PARTICIPANTS
Mark Brisley
Managing Director and Head of Dynamic Funds
Romas Budd
Vice President & Senior Portfolio Manager
Derek Amery
Vice President & Senior Portfolio Manager
PRESENTATION
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 what their insights on the market environment and navigating the investment landscape.
Welcome to another edition of On The Money with Dynamic Funds. I'm Mark Brisley, head of Dynamic and I'm going to start off to take a quote from one of my guest's recent commentaries, where he said, "There's obviously been no shortage of surprises, uncertainty, and unprecedented events in 2020."
As we think about the recent events that have just transpired, the removal, hopefully, of election uncertainty in the US, hope on the pandemic front with positive vaccine news, the current investing landscape of low bond yields and low rate or lower for longer interest rate environment continue to pose challenges for investors and their fixed income allocation within portfolios.
Not surprisingly, fixed income investing in this environment generates many questions. How will fixed income markets fair has major central banks reduce monetarizing? Is the 60-40 portfolio still relevant? Are there particular areas where investors should be cautious, and where are the opportunities to find yield in this environment?
For that reason, I'm fortunate to be joined by two gentlemen today that bring more than 50 years of combined experience managing portfolios in the fixed income arena. Romas Budd started in the investment industry back in 1984 and has a widely recognized successful long-term track record with more than 30 years of extensive fixed-income money management experience.
He's responsible for directly managing about $22 billion of assets and is a member of our core fixed income team that manages close to $42 billion in fixed-income assets for the retail, institutional, and private client channels.
Also joining me is Derek Amery, who has over 20 years of investment industry experience with a focus on Canadian fixed-income portfolio management. Prior to joining Dynamic, Derek spent 16 years as a portfolio manager at HSBC Global Asset Management. The last 11 of those years as the head of Canadian Fixed Income, where he was directly responsible for over $6 billion in AUM.
It's a pleasure to have them both with me today. I'm going to start with a question for the both of them. First to Romas. Romas, moving forward, how could the bond markets be influenced by central bank action and government support programs, just an incredible amount of stimulus that we've seen pumped into the system over the last year?
Romas Budd: Mark, that's really the big question going forward. As we know, this year, we really have unprecedented government support through the fiscal side, more direct support of bond markets through central banks.
Certainly in Canada, more so than we've ever had because this time around they're actually buying corporates and provincials to keep spreads in and we didn't see that in the last recession, even though we saw similar actions essentially in the US previously. Traditionally central banks, as we know, keep their eye on short-term rates or adjust short-term rates to respond to demand shortages in the economy, to get people to spend, to bring forward spending and demand and improve the economy when we go through a slowdown.
This time around, of course, it's been so severe, number one, that they've brought in other tools, and number two, they've gotten rates down to close to zero. They've had to go elsewhere to ease the system and that's through quantitative easing, which is buying of government bonds securities.
As I mentioned, they've also gone into provincials corporates. They may even go to yield curve control. The big difference this time around is they're not only controlling short-term rates, they're actually also controlling long-term rates up to a certain degree. As investors, as portfolio managers, that creates other challenges going forward, regardless of where you think yield should be, you have to be aware that the central banks are definitely suppressing interest rates at this time.
Mark Brisley: Derek, if we think about the same question, but out of you from the corporate side, how do you think markets could be influenced by the same central bank action and government programs?
Derek Amery: I think it's quite clear based on the current policies and programs that central bank action and fiscal policy is going to continue to be incredibly influential on the bond market for years to come. As Romas mentioned, not only on the rate side, but also now on the corporate side. This really started during the financial crisis, but as we've seen during the pandemic this year, the scope and scale of that central bank intervention has really increased dramatically.
What we've seen as Romas alluded to, was that central banks have expanded their toolkits to include corporate bond purchases. While we saw some other major central banks, notably the BOJ and the ECB make such moves earlier in the past decade. Really, it was the Fed's decision to purchase corporate bonds in March and April that has had and will continue to have the most dramatic impact on financial markets.
When you think about it, was that the Fed's announcement that they would engage in direct purchases of investment-grade corporate bonds, that was one of, if not the main catalyst for the rally in risk assets that we saw. More importantly by signaling that they would use basically any means necessary to backstop credit markets. The question now becomes, what will happen going forward?
