On the Money with Dynamic Funds

PARTICIPANTS

Daryl Diamond
Chief Retirement Income Strategist

Marc-André Gaudreau
Vice President and Senior Portfolio Manager

David De Pastena
Vice President of Portfolio Solutions

Mark Brisley: You're listening to Retirement Income the Right Way presented by On the Money with Dynamic Funds, the podcast series dedicated to changing the retirement conversation. Join us as we pull back the curtain on retirement planning.

David De Pastena: Welcome to another edition of Retirement Income the Right Way. I'm your host, David De Pastena, Vice President of Portfolio Solutions. Today, we're going to take a deep dive into the hidden pitfalls of bond investing for retirees. With bond market volatility, rising prices, and the constant worry of fluctuating interest rates, how can retirees relying on bond income avoid the dreaded income shortfalls?

To unpack these critical issues, my guest today is Daryl Diamond, Dynamic's Chief Retirement Income Strategist. He's also one of Canada's pioneers in creating efficient retirement income. He's got over 44 years of experience, and he's a best-selling author. We're also joined by Marc-André Gaudreau, a seasoned bond manager with over 25 years in the industry, currently serving as Vice President and Head of the Specialized Credit Team, a team that manages over $8 billion in assets.

Marc-André's extensive background includes managing high-yield and investment-grade portfolios and holding key roles in corporate credit and risk management. Gentlemen, thank you for joining us today.

Marc-André Gaudreau: Thanks, David, for inviting me.

Daryl Diamond: Yes, thank you. Great to be here with you, David.

David: Daryl, let's start with you. As a former advisor, I really want to get your opinion on the specific metrics and features of bond funds that you looked at when you were choosing them for your paycheck portfolio and distribution portfolios, when you were doing this for years with clients. Tell us a little bit about what you looked at.

Daryl: Allow me, David, to, first of all, go back to pre-paycheck portfolio and just touch very briefly on the cash wedge. We used to be very specific about having separate asset classifications under the cash wedge strategy because we were working a form of grow and sell, if you will, to create the cash flow that retirees needed. We were specific in terms of investment classes.

On the bond, on the fixed income side, we would like to have, in addition to the cash that is part of that strategy, we would have short-term bond, look at some, for example, total return positions, complement those with some potential higher yield from corporate bonds or high yield classification. We were, if you will, looking at a number of different categories of bond positions in that strategy.

In the paycheck portfolio approach, we really see a lot of merit in terms of the structure of investments that have multi-asset classes in them already. Things like strategic yield, things like alternative yield, approaches such as premium yield plus. What we find in the paycheck portfolio strategy is that as opposed to us selecting a bond classification on its own, they tend to be in the mix of what we would commonly use. Not only do we have some variation with the type of bonds being used, but the managers who run those positions also are in charge of the overall asset mix and maneuver it as they see fit.

David: That's really interesting, Daryl. I'm also really curious to hear from Marc-André on his perspective as a portfolio manager. As retirees building paycheck portfolios are looking for that steady income, that steady monthly income that they can depend on every single month, as a portfolio manager, how do you maintain your funds distribution? Some managers use tools like return of capital or other methods. How do you make sure that your unit holders maintain their income?

Marc-André: As Daryl mentioned, mandates that we're managing are actively managed. We do our own work and selection. We try to build a portfolio that can earn the distribution without taking on too much risk. Unlike equities, as you can appreciate in fixed income, it's a contract. You'll have mark-to-market movements, but it's a contract. That's really how we've always tried to meet our distribution. Let's call it a spade a spade. It was a lot more challenging for what, 8 out of the past 10 years in generating income because we were in financial repression.

It is a lot easier today to do. We've used sometimes, for a short period, a little bit of a return of capital, but mostly, we've tried, through active management, to select bonds that allow us to continue meeting our distribution.

David: Even though you're using a little bit of return of capital to maintain that fixed distribution, at the end of the year, you make it up. Is that right?

Marc-André: That's accurate. Active management tends, at least in fixed income, to have a pretty good shot at outperforming passive strategies. We've been able to do that over the years, and hopefully, we'll be able to do that in the future.

David: I'm really curious. I've got a follow-up question for you, Marc-André. There's many people out there and some investors that are flocking to GICs. What are your thoughts on using GICs to replace bond funds for retirees?

Marc-André: From my standpoint, GICs are, when you look at it, the basis is really funding from a bank. Typically, when a bank funds itself through retail investors versus wholesale investors, so buying bonds directly from the bank, we tend to be able to have a higher running yield, if you can call it this way, than a GIC. I prefer to take on that additional return, if I can call it that way.

We've been able to have a higher running yield than a GIC, and on top of that, as we all know, bonds are liquid. Your money is not part there, or there's no penalties if you need your cash for unforeseen reasons. For me, I think it's very clear, if you have a midterm horizon, that a bond will have a better shot at providing you with more return.

David: GICs are guaranteed, and I think that's why a lot of people go into them. What are your thoughts on the guarantee of GICs versus bond funds?

