Identifier: Fixed Income

Blocks showing transition from year 2022 to 2023

The market turbulence experienced over the last several years culminated with a major downturn for both public equities and fixed income in 2022. However, the journey along the way did provide useful insights and lessons, particularly from the experiences during the height of the pandemic in 2020. This article considers the extent to which investors heeded the warning signs, or whether they were desensitized to the ensuing risks.

The international risk consultant, David Hillson, defines risk as “uncertainties that matter”. In other words, when reviewing various investment uncertainties, the key is to understand how material the consequences could be if things do not go as expected. The assessment and acceptance of risk varies among investors. This is because different investors have varying levels of risk appetite and risk tolerance.

The practical implications for investors from Hillson’s definition is to prioritize risks when deciding how to respond to them. For example, if a particular risk has a minimal impact and low probability, then you may choose to accept the risk. However, for risks identified as material and with a higher probability of occurring, you will want to act. This may include controlling the risk exposure through better portfolio diversification, or avoiding the risk altogether, if possible.

Insights from the global pandemic

In the recent market environment, the global pandemic surfaced insights and warning signs, including:

  • Further concentration of equity markets, particularly towards technology companies;
  • Increased risk of rising interest rates and potential for negative fixed income returns;
  • Governments around the world working together to manage important global issues.

Equity market concentration

There was no surprise when equity markets declined in reaction to the spread of the pandemic in the first quarter of 2020 as investors responded to the implications for the economy and the fate of individual companies, particularly those in the travel and tourism industry as the world entered various stages of lockdown. However, the speed of recovery was a surprise to most.

Aided by extensive quantitative easing, equity markets bounced back robustly, with several delivering double-digit positive returns for calendar year 2020. Some of the strongest performing stocks globally in 2020 were technology companies that benefitted from the increased reliance on e-commerce during the pandemic. However, the strong performance also led to further concentration in the major equity indices. For example, Apple, Microsoft, Amazon, Facebook and Alphabet Inc. comprised over 20% of the S&P 500 Index at the end of 2020. The impressive performance also desensitized investors to concentration risk.

US equities are typically the largest equity component in most investors’ portfolios, so the increased concentration suggested a review of overall equity portfolio construction was appropriate. For those with a bias to global large capitalization developed equity markets, where the US dominates the overall market capitalization, potential considerations included the introduction of global small cap and emerging market equity allocations.

However, diversifying the overall equity allocation to reduce US stock specific risk did not address the information technology bias, since technology stocks globally benefitted hugely from the reliance on e-commerce during the pandemic. Therefore, an assessment of the overall equity style bias was also in order. For example, value style managers are less inclined to invest in technology stocks, thereby offering a source of sector diversification.

Reducing any bias to technology and growth stocks in general would have been a benefit in 2022, since technology stocks suffered the most for the calendar year. The ups and downs of specific stocks and sectors highlights the importance of having a formal risk assessment process to discuss and address uncertainties that arise, such as concentration risk.

Risk from rising interest rates

Fixed income yields have been in decline for decades, during which time governments and companies took the opportunity to significantly lengthen their bond maturities when issuing new debt. In doing so they contributed to an increased sensitivity to changes in interest rates (duration) for fixed income indices, such as the FTSE Canada Universe Bond Index, and the associated risk of low yields combined with high duration in a rising rate environment. For years “experts” predicted rising interest rates that did not unfold, leading to investors dropping their guard with respect to the ensuing risk.

Moreover, the fixed income market experience during the pandemic simply fueled investor desensitization. In times of equity market stress, a quality fixed income portfolio with high duration can provide an important source of diversification due to an increased demand for safe-haven assets and declining rates, which has seen fixed income markets deliver positive returns when equity markets experience significant declines. The defensive nature of fixed income came through in 2020 with the FTSE Canada Universe Bond Index returning 8.7% for the year, despite the low prevailing yield.

However, the risk associated with low yields and high duration in a rising rate environment reared its ugly head in full force in 2022 with the FTSE Canada Universe Bond Index declining over 11% and the FTSE Canada Long Term Overall Bond Index declining over 21% for the calendar year.

Actions taken by investors with an absolute return goal that heeded the low yield and high duration warning signs included:

  • Adopting fixed income strategies with a capital preservation focus and less sensitivity to interest rates;
  • Relaxing the constraints on fixed income managers with the goal of generating higher added value versus traditional fixed income strategies;
  • Increasing the yield through other fixed income assets, such as commercial mortgages;
  • Investing in higher yielding non-fixed income assets, including direct infrastructure and commercial real estate.

It is a different story for investors with liability-related goals, such as defined benefit (DB) pension plans, where in many cases, despite negative returns from the pension plan assets in 2022, the decline in the liabilities was greater, resulting in an improved funded position. However, for plans using leverage within their fixed income portfolio to increase the liability hedge, the market experience in 2022 may have worsened the funded position.