Clearly, as we saw during the rally in risk assets, this year credit markets have become very much dependent on and influenced by those central bank initiatives, particularly during, as they say, periods of crisis or severe market turmoil. So I think it's clear that central banks will likely be willing to step in, again, in such periods to support credit markets.
What I think though, that is going to be more interesting, and perhaps less clear is what rule or level of engagement the central banks will have in more normalized market environments. The central banks have said that their corporate bond purchase programs that we've seen this year are basically emergency measures, and not necessarily part of their normal course of business.
As I said, it'll be interesting to see how they react to the next downturn in risk assets that's not caused by a health crisis like we saw in late 2018. Will they lend equities and credit markets and do a more classical bear market? Or is the Fed always going to be in place to stop any sizable declines in risk assets no matter the cost?
I think that's really the question that will be interesting to see how that unfolds. I would argue that if the experiences of the last 12 years or so are any indication, I think it's going to be quite difficult for central banks to extricate themselves from their current levels of intervention in the credit market. Now that they've gone down the path of buying corporate bonds and directly influencing and supporting the credit markets, I think it's going to be difficult for them to remove that support.
Ultimately, I think that's probably another reason why you want to be bullish credit over the medium to longer-term is that you have ultimately, what I think will be ongoing support from central banks.
Mark Brisley: There's been a lot of attention on the 10-year yield number and we've seen recently the US 10-year trading above the range that it's been in, really since March. Romas, what does that mean for future bond yields, and probably useful to our investor or listeners as well is, why is that important?
Romas Budd: This is, obviously, a very timely topic here, because people have been watching the 10-year yield and actually adjusting somewhat their financial assets within their portfolios. So talking about things like income versus- or value versus growth, et cetera, depending on what 10-year bond yields to. Now in the US, we got down to about half a percent earlier this year and to the crisis.
Most recently, Mark, as you alluded to, it got all the way up to 0.96. A lot of that, I think, was around election time, the market start to discount the blue wave, which at this point we haven't had. Mind you in January, we'll find out about the Senate, but at this time, it still looks like Republicans will keep the senate buy one seat.
Assuming that is true, the markets have backed off a little bit and brought rates back down a little bit down to about 0.85, and in Canada, about 0.7, our rates are a little bit lower. Now, what we have happening, though, is, obviously, the bond markets are quite expensive from the standpoint if you look at indicators such as inflation. As we mentioned earlier on, we have the central banks suppressing interest rates.
It is a bit of a cat and mouse game. For us, as tactical managers, we have looked to reduce our duration target or the price sensitivity of the unconstrained portfolios. For example, funds such as tactical bond fund, or the ETF DXP.
We reduced target at the end of August when retaining rates were much lower, even though we're looking almost with a magnifying glass because rates are so low, but they were under 0.5% at the time when we reduced the target.
Now, having said that, our most likely scenario is that we will reduce the target further and bring down price risk, but it's going to depend on a lot of things. Right now, I'd say one of the biggest factors is what happens with fiscal policy coming out of the election and whether monetary policy itself starts to look like fiscal policy, which sounds odd, but we might end up in that situation if we have more to talk, but later, we'll perhaps get into it.
The ECB is actually doing certain actions that make monetary policy look like fiscal. Now, the central banks have generally said, "Look, we've got rates down to zero. In Europe and Japan, we're actually even below zero. There's not a lot more we can do."
It's going to be up to fiscal but it is complicated from the standpoint of if we don't get the fiscal for whatever reason, if it's because of Republicans in the Senate, whatever the reason is, then it's not as clear that rates will move up. We may end up closer to situation that we have in Europe and Japan.
We've taken the path as the most likely is that rates are in a long-term bottoming process, but it's going to take time, and there's a lot of other factors that might come into it. We will adjust the portfolio's accordingly to the data as it comes in and what happens on the monetary side, the fiscal side, and then the real economy.
Mark Brisley: Derek, if we look at the corporate side, what would you say right now is the risk-reward for credit in this environment?
Derek Amery: I would say, generally speaking, we remain quite constructive on credit, certainly in the near term. When I look at the outlook for the sector, I try to do so typically through three lenses, and that's looking at the fundamentals, the valuations, and the technicals.
