PARTICIPANTS
Mark Brisley
Managing Director and Head of Dynamic Funds
Romas Budd
Vice President and Senior Portfolio Manager
PRESENTATION
Mark Brisley: You're 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. What's the saying? Patience is a virtue. Probably applies to a lot of things these days, but especially rings true for fixed-income investing. The question is, is the long-term horizon where investors should be focusing in this market environment? Bond funds traditionally have been recognized as a great way to access an area of the market, and especially asset classes, that the average retail investor wouldn't do easily on their own, but given that allocations to bonds and portfolios globally are down significantly, it's not surprising that fixed-income investing in this environment is generating more questions than ever.
To unpack some of these questions, my guest today, Portfolio Manager Romas Budd started in the investment industry in 1984 and has a widely recognized successful long-term track record with more than 30 years of extensive fixed-income money management. He's responsible for directly managing about $22 billion in assets and is a member of the core fixed income team here at Dynamic Funds that manages close to $42 billion in fixed-income assets for the retail, institutional, and private client channels.
Romas, it's great to have you here. With allocations to bonds in portfolios down by close to 80% according to a recent Bank of America survey, does that change how a manager is managing a bond portfolio?
Romas Budd: If the allocation to bonds is down; for most people it's down quite dramatically for a good reason, mostly because yields are so low and inflation is creeping up as we know. Now people are asking their bond portfolios to do a lot more than they used to. In other words, you've got a much smaller allocation that has to do the heavy lifting that you had in a much bigger portfolio. I think people have to decide then what their bonds are being used for within a diversified portfolio.
The kind of options that we look at, that most investors and portfolio managers would have, you've got the idea of a benchmark investor index or passive index manager, which we are not, of course, but people should be aware that the benchmark duration of price risk in the index has gone up by 50%. Investing in a bond index now is nothing like it used to be 10 or 20 years ago. It's much riskier. The triple B component of the index has doubled, so the credit quality is much less. Those are issues with index or passive index and other choices where some people go into corporates and heavy corporate credit type portfolios.
It almost causes you to be a market timer if you're running the overall portfolio or if you're looking for this allocation of bonds to diversify your portfolio against other risks, which usually is equity portion because, as we know, corporates do much better when equities do better. When equities have a hiccup and you want your bonds to perform and to offset what equities are doing and provide a diversifier, a corporate credit portfolio often will not be able to do that because the correlations are more positive to equities.
Now, getting to the type of portfolios we manage. We actually manage portfolios that are tactically adjusted on many levels that we'll talk about in a second. Historically, they've done well through the cycle, but they've done especially well when equities have done more poorly and you want that diversification. You think back to December of 2018, March of 2020, our tactical bond funds that we managed did very well and helped to offset some of the risks we had in the equity side of the portfolio. The way we do that, and the way we've been successful at doing it over a number of years, is they're tactical right in the name.
We adjust things like duration. We don't automatically just leave duration at an 8-year average duration that the index is at now which creates huge price risk in the portfolio for a given change in interest rates. We adjust yield curve. Of course, yield curves have been in the news quite a bit this year, the flattening of the yield curve. We've actually positioned for that in the second half of the year and that's worked out well. We adjust the credit sector allocation. Again, remember how the general index and the market has gotten; credit quality has deteriorated significantly, so what that means is the general bond market is even more correlated to equities than it used to be and doesn't give that diversification unless you're being tactical about it. Other factors that we use as well are things like Canada-US spread, international bonds. We have many tools or levers to pull in our portfolios so that if you're an investor or putting together a diversified portfolio, you individually don't have to worry about those and you don’t have to market time those.
Times of stress; as we know, going to the next year, we're likely going to see some interest rate hikes. We see inflation issues. Us as bond managers of tactical bonds, we're always on the lookout to see where there's value. What we do with duration, for example, now we are taking duration down. We expect the Bank of Canada to be hiking a number of times next year, probably more so than most investors are expecting. Same thing in the US. Credit, we also think is going to be an important driver next year. We're going to end up in an environment, in our opinion, with inflation that's going to create a little more stress in the financial market, so that’s tactical on managers. We're going to make our adjustments, look where things are overpriced or overvalued, where they're cheaper, and make adjustments in that way. That way, our funds fit into creating a robust portfolio through an entire cycle rather than having to buy a credit-based bond fund then rotate to a government-based bond fund. We basically make those decisions for you.