Due to the asset and liability dynamics of DB pension plans, upcoming risk assessments and related discussions will likely be focused on whether the experience in 2022 has created an opportunity to take advantage of an improved funded position. For example, where the goal is to manage the volatility associated with the funded position, increasing the allocation to fixed income assets could be one risk management consideration.

Governments working together

The global pandemic showed that governments around the world can work together to manage important global issues and created expectations for greater coordination on responsible investing in general, and specifically climate risk.

The current war in the Ukraine and associated impact to the energy supply and prices, saw resource-heavy markets, such as Canada, benefit from their higher energy allocation, which helped limit the extent of market declines in 2022 compared to markets with lower resource exposure. It also highlighted the challenges of adopting a position of no fossil fuel investments within a portfolio during a period when energy was the best performing equity sector.

However, it is crucial for governments and asset owners not to be desensitized to the importance and urgency of transitioning to renewable, cleaner energy, simply based on the recent investment return experience. While the world is still heavily reliant on traditional energy sources and there is still a long way to go to reducing our carbon footprint, a continued and orderly transition to cleaner energy is essential to manage the impact of climate risk.

Looking forward

Market turbulence of the last several years has contributed to desensitizing investors to ensuing risks. Risk management does not only have to rely on sophisticated modelling; it can take different forms including a simple discussion among trustees or committee members, drawing on the insights of investment managers and consultants, and fine tuning the asset strategy and portfolio diversification. In early 2023, take time to formally review your portfolio to identify any uncertainties which may elevate the risk of not delivering on your goals.

Stressed businessman feeling desperate on crisis stock market, investment concept.

Investors with a total return objective have historically been served well by the fixed income component of portfolios, such as a portfolio benchmarked to the FTSE Canada Universe Bond Index (the Universe Bond Index), which has delivered a reliable return experience and valuable diversification to more volatile equity investments.

The experience today for investors such asendowments, foundations, target benefit plans and capital accumulation investors has been vastly different with double-digit negative fixed income returns year-to-date to May 20, 2022. This has been the result of the combination of high duration (sensitivity to changes in interest rates) and significant increase in interest rates.

This article investigates how investors found themselves in this duration trap and what options are available to limit future downside experience.

Increased Interest Rate Sensitivity

With the multi-decade decline in fixed income yields investors had become accustomed to the implications for lower longer-term fixed income returns. However, as yields declined, governments and companies took the opportunity to significantly lengthen their bond maturities when issuing new debt. In doing so, they have contributed to the increase in the Universe Bond Index duration and associated increased sensitivity to changes in interest rates.

While it made sense for borrowers to seize the opportunity to reduce their borrowing costs and lock in certainty by extending the lending period, there were few compelling benefits for investors with a total return objective to own these securities, especially in a lower yield environment.

It is a different situation for investors with liability-related objectives, such as defined benefit pension plans. The resulting dynamics significantly increased the risk of negative returns in a rising interest rate environment. The math is simple: if a fixed income portfolio has a yield of 2% and the duration is 8 years, and interest rates across the yield curve rise 1%, then the portfolio value would be expected decline by 6% (not considering the merits of active management).

Desensitized

The initial response to lower yields was characterized by a “hunt for yield,” which included the consideration of a core plus fixed income component that incorporated an allocation to strategies such as high yield and emerging market debt, and in some cases dedicated allocations to higher yielding assets.

Lower yields also triggered the decision by investors to look beyond fixed income and introduce allocations to less-liquid private markets, such as commercial real estate and infrastructure. Taken together, while this has witnessed a general reduction to domestic fixed income, in many cases fixed income still represents a sizable portion of total assets.

Investors have also had to deal with the desensitization to rising interest rates. For many years “experts” have predicted a rising interest rate environment that did not unfold. The volume of such predictions has led to many investors dropping their guard with respect to the ensuing risk.

Investors are currently experiencing some of the toughest fixed income markets in history, which combined with challenging equity markets, has seen the value of total portfolio assets significantly reduce from recent highs following the strong post-pandemic returns.

Avoiding the Duration Trap

There is still uncertainty with respect to interest rates, so what can be done to limit further downside performance from fixed income?

There are several potential considerations:

  1. Absolute Return Focus. Fixed income strategies with an absolute return focus, where the investment manager has greater flexibility. The manager is afforded greater flexibility with respect to the duration range, the ability to adopt both long and short positions in securities, incorporate higher yielding below investment grade securities, or a combination of these. Some of these strategies have managed to broadly maintain a fixed portfolio’s capital value while the Universe Bond Index has experienced double-digit declines.
  2. Total Return Objective. An alternative to 1) above is to work with your fixed income investment manager to determine a target return considering current yield opportunities. Under this approach, the extent to which there is a willingness to experience some level of downside risk will influence the longer-term total return potential.