If I just quickly walk through those three lenses from a fundamental perspective, while the fundamentals are still weaker than prior to the crisis, and they are approving. The macro backdrop has seen a sharp bounce back from where we were in the March, April, made time horizon, and while, obviously, the speed of that recovery is starting to slow, there's still considerable ground to makeup.
I would say the trajectory of the macro outlook is still positive. Also from a bottom-up perspective similarly, credit fundamentals, in general, they're softer than they were at the start of the year. Obviously, with weaker demand has resulted in weaker revenues and earnings and it leverages increased.
Obviously, credit metrics have deteriorated, but again, similarly to the macro picture, credit fundamentals are stabilizing and look to improve as that demand recovery continues. In terms of valuations, they appear to be, I would say, fair to maybe slightly rich based on where we are in the recovery. Credit spreads are tighter than where they would typically be during recession, but obviously, we're not technically in a recession any longer.
That from my perspective would seem fair. I would say that they're possibly a little bit too tight given where we are in the recovery, obviously, we're still in the very early stages of the recovery. I would categorize valuations as fair to maybe slightly expensive, but having said that, they still remain 35 to 40 basis points wider on average than prior to the crisis. From my perspective, I still think there remains some value in the space.
Then finally from a technical perspective, the technical backdrop is where we continue to see the most support for the credit sector. What's been one of the most remarkable elements of the performance of the credit markets this year is how well record levels of supply have been absorbed by the market. We've seen about 1.7 trillion in new corporate bonds issued in the US on a year to date basis.
That would be about 45% more than what we saw during the previous record year in 2017. Outside of a couple of weeks in March, that new issue supply has been absorbed very well by the market. We've seen relatively small new issue concessions. We've seen new issues perform very well on the break in the secondary market.
Despite a huge increase in supply, the demand-supply imbalance, in my opinion, remains quite strong in credit. Finally, I'll say the search for yield remains a very strong technical driver of demand in credit. While absolute yields are obviously historically low. On average, corporate bonds in Canada are yielding almost four times that of government bonds.
It's still within the fixed income space and for fixed income investors credit remains an attractive alternative in my opinion. Overall, we like the risk-reward relationship in credit at the moment, but having said that, again, we're closely watching the fundamentals to see if there is any signs of deterioration in either macro-environment or the credit profiles that I highlighted earlier.
Mark Brisley: Speaking of closely watching, the whole world was watching over the last couple of weeks and continues to on what's happening with the border. Derek, what is the ramification on the bond market itself and what does that do to impact bond investors?
Derek Amery: Going into the election, given what we were seeing in the polls, and what we saw in the betting markets, financial markets certainly appeared to be pricing in a relatively high probability of that Democratic sweep that Romas alluded to with a Biden administration and a Democratically controlled Senate. I would say the next most likely scenario that the market was anticipating was a Biden-presidency, a Republican-controlled Senate, and Democrats continuing to control the House of Representatives.
Now, obviously, at this point, it would appear that the latter is the outcome that we're dealing with. Obviously, it's still yet to be confirmed, and there are still two upcoming senate runoff elections in Georgia. It's certainly widely expected that the Republicans will retain their slight majority in the Senate. It looks like the US is headed for a divided government in January.
In terms of the potential ramification for bond investors starting with the race market, the consensus view and market action, as I mentioned, heading into the election, was that the blue wave of both a Biden-presidency and a Democratically controlled Senate would see more aggressive fiscal stimulus and a larger near term boost to the economy, which would likely put upward pressure on both equity markets and bond yields.
The divided government outcome, obviously, is now going to be associated with expectations for a smaller fiscal support response, and should at the margin, put less upward pressure on yields, at least in the near term. In over the medium to longer-term, I would argue that by keeping the policy agenda more moderate, and down the fairway, if you will, a divided government takes many of Biden's more progressive initiatives such as aggressive tax and environmental reforms off the table.
This will likely be of some comfort to equity investors, at least over the medium term, and ultimately likely at the margin would push you to retire. In terms of their credit markets, obviously, the outcome of the election has the potential to move credit spreads, given the outcome in the waning market optimism over the size of the potential fiscal stimulus package that we could see. It's a positive outcome on the macro picture, I think that spreads could move slightly wider here in the near term.