Mark Brisley: Romas, listening to you talk about all these variables and the different types of outcomes that might be desired in constructing a portfolio, fixed income is complex enough as it is right now, just given market conditions, but this is also making me think that it's important for an investor to hold an actively managed fixed-income component in the portfolio. Do you agree with that, especially in today's market environment?
Romas Budd: Absolutely. I think this won't come as a huge surprise to people because we've talked about it and others have talked about it, but when you talk about passive or something that managers closer to a traditional Canadian fixed-income portfolio, which is higher in corporates and closer to benchmark, the benchmarks have changed dramatically over time. The duration of the Canadian Bond Universe benchmark has gone from about five years to eight years. The price risk for any change in interest rates has gone up by about 50%. Today's benchmark is nothing like it was.
Another part that's also similar from the standpoint of how much it's changed is, of course, the credit quality of the benchmark. The Triple-B component of corporates in the Universe Index has doubled, and it's basically half of the entire corporates held in the Universe benchmark are now Triple-B. The credit quality is way down, the price risk is way up. Like I say, today the benchmark is nothing like it used to be. "The market", if you want to think about it that way, "the bond market" is a very different animal.
We do have to think a lot more about price risk, we have to think about credit quality. That's actually one of the areas that we’ve spent a lot of effort and time and money on here at Dynamic and at 1832 as well, is building out the credit team, which is more important than ever. The old days you could have a few bank bonds in a portfolio and not think much about it, but like I say, now half of the corporates in the investment grade universe index are now Triple-B, you have to be very careful about what names you hold in the portfolio. We've invested a lot of our time and effort that we have one of the best teams on that.
Mark Brisley: Let's talk a little bit about the influence of how things are evolving right now with a more macro lens. One of the things that we've heard a lot about is the Fed and the US beginning to taper its Quantitative Easing program and for our retail listeners, bond purchases being a big component of that. What are the effects of this tapering of QE programs?
Romas Budd: Now we're into a really interesting topic. I believe we've had a top-down basis; I think we've had three QE programs, something on that order. Most people are probably not aware that in fact, every time the Fed has tapered or ended QE, yields in the 10-year have actually gone down, surprisingly. People tend to think of it the other way around, that if the government, Federal Reserve, the Central Bank is not buying bonds and pushing prices up, that yields should naturally go up and prices should actually fall, but in fact, historically, the complete opposite has happened.
Do we think the exact same thing will happen this time? It's hard to say, but it's good to know the historical basis. One of the things that is different this time is that real rates are quite negative. I'm sure people are aware when they look at where the yields are, they seem very low; let's say, a 10-year corporate, you’re getting into the 2.30, 2.40s 2.50s, Government of Canada is around 1.60, that seems very low considering inflation has bumped up significantly, but what's really holding down the nominal yield is actually the real yield, and we can measure that; Real Return Bonds in Canada or the TIPS market in the US, they are deeply negative.
When you subtract nominal from the real, you arrive at what the market's actually discounting for the inflation breakeven, and that's actually quite reasonable. In Canada, the inflation breakeven in the bond market is now 2%. In the US about 2.55. The issue is not really the inflation component. People are worried about inflation and holding bonds, I would suggest that's not a huge issue right now, unless you think inflation's going to be 3%, 4% or 5%, which we don't see and the market's actually not pricing for that.
What's really going on is real yields, and I'm sure we'll touch on that in a minute, but historically, the taper is all about Central Bank removing liquidity. Historically, that is a time period when risk assets have struggled somewhat. When I say risk, and often substitute the word equities, but we can't say that we're going to get the exact same outcome every time they taper but historically, equities have struggled and bonds have actually done reasonably well and in fact, yields have fallen.
This time, like I say, it's a little different, the break-evens are good, but real rates are low. Maybe we won't have quite the same outcome but certainly, when Central Banks are removing liquidity, the economy and the financial markets get more susceptible to accidents, for lack of a better term. We know we've seen that multiple times during the reversal of these QE program. From the standpoint of a bond investor to think taper, most people would think is a bad thing but we would say it's not necessarily depending on how that liquidity flows out of the market, in fact, that may push money back in to the fixed income markets, and especially the higher quality fixed income markets, whether that's into provincials and government bonds which are also, as I alluded to a little bit in the beginning, are a very important component of negative correlation against other risk in the portfolio.
