helping investors spot those occasional fat pitches in the bedlam of the markets, which we see day in and day out, especially where the math is being turned materially in a bond investor's favor. Welcome, Roger.

Roger Rouleau: Thanks for having me, Lloyd.

Lloyd: Roger, why don't we start by helping our audience understand how we went from near-zero rates in 2021 to a Warren Buffett-like fat pitch that I alluded to earlier?

Roger: The last few years have seen dramatic change in the bond markets, and the main driver behind that is inflation. To understand how inflation brought about this change, we need to do two things.

The first thing is we need to understand the way central bank mandates are structured. The Bank of Canada and the Federal Reserve have been given two mandates to maximize employment, which is another way to say to support economic growth. The second mandate is price stability, right, which is another way to say, keep inflation under control. We target two, we don't want that much more and we don't want that much less. These two central banks go about trying to achieve both these mandates and their tool of choice is the general level of interest rates, right? Now that we understand how they function, the second thing we need to do is we need to go back in the past few years and sort of see how we got ourselves to today.

I'll take you back to 2020, the year of the pandemic. We went from everything is fine, to, suddenly, you cannot leave your home, and obviously, that brought economic growth to a standstill. The Bank of Canada, the Federal Reserve, and quite frankly, every single central bank all around the planet stepped in, right? Their first mandate is to support economic growth, keep people employed, and obviously, there was, I guess, a lot of problems with that during the pandemic.

Interest rates come down to zero, central banks are buying bonds to try to inject liquidity into the markets. At the same time, you have governments that stepped in to try to support. If you just think of us here in Canada, you have the CERB program. If you'd lost your job because of the pandemic, they would essentially try to replace the income, so a lot of support was being thrown at the economy, but then as time went on, the pandemic started fading. We had vaccines come out and economic activity started normalizing. What didn't normalize at first, though, was the support that central banks and governments were throwing at us.

We ended up with a situation where you had too much money chasing too few goods, and we started to see prices rise. At the beginning, this was considered transitory. We're just going to work our way through it. This is going to be fine. Inflation can come right down on its own. This was a time of supply chain issues. You'll remember the boat that got stuck in the Suez Canal, et cetera, et cetera. Lo and behold, it wasn't transitory. This was a real issue and so central banks had to switch their focus from economic growth to inflation.

Again, their tool to accomplish all these goals are interest rates and so we went from money is essentially free, right, interest rates at a rock bottom, to high interest rates. This has an impact on economic growth, right? Slows economic growth. If it costs you more money to borrow to buy a house, a car, what have you, obviously, you're going to do less of it, and so it also brings down inflation. This has been the war that central banks have brought to try to bring inflation under control.

Now, the good news, of course, is that inflation now has come more under control, but it's come at the cost of a lot of drama in the bond market. Higher interest rates, all else equal, bring about lower bond prices. If you look at 2022, right, which was really the, I guess, more intense part of the central banks' war against inflation, the performance of the bond market, which is known for its stability, was dramatically disappointing, I'll say. You had these bond prices come down, obviously traumatic for any investors. The silver lining in all this is that for any incremental dollar, right, that dollar in your pocket that you are now looking to invest, the bond market has gone from not having much interesting going on in it, to suddenly having some very attractive yields.

Lloyd: With that said, why do you view discount bonds differently today than you did, say, two-plus years ago?

Roger: Two years ago, interest rates were rock bottom. Remember, the central banks were pedal to the metal, we've got to stimulate this economy, and so rock bottom interest rates meant not many discounted bonds. Now, obviously, there were some discounted bonds, but the bonds were trading at a discount, not because of interest rates, but because we were worried about getting paid back. If you found a discounted bond two years ago, it's because people were worried about getting their money back, and so I would say it's probably justified to trade at a discount.

Today, we see lots of discounted bonds, but it's not typically because there's something wrong with the company that issued the bond. It's because of this movement in interest rates. To understand that, I think it would probably be helpful to go through an example. Let's think back two years ago, interest rates are very low. You buy a bond that has a coupon of 2%, let's say. That's the general level of interest rates. That's a fair rate to be paid. Obviously, for us, it's underwhelming if you're trying to achieve a retirement goal and you're working with 2% per year. It's not a great opportunity, right?

Then the Bank of Canada comes along, increases interest rates, and suddenly that 2% is underwhelming, right? Fair market rate, let's just say, is 4%. You say, well, nothing wrong with that 2% coupon bond, but it should pay 4%, so I'll buy it from you at a discount, right? This is how the discounts come about. Again, these discounts are not there because there's something wrong with the bond or the company that issued it, it's just because that coupon's a little too low, and so e look at those bonds as being a good opportunity.