However, if ultimately, a divided government is positive for risk assets. As I mentioned, I think that that should help to push spreads lower over the medium term, I must say, however, the immediate impact of the election on financial markets would appear to have been relatively short-lived. This is obviously due to developments on the pandemic taking center stage and stealing the spotlight.
I think that the battle between the near term challenges brought on by the significant deterioration in the pandemic caseloads and the reinstitution of activity restrictions across the globe, offset by the optimism surrounding a vaccine have probably overshadowed the election results and dampened the ramifications that it might have on the markets and on investors.
Mark Brisley: The information is moving so quickly. To steal a comment away from Malcolm Gladwell, a lot of questions around tipping points. Romas, one of the questions that we seem to get pretty frequently is whether or not there's a tipping point for the bond market that could maybe result in us seeing rates moving higher? Second to that, what could possibly cause a probability for rates to fall again?
Romas Budd: Well, as we've been telling clients the last few weeks, one of the sayings that we came up with took from someone else so I can't take credit, but I really liked it. It's, "Is July the new January?" The thought process behind that is the governments and central banks, most businesses, when we start into this pandemic, into that March-April period, really, we thought we'd be through most of it by about January, and life would be starting to return to somewhat normal.
Now, we're already in November so there's no way January we're going to be seeing anything close to normal. We would expect it's going to be pushed further out into July. That's one of the factors that keeps rates suppressed. In the meantime, the last couple of weeks, of course, we've got some really good news on vaccines, whether it's Pfizer, I'd actually even think the Moderna one, at least from what I've seen, not being an expert on vaccines, but certainly, the storage aspect to it requiring these extremely low temperatures. I think that'll be more widely used or able to be used more widely globally.
Does that mean, is that the beginning of the end of the pandemic? That pressures rates in the opposite direction. We have both pressures happening, right now we've got the central banks trying to keep rates down. We've got fiscal policy that we're not 100% clear on how it's going to shape up from here, but keeping in mind that, as I said earlier, the central banks want to pass that baton to fiscal policy and spending.
If they continue down that path aggressively, I think we can talk about, as we said before, that rates could be moving up slowly. However, where it gets tricky, and that's for us as active managers, this is where we have to be careful where we adjust the portfolios and go to where the data takes us is, as Derek alluded to, if Republicans keep the Senate, there is a chance that the spending that comes out of the government side-- Again, I'm not making any judgment on whether a lot of spending or not a lot of spending is good for the economy or for standards of living, I'm just going with the cards we dealt as managers.
If the Republicans really quash a lot of the spending or other investments in the economy, whether it's into healthcare, whether it's into education, wherever that money goes, whether it's cutting back on the student loan forgiveness, for example, all these things.
If the Republican Senate really puts a stop to a lot of those programs, that's where we start thinking about heading more into the scenario that Europe and Japan have gotten themselves into. That is a period of very low-interest rates, and in fact, the rates go even lower and into negative territory.
Again, that's one of the reasons it's important for people with many risk assets in their financial portfolios and real estate portfolios, if you've got other risks in a portfolio, bonds still help offset that. Even though yields are extremely low, if those assets run into trouble, policy mistakes, we get hit by a pandemic like we did it in March. If something comes out of left field, then you're going to be very happy to still have those bonds in the portfolio because they act as a-- Number one, they act as an insurance policy against other assets, but also as an ability to bring down the volatility of those portfolios and the returns going forward.
We are in a bit of a crossroad here. If we really get aggressive on fiscal, we could be seeing the bottom off rates, and I've mentioned that a few times now. If that gets short-circuited for whatever reason, then we're headed towards Europe and Japan. Again, as active managers, we'll adjust the portfolio to where the data takes us, but at this time, our most likely is still a gentle rise in yields over the next couple of years, if not longer.
Having said that, it's not guaranteed. Another thing I'll just throw in there, Mark, just quickly on that because people often get worried about the level of interest rates and why people put money in bonds at this time. Just to realize along with the insurance aspects and decreasing the volatility of the portfolio or negative correlation when those assets fall, that over a longer period of time over five years, if rates rise gently, you actually end up with a higher total return in your bond portfolio than you would if rates stayed where they are.