Mark Brisley: Romas, thinking about what you as a portfolio manager are facing in this current environment, I wanted to ask you about the strategies or perhaps new strategies that you might have available to generate additional income in your portfolios.
Romas Budd: We actually have an exciting new way of adding return to the portfolio starting in January. What we're looking at is an option selling strategy to capture the premium that options provide and by doing so, adding income and return to our bond portfolios.
We would look at that as a continuum of the things that we've done over the years, whether it's being involved in the futures markets as one of the first in Canada as heavy users of the derivative and futures markets, whether it's ways to hedge the corporate bonds in the portfolio without actually selling them, by using a derivative market and using something that's called CDX, and now we're moving on that continuum to providing added income and return to the portfolios by what we call Harvesting Option Premium. It sounds really technical, but we've done it on the equity side for a number of years and now we're just moving on to do it for the bond portfolios as well.
Mark Brisley: If you're looking forward now into 2022, what would be some of the insights that you're gleaning from, where we've been, what we're going through, and some of the more recent news that we've heard, especially with the addition of further information around a new variant and concerns about the pandemic continuing or at least staying with us for the foreseeable future, if you have that crystal ball or at least the most educated view that you have as you're thinking about things going forward, what would it look like?
Romas Budd: In broad sense, you can probably put it down to two categories. We're either getting through COVID and getting through the pandemic and moving on to the new normal, or we're essentially stuck in the mud. Now, of course, we will play the hand that is dealt to us because it's really difficult to say which one's going to win. As you see, like most people expected and governments and individuals expected us to be through this pandemic, a year, year and a half, and here we are, now we hear of another variant that's significant possibility to slow things down globally again.
It does seem on the side of the ledger where we talk about stuck in the mud. If that's the case, there are some concerns about what governments and Central Banks will do going forward because of course, they've really spent a lot of their bazooka, so to speak, on the fiscal and monetary side on the expectation that we're only going to have a year, year and a half and get through this pandemic. I think the inclination of governments to spend more that's going down and politically, you're starting to hear pressure about spending programs contributing to inflation, et cetera.
If we end up in this stuck in the mud type scenario where the pandemic and various cycles through it potentially goes through a number of years, then I think you're going to see growth perhaps disappoint. In that scenario, we could see real yields decline even though they're already negative. We look back through history, there's been periods of history where real yields have actually been as far as negative as -10%, or -15%, if you can believe it.
This theory that just because real yields are negative and nominal, yields are low, that you have to avoid bonds, certainly from the standpoint of offset the risk, that's not really true because they've moved further, bond price have moved even further and real yields have gone even further down, so stuck in the mud. One of the possible results in that scenario is that we become more like Europe and yields actually decline again and surprise most people.
Now the other one, the other scenario is more of a positive scenario that we're actually getting through COVID. I think if we get through it over the next year, the Central Banks clearly now are feeling a lot of pressure to get inflation down so they will continue tapering. Of course, in Canada, we've already ended our QE program, so we would be moving on to rate hikes but the US would probably accelerate the taper right now, it's expected to end in June. If general consensus is that we're getting through it, the Fed will eventually most likely accelerate the taper, perhaps even finish it by March or so. The rate hikes would be moved forward.
Having said that, yields cannot move a lot higher because the debt levels are very high, whether it's the consumer, business or government sector. There's only so far yields can go up. In Canada, in fact, the bond market is already pricing for seven rate hikes, if you can believe it, from the Bank of Canada over the next year, year and a half. We actually think that's probably over-discounting how far the Bank of Canada will raise rates. In the US, only discounting two or three next year. We think even in Canada, that would be closer to what we end up with, even if we're making it through the pandemic.
From bond market standpoint, as a bond investor, as a bond portfolio manager, under both scenarios, potentially the bond market can do okay. Look, we're probably not going to have run-away type of returns that we used to have when yields were higher but certainly, we can provide that offset to risk. we can take some of these rate hikes that are discounted in the market off the table and either way, whether we're making it through the pandemic or whether we're stuck in the mud, a good quality bond portfolio here still has a very important place within a diversified portfolio.
Mark Brisley: I would imagine a lot of our listeners that wouldn't necessarily be investment professionals, a lot of people would be retail investors, and probably if they're like me listening to a podcast in their car, but right now they're going to the grocery stores and gas stations and buying hard goods and thinking about Christmas and these types of things, and inflation for a lot of people probably seems real. How do you address or reconcile the household balance sheet issue with that macro view of what's really going on with inflation right now?