You're getting paid 4% instead of 2%, right? It's the same bond, so you're getting paid more, and it comes also with a fiscal advantage, right? Because if you buy something at a discount and it matures at par, well, that discount that you bought it at will be considered a capital gain rather than interest income, which is how the 2% would be treated. Attractive opportunity there in this, I'll use the term, new kind of discounted bond that we did not see two years ago.

Lloyd: So there's no confusion, that's something I think that would catch a lot of people by surprise. Ostensibly, what you can do now is from the same issuer, the same term possibly remaining, get the same total return or yield. Can you walk us through how that plays out as far as the tax part?

Roger: Yes, so let's keep rolling with our 2% coupon bond example. Let's say that you buy that bond discount, right? Let's say it's a one-year bond, so you'd buy it at a price of 98 for a face value of 100, right? You're getting that 2% discount right there and you've got your 2% coupon, right? Your total yield would be 4%. Let's also think of a similar bond from the same issuer that would be identical in all respects, except for it would have a coupon of 4%, right? Same issuer, same maturity, same term, same everything. Your same before-tax return, right? You're either getting paid 4% in interest and then the bond matures and we're done, or you're getting paid 2% in interest. You're getting it at a $2 discount or 2% discount for an all-in return of 4%.

Before tax, there's no difference there. After tax, however, we have to remember that the 4% of coupon that you get on one hand would be taxed fully at the marginal rate, and for the discounted bond, you would get 2% tax at the marginal rate. That other 2%, right, the discount that you're getting it at, that one would be taxed at the capital gains rate, which is half of the marginal rate. All else equal on an after-tax basis, I think as you said in your introduction, more money in your pockets.

Lloyd: I think that's fairly astounding, especially for a Canadian populace who invests, who are, needless to say, very tax-sensitive. Another thing that I think is probably quite huge for us to get our head around is the size of the bond market itself and discount bonds are just a part of that universe. Is fixed income generally attractive today and where is it attractive to your team?

Roger: All else equal, Lloyd, the fixed-income market is more attractive now than it was two years ago. In 2021, rates were super low. You had to take a lot of risk to get what I think most of us would consider a reasonable return. In 2021, if you were looking for a 4% return, you had to buy junk bonds, right? You'd take a lot of credit risk. These are companies that may or may not pay you back. Obviously, you're getting a 4% yield, but you may have losses on some of these bonds so that 4% yield was very risky.

The other option you had was to buy very, very long bonds, right? In 2021, we had the issuance of a 100-year bond from Austria. Pretty comfortable thinking that Austria will be there in 100 years, but they paid you a coupon of 2.4%. That's not a lot of yield to get for 100 years, right? That's a lot of risk right there. When we look at the market today, you're getting paid a lot more for a lot less risk.

The opportunity we see is, A, to get a good return without taking much credit risk. You don't need to buy junk bonds. You can buy high-quality bonds, whether they be government bonds, provincial bonds, or high-quality corporate bonds. Think the large-cap TSX-60 type companies. We're very comfortable with the risks there. You don't need to buy very long-duration bonds. You don't need to buy a 100-year bond to get a reasonable return. You could buy a 3-, 4-, 5-year bond.

Across the board, more attractive, but we see a real opportunity here to get some good returns, 4, 5s, whereas before that would have been 2, 3s, without taking much credit risk and without taking much interest rate risk. Think 3-, 4-, 5-, 6-, 7-year bonds from household names, big banks, big insurance companies, provincial governments, cities, federal government, et cetera, et cetera.

Lloyd: Roger, how exactly do you tackle a universe of securities this large?

Roger: Well, there definitely are many, many bonds to choose from. As listeners may surmise from the name of my team, the Specialized Credit Team, we are specialized in credit. Our bread and butter is sorting through all these bonds, all these bond issuers, to try to find the ones that, in our view, represent the lowest risk. Ultimately, fixed income is supposed to be a stable investment for our clients. We're not looking for excitement one way or another from bonds. When we are picking which bonds we buy, we always keep that in mind. We want to make sure that these are stable companies with solid business plans, very good managements. We want them to be focused on reducing risk in their business because that reduced risk plays into reduced risk for our clients. Sorting through them with that eye on keeping risk controlled is the secret sauce to our approach.

Lloyd: Yes, that does sound like quite a daunting task, Roger. For those listening who might want to take advantage of your team's capabilities, how would you guide them or recommend they do so?

Roger: I think a good starting point would be to look at the dynamic, actively managed discount bond ETF that my team manages. The ticker is DXDB. It does pretty much everything that we talked about today. It is a very high-quality bond portfolio. The bonds are relatively short in term, so three to seven years. You're really there and that's the sweet spot of that opportunity. As you can imagine from the name, it is focused on discounted bonds so there's a nice tax advantage there too. I think that would probably be a good starting spot for investors.

Lloyd: That was fantastic, Roger. Thank you for your time and insights today. It has been a genuine pleasure. Thank you to our audience for your time and kind consideration. Stay well.

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