The principal gets reinvested at higher rates. The coupons get reinvested at higher rates. It's not the end of the world if rates go up gently. If rates spike up, that's a different type of issue. You asked a little bit about that at the beginning of this question. I think the odds of a spike up at rates are pretty low as the central banks would try to mitigate that as much as they can. It really would take something extraordinary, like a big spike in inflation, I think, where they would start to lose their handle on keeping yields generally lower than the market would without them, but that's the lower odd scenario I think of rates spiking up.
At this point, we expect rates to gently rise. We're adjusting the portfolio actively to reflect that, but we cannot take off the table a scenario where rates go sideways or even go lower, so we are at a crossroads.
Mark Brisley: Romas, you talked a little bit about what we now call the 60-40 conundrum and I think a lot of our listeners would be familiar with that split of 60% equities, 40% fixed income in traditional portfolios. Probably, many of them are going through that experience right now, tons of attention on this subject and due to this lower for longer rate environment and low yields, maybe one of the most simple questions we hear is, "Do bonds still matter in a diversified portfolio?"
You've talked about some of that against protecting against risk in a long-term view, but what advice do you give to the investor that's thinking they need to assess more closely that traditional asset mix?
Romas Budd: Clearly, as yields get lower, over time, your upside and price gains and capital gain potential decreases. What I think I can put into that discussion is what we did see in March 2020. It's interesting because, in North America, we still did see that positive response from government bonds and very high-quality corporate bonds, where they actually went up in price when equities and other risk assets declined.
In other parts of the world where rates were already negative, we didn't see that impact. They acted more like cash securities. I think the 60-40 question, clearly people should start thinking about it for the future, but the fact that we still have positive yields in North America I think still gives us time to work through that.
In other words, they're still providing that insurance aspect of negative correlation against other assets, as long as yields are positive. Even if they are tiny, they're still giving you that protection. If we go down that path and to negative yields, I think then it's a legitimate question about how you look at your bonds in a diversified portfolio. I think we're not quite there yet, at least in North America.
Mark Brisley: Derek, I know you have a lot of thoughts as well on this 60-40 conundrum. One of the other things that's come up as a result of that conversation is the deployment of capital within portfolios to things like alternative strategies, some of which people are going to the extent of calling them a third asset class. What are your thoughts on this area as well?
Derek Amery: Well, Mark, I certainly think that bonds continue to matter in a diversified portfolio. As Romas alluded to, when you look at periods of market turmoil, like we saw in March of this year, bonds and fixed income assets continue to provide that ballast, that hedge, if you will, in a balanced portfolio, correlations continue to be lower negative. Again, in those periods when risk assets are under pressure.
I still think that the traditional portfolio theory in terms of diversification that you get from bonds is still important. To Romas's point, I still think that that maybe is more prevalent here in North America with yield levels here that are materially higher than in maybe other jurisdictions around the globe. That said, when you look at the traditional role that bonds have played in that 60-40 portfolio, I do think that there are going to be challenges to the role that fixed income has played.
Fixed income has acted, as I say, as that ballast, as that portfolio insurance in a balanced portfolio, but what made bonds such a beneficial counterbalance asset in those portfolios for investors is the fact that they did have positive expected returns, and a lot of that came from income and certainly the income part of the role that fixed income has played in that traditional balanced fund construct, obviously, is going to be more challenging with yield levels where they are.
I do think that it is now at the point where investors are going to want to start to look at alternatives and how that traditional balanced fund construct is going to evolve over time. I think that there will be an important place for alternatives as an asset class within what will be I think kind of the new normal for balanced funds going forward.
Mark Brisley: That's great. Gentlemen, thank you very much for these insights. Markets are changing more than ever, and of course, for all of our listeners that have joined us today, we really do believe that a Dynamic financial advisor can help address all your evolving portfolio needs, including those that we discussed today around the fixed income arena.
I want to thank you for taking the time to listen. If there's more information that you'd like to hear about these portfolio managers or any of the offerings that we have at Dynamic Funds, please feel free to visit our website at dynamic.ca.
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