Romas Budd: Well, there's no doubt, it is real. I think what's going on in the background is a lot of it was caused by the government - well, it was two sides. One side is the government response to the pandemic. As we know, they were very aggressively backstopping people and people's income and businesses, for example, especially so in the US. It was so dramatic that personal income last year in the US especially actually went up, even though we technically had a recession at the beginning of the year when the pandemic hit. That's a hugely unusual situation.
What happened was because people were more stuck at home or working from home, they actually spent a much bigger proportion of their budget on goods versus services. That created this huge demand for actual goods, things you can hold or use but combine with that the supply side, the factories, a lot of them were closed down so the supply chains got messed up and the demand was extremely high. You put that combination together, it's a lethal mix, and all of a sudden you've got price pressures.
Now, a lot of that part of it should unfold as we work through the pandemic, as people go back to work, as the factories go back and people go back to work at the factories, the factories come back online, and the natural demand for goods probably will drift down somewhat. There's been a secular trend towards spending on services for decades now. We would expect that that will likely come back over time, might just take longer.
One of the parts that I'm a little bit more concerned about on the inflation side as far as what's not as transitory, I think that is on the labour side for lots of reasons, whether it's people leaving the labour force, labour force has shrunk versus what it was pre-pandemic. Again, in Canada, not so much but especially in the US, we're having a lot of trouble filling jobs for various reasons, but I think there's going to be more stickiness on the labour side.
I would not be surprised to see inflation be more in that 2% to 2.5% range longer term, even though this year, next year we're we're going to be sitting more in the 3% to 4% range, versus an environment where we really were more in that 1% to 2% on inflation. I don't think these 4% to 5% inflation type numbers will continue past about the middle of next year. I'm in the camp of the Central Banks as far as that goes, but I think the labour side, depending of course which side of labour you're on, whether you're one that's paying the labour or receiving for your own labour, there's probably going to be more cost pressures there.
The general macro environment to us has shifted, it's shifted from a period of 20 years where inflation declined and interest rates were extremely low, to an environment perhaps, where we may be looking at slightly higher inflation but not as significant as we're seeing now. That's what the data would indicate today. The good sides should ease up. Labour is going to be a little more sticky but still, as far as bond investing goes, you still have to think about the fact that yields cannot go up very much or we could end up in a recession, which would mean then we'll see yields plunge again.
None of the Central Banks, none of the governments, of course, want a recession at this point. They will be working actively to try to prevent it. Having said, that we now have moved to the tapering stage, the rate hike stage, the withdrawal of liquidity stage, and that is it tends to be a time when you have more accidents. As far as people thinking about their portfolio, they should definitely be looking at what kind of risk they have in the portfolios, what they're comfortable with, what they expect the fixed income to do.
As I've said, fixed income allocations are much lower than they have been for quite a while. People are actually often looking for income now in the equity market, and whether it's a bank bond or utilities versus the traditional fixed income, use of income. Again, the total return, tactical bond, DXB for example, are all good candidates for people that are looking for offsets to risk in this type of environment, and especially now that the Central Banks are withdrawing liquidity.
Mark Brisley: I just wanted to mention when you were talking about DXB, that's a ticker symbol for an ETF that you run in the fixed income space here at Dynamic. Romas, final question for you then, just your pitch for the retail investor, building a diversified portfolio, bonds still matter?
Romas Budd: Oh sure. They matter a lot. I think people have to think about what they want from that sector or that allocation of fixed income. If they still have a very large allocation of fixed income, then it's reasonable to be higher percentage in investment grade, for example, or if they want to be dynamically adjusting asset mix, which is very difficult to do, but for people that want to do that, they can try to shift back and forth between funds, but if they want to build a robust portfolio that's going to have protection on downside, that's what we're here for.
Mark Brisley: Romas, appreciate these insights. It's a complex subject and one that we constantly need to keep talking about, especially within the context of portfolios and building out efficient effective portfolios at the retail level. Thank you for your insights and your comments today and look forward to having you back soon to continue this conversation.
Romas Budd: Thanks for having me, Mark.
Mark Brisley: Thanks to all of our listeners. Again, this is another edition of On the Money and on behalf of all of us at Dynamic Funds, we wish you all continued good health and safety. Thanks 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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