Marc-André: Yes. If you don't own more than $100,000, if the bank goes under, it'll be guaranteed. Anything above, you're equal with bond investors. Your downside is the same. In fact, I'd say a bond fund is probably better because it's a diversified portfolio of companies. You don't see the mark to market, I guess, on your GIC, but you do see it on the bond side. Again, if you have a midterm horizon, you stick to high-quality portfolios, maybe you use an active manager to evaluate the risk instead of relying on rating agencies, I think your shots are probably better in fixed income, in bonds, than GICs.

David: Daryl, what's your opinion as a former advisor? How do bonds compete with GICs?

Daryl: In the mind of the retiree, the word guarantee carries a lot of weight, especially for those people that don't have a formal pension plan. One of the advantages of having done this for several decades is you get to go to the movie several times where prevailing interest rates are rising against existing coupons, and subsequently, the reverse of that. We had a tough year in 2022, obviously, and people looking at the advisor going, "Well, wouldn't I be better off in a GIC?" Because, as Marc-André says, there's no mark to market and the GIC value hasn't dropped as the bond value may in a period of rising interest rates.

What we've experienced, and particularly coming through the 1990s, and it's just setting up to mirror that, nothing ever repeats itself perfectly, but boy, there's a lot of boxes being checked in. Does this look familiar? It's the fact that, sure, I've got a 5% in my GIC today, I know my capital is guaranteed and there's no mark to market along the way, no volatility, and I'm getting a 5% yield.

That's fine today, but to use Marc-André's term, if there's a midterm horizon and if you plan to be retired for more than five years, what's going to happen when those GICs mature? Inevitably, and we just saw this throughout the 1990s and even into the 2000s, that it's fine to have the guarantees, but if you're renewing your income and that's what you're dependent upon, if you're renewing that income at a lower rate because prevailing rates have fallen, your income's really not guaranteed.

It's a matter of trade-off, as so many things are in the investment world, and particularly for retirement income, it's that trade-off. You're trading off the potential of a lower income from lower GIC rates in the future in exchange for, "I feel good and comfortable now." It's a discussion you need to have with clients. To come back to a phrase we always like to use, we found that it was never the wrong thing to do to keep people intact with their bond positions, even when the asset values have dropped because of rising prevailing rates. Again, to see that income fall, it's not what you want when you're retired and depending on your own assets to create the cash flow you need.

David: Marc-André, let's shift gears a little bit. I want to talk about a very popular sub-asset class in alternatives, and alternatives have been really popular recently. Private debt has exploded as an asset class here in Canada. It can often yield more cash for retirees, but can you comment on the risks associated with this sub-asset class?

Marc-André: Definitely. You mentioned it. More return, more risk, and on the risk side, and I look at my experience, I've seen a few cycles, maybe not as many as Daryl here, but I've seen a few and I've studied a few. To me, whenever you see very impressive growth in an asset class, typically later in the cycle, the quality of those terms or your return profile, becomes less and less compelling because there's an imbalance between supply and demand.

When you look at private debt, for example, there's been a couple of reasons why we've seen this huge growth there. One is, as I mentioned earlier, financial repression. We were in an environment where you didn't earn a lot without taking on more risk. There was a willingness and demand to earn more.

The second reason is because banks were not willing to lend to those riskier borrowers, whether it's for tighter regulation reasons following 2008, or just plain vanilla to risky. That's an asset class that has completely grown, ballooned a lot. The main risk is very simple. It's plain vanilla default risk, or if there's a recession coming, or even if there's no recession, a higher cost of funding impacting cash flows of those companies.

Obviously, those companies that cannot fund themselves through the public market tend to be smaller, less diversified, if I can call it this way. If or when there's going to be a slowdown in the economy, the main driver of the return will be defaults. The second one, obviously, is going to be liquidity because those are private. If you have a pool, obviously, of private, you don't have access to all your capital whenever you want. That beating, I call it the second risk, you need to be mindful of that lack of liquidity if I can call this way.

David: I'm just curious, when you say liquidity, do you mean you wouldn't be able to get your money out?

Marc-André: It depends on various products, I guess, and I'm no expert there. If you look at who has been involved in private debt over the decades, it's been committed capital; large pension plans, very healthy pension plans, not necessarily individuals who die. My point here, or the answer to your question is, if you need all your capital tomorrow, it'll be more challenging than just selling a bond or things like that. That's what I mean by liquidity.

That's why, by the way, we're seeing funds being gated in less liquid asset classes, private debt, you'll have real estate, you'll have private debt in real estate. You're basically seeing this mismatch of cash redemptions versus the ability to sell or monetize the investments underneath.

David: You mentioned commercial real estate and real estate. Is the debt level there a big problem? Something that we need to be aware of? Is this the next great financial crisis to come?

Marc-André: Similar to private debt, there's been a lot of demand over the past 10, 15 years for commercial real estate or commercial debt and real estate. Yes, there's been a continued imbalance of demand versus supply and underwriting criteria has got loosened and a lot of those valuations, as we all know, were based on very low cap rates. That has changed obviously quite a bit over the past two years.