    For smaller-sized investors, the total return objective could be achieved by allowing the fixed income manager to invest opportunistically across a range of pooled funds, such as short-term, universe, and higher yielding funds.
  3. Higher Yielding Strategies. The addition of higher yielding strategies (or increase to existing allocations) will by their nature have a lower duration compared to the Universe Bond Index, thereby reducing interest rate sensitivity. However, many of these strategies are still susceptible to negative returns as experienced year-to-date to May 20, 2022, with high yield and emerging market debt indices both declining significantly.

    Careful review of potential strategies will be required to appreciate the extent of the downside protection and diversification qualities. For example, Canadian commercial mortgage strategies in general have declined much less than universe bonds so far in 2022, although consideration would also need to be given to the less-liquid nature of these strategies.
  4. Private Market Strategies. The addition of private market strategies (or increase to existing allocations) such as commercial real estate and infrastructure offer alternative and stable sources of income, as well as providing diversification to equities and fixed income. However, investors need to be comfortable with the less-liquid nature of these assets, since they are valued on a much less frequent basis compared to public market investments.

Start the Conversation

The increased duration of the Universe Bond Index has created an environment where investors are experiencing some of the toughest fixed income markets ever witnessed. Uncertainty remains with respect to interest rates, but there are several considerations for investors to help manage the downside risk from fixed income investments. Start the conversation with your consultant or investment manager to see how your assets can be better protected.

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The last forty years have delivered strong returns for bonds and now, “the times they are a-changin’.” The strong returns of the past now come at the price of low returns in the future, so low that we expect bonds won’t keep pace with inflation. This is the result of a long term decline in bond yields and the fact that these ultra-low yields today influence future return.  The chart below illustrates the relationship between bond yield and total return. As yields fell so followed the total return.  

Four decades of falling yield and return

Compounding the issue, when bond yields inevitably rise, we expect bonds to experience periods of negative returns. We experienced such a decline in the first quarter of 2021 when the Canadian core bond index, made up of investment grade bonds, fell 5.0%**. More recently we have seen negative returns as inflation rises and central banks begin to reduce the level of stimulus. 

Think of bonds as insurance

The purpose of holding core bonds in a portfolio has been to generate income and provide stability. With today’s low levels of income, the reason to hold bonds is for the protection they provide during periods of significant equity decline. This protection from bonds is similar to buying insurance on a home. We expect to pay for home insurance and only benefit if there is unforeseen damage. Now investors are paying more for the protection of bonds in the form of lower portfolio returns. 

An active approach is critical

At CC&L Private Capital, we are focused on positioning client portfolios for success. This includes uncovering opportunities in the capital market that generate better outcomes. Over the last ten years we have moved away from traditional sources of return and reduced allocations to core bonds. In their place we have added private market direct investments in:

  • Real estate
  • Infrastructure
  • Private loans

We have also added public market strategies to our investment platform including:

  • High yield bonds
  • Market neutral hedge

Overall these strategies improve portfolio income and expected return. They also more broadly diversify portfolio risk, which allows us to reduce the protection that comes with core bonds while not meaningfully increasing overall risk.  As such, these strategies are a good solution for many investor portfolios.

For those that hold core bonds, active management has never been more important. It’s vital to have a manager that incorporates macro-economic views and deep credit research. Both are essential if you are going to generate above-market returns while managing risk. Using their broad set of tools, our experienced team of portfolio managers and analysts are able to uncover opportunities despite the ultra-low yield environment. 

Consider your objectives

Changes to a portfolios asset allocation should not be made lightly. It’s important to consider how changes to a portfolio’s asset allocation may affect its ability to meet one’s desired objectives. We work closely with our clients to develop a plan that incorporates historical risk and forecasts for asset class returns, and marries these inputs with clients’ financial situations. This process allows clients to pre-experience their wealth under different allocation scenarios and ensure the strategy is best suited to meet their desired outcome. For some, reducing core bonds is warranted. Others may choose to maintain their asset mix because they have enough capital to meet their future goals. Of course another option is to make lifestyle decisions like save more or spend less over time. Whatever the preference, we can quantify the long-term outcome to wealth and likelihood of meeting specific objectives. We have dedicated significant resources to this planning so that our clients can feel confident they are well positioned to meet their personal version of financial success. 

This post is for information only and not intended as investment advice. The views expressed are subject to change at any time.

** FTSE Canada Universe Bond Index.

US Treasury yields have risen sharply since Fed Chair Powell’s signal last week of a likely tapering decision at the November or December FOMC meeting. The move higher mainly reflects an increase in real yields, with inflation break-evens range-bound – see chart 1.

Chart 1

The reaction recalls a surge in nominal and real yields when former Chair Bernanke signalled that the Fed was considering tapering in Congressional testimony on 21 May 2013. Inflation breakevens, which had been falling into the announcement, declined further before recovering – chart 2.

Chart 2

Bernanke’s signal was a catalyst for real yields – which had reached negative levels similar to recently – to return to positive territory. The yield surge triggered a short-lived “risk-off” move in markets, focused on emerging markets and credit (the “taper tantrum”).

The market response spooked the Fed, causing the taper decision to be delayed until December 2013. When tapering finally started in January 2014, nominal and real yields embarked on a sustained decline. Inflation breakevens moved sideways but also fell later in 2014.

Cyclical sectors of equity markets outperformed defensive sectors between Bernanke’s May announcement and the start of tapering in January.

The view here, though, is that investors should be cautious about drawing parallels between 2013-14 and now.

The economic backdrop is a key difference. The global manufacturing PMI new orders index was about to embark on a significant rise as Bernanke gave his taper signal in May 2013 – chart 3. So it is difficult to disentangle the taper effect on yields from the usual correlation with cyclical momentum.

Chart 3

Economic momentum is slowing currently, with money trends suggesting a further PMI decline into early 2022.

This suggests that 1) the yield increase won’t mirror 2013 because the taper announcement effect is offset by a weakening cyclical backdrop, and 2) any rise in real yields could be dangerous for cyclical assets because – in contrast to 2013 – a higher discount rate is unlikely to be balanced by positive economic / earnings news.

The biggest investment challenge today is that bond yields are near all-time lows. This means lower bond returns in the future. Equities will continue to be a source of long-term return but developed market valuations are above average. Further, the integrated global supply chain means developed market equities are more interconnected today and don’t always provide the desired level of diversification. This is where the search for alternative sources of return and increased diversification begins.

Evolution of our investment platform

Part of our job is to find sources of differentiated return and evolve our investment platform to include new strategies when appropriate. This happens when the opportunity is significant and we can find the right talent. Two years ago, we found just such an opportunity and brought on an experienced team to manage frontier equity investments. We are now making this strategy available in client portfolios.

The opportunity in frontier markets

Let’s start with a definition. Frontier markets are made up of some of the fastest growing countries in the world that are not yet considered emerging markets. These countries are located in Southeast Asia, the Middle East and Africa and are largely overlooked by global investors. We focus on buying companies in countries with large populations and rising incomes. As incomes rise, large segments of the population move out of poverty and begin to increase their spending significantly on goods and services that weren’t affordable before. Our investment team finds companies that benefit from this growth in consumption.  The companies we choose to own are very different to businesses in the developed world because they are meeting local consumption demand rather than being another supplier to global markets.

We also invest in companies that are exposed to other long-term trends exhibited by countries experiencing significant economic change. These include the benefits from urbanization, improvements in technology and access to healthcare, to name a few. These trends present investors with long-term growth opportunities. Along the way, investors are also providing much needed capital to companies that are under invested, which also has an impact on the development of these countries.

What about risk?

Managing risk in our portfolio is as much about what we don’t own as what we do own. For example, our investment universe has 8,000 companies of which we only expect to own 20-40. We start by avoiding higher risk industries and buy those companies with strong growth trends. We also focus on industries and companies with favorable environmental, social and governance (ESG) characteristics. This is an important part of our risk management process. We reward companies with strong ESG factors and engage those companies who need to improve. Once we have screened out the industries and types of companies we don’t want to own, we identify high quality companies with strong brands in large markets. Finally, we only invest in companies with experienced leadership teams and companies that we see as underappreciated by the market. Together, this helps us screen out risk in our portfolio and focus on the investments with the highest probability of success. 

The nature of investing in frontier markets is that these are developing countries which often lack a truly democratic process and strong regulations. This can’t be ignored and our research process identifies these risk exposures and adjusts our targets and ultimately the exposure to the companies in that country. For some countries, the risk is too high and we avoid them altogether. 

Adding frontier markets to a portfolio

Adding frontier markets will increase portfolio expected return and diversification. The added diversification is important because it means we can add a modest allocation to this volatile asset class without meaningfully increasing risk. This is possible because frontier markets experience volatility for different reasons and often at different times. In the chart below we show the degree to which frontier markets and other asset class returns move in relation to global equities. The lower the asset class is on the chart, the more different the returns are and the greater the benefit of diversification. 

Diversification benefit of frontier

Despite frontier markets’ low correlation to other parts of a portfolio, we recommend a modest allocation that varies depending on the portfolios’ mix of stocks and bonds. At modest allocation levels, investors can increase expected portfolio return and improve the relationship between the portfolio return and the risk required to generate that return.

Is adding frontier markets right for you?

As a firm we want to provide our clients with differentiated sources of return that will benefit their portfolios as long-term market outlooks change and new opportunities become compelling. We believe adding a modest allocation of frontier markets to a portfolio is a good option for many investors. However, the decision to change the portfolio asset