When we look at what could be in front of us, just from a commercial real estate standpoint, typically, and I'm going to use my own experience or what I've seen when I started my career, if you use the savings and loans, or the experience of the early '90s in that space, both Canada and the US, it can take a few more years to clear out the excesses. There's opportunities for sure today in that market, but overall, I think that story will be with us for a while.

Back to your question—is this a catalyst for a full-blown financial crisis? I don't think so. At least the largest US banks are a lot more diversified. They don't have as much exposure. I would say, if that is combined with a housing issue, especially in Canada, that could create a problem. I don't think that's a problem in the US, but in reality, I think it's going to take some time. It'll be with us for a while. Whenever there's a panic, which we started to see, we're going to see opportunities arising, but it'll be with us for a while in my mind.

David: In the world of alternatives, specifically in fixed income, what type of strategies should retired investors consider and why?

Marc-André: There's always opportunities everywhere. What you're talking about here in fixed income, those are, I call it liquid alternatives. Basically, securities that can be bought and sold every day or clients can buy and redeem every day. I think, as I said earlier, facts have changed. Overnight rates at zero, similar to what we've seen in '08, what we've seen during COVID, are extremely rare occasions when you look at a hundred year, you see that very rarely. I think that the odds of going back to zero, over the next 10, 15 years, are quite low.

In fact, there's fundamental inflation pressures that might be with us, which I could see those overnight rates range between, I don't know, 6% and 2.5%. This is good for fixed income investors. If you can use alternative strategies to enhance that return, it's giving you a lot more cushion to deal with small mark-to-market losses. I think it's quite compelling. We have a significant cushion and finding partners that have that track record can come up with strategies that are not correlated to your traditional fixed income and equity 60/40 are pretty interesting solutions to add to a portfolio, which will enhance your running yield, your income, your cashflow. Liquid alternatives, in my mind, have a place in the portfolio.

David: It's really interesting. You've been talking about alternatives and I know you run a couple of very popular liquid alternative funds. What are some of the specific strategies you use and how do they help investors and how do they work in a really simple way for us normal people to understand?

Marc-André: As I said earlier, if we can enhance that income through, for example, the modest use of leverage on high quality, three, four, or five-year bond, like what pension plans have been doing for decades or like a bank would do with 30 times leverage. If you can add one turn or two turns or three turns of leverage on very high-quality, short-term investment grade bond and get that additional spread and yield, it is very attractive.

On top of that, as we know, in those strategies, you can add leverage on bonds you like. In addition to it, you can protect capital on broad views. If you're more defensive, well, you can use credit derivatives, for example, or derivatives to neutralize or help the downside if you think there's potential downside. Those are tools that portfolio managers have in order to supplement the return and come up with a nice, smooth experience for the advisors while capturing this additional return. That's really what I find exciting with liquid alternatives.

David: Daryl, let's pick your brain on the alternative space. When you were an advisor building paycheck portfolios for some of your clients, how did you use alternative investments? If you did, what type of investments did you use, and why did you use those investments?

Daryl: There was definitely an opportunity that was created by the introduction of alternative investments. I'm thinking specifically dynamic alternative yield, which commonly found its way into the paycheck portfolios we were creating as a complement to other positions. What I mean by that is the inclusion of the alternative yield distribution rate allowed us to bump up the overall payout or yield to the client. That helped us in two key ways. I'll just use some round numbers.

If we were able to manufacture something in the neighborhood of a 7% distribution rate or yield, we could take 1% of that 7% and use it to cover off the dealer fees, how we got paid. We used F-series, not A-series most of the time. To be able to manipulate, and I use that in a very positive way, the fee that we were paid, that worked well. To take it out of the distribution made sense because we weren't selling units to pay fees.

The second thing that that larger distribution allowed us to do, and let's go with that 6% that remains, we would reinvest 1% of that 6% into the underlying investments so we could build income up over the years. That helped us, to a large degree, deal with some of the inflationary issues. We weren't anticipating 8% in one year, but notwithstanding, things do increase pricewise as you move through retirement.

The ability to reinvest any portion, it could be 50 basis points, 100 basis points of that distribution, we believed and found that it helped clients deal with some of the inflationary concerns that were going to present themselves as they moved out through their retirement years.

David: It sounds as though the strategy you use within the paycheck portfolio allowed investors to have an automatic paycheck increase. Is that right?

Daryl: That is right in the way you describe it. It was also an option too, David, that we were reinvesting 1% in the example we used, to acquire new units, which, of course, you're correct, does enhance the income payout, but it wasn't always necessarily the case that they needed the extra income, which just simply magnified in a very positive way, this deferral of ultimately taking higher income down the road. The idea of covering fees, reinvesting part of the distribution, while at the same time allowing them to have the cash flow they need, that's a nice trifecta.

David: Gentlemen, this has been a fascinating discussion around bonds. I want to thank you for your time today and thank you for being here.

Marc-André: Great to be here with you, David.

Daryl: Yes, thank you very much, David.

Mark Brisley:You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor, or visit our website at dynamic.ca. Thanks for joining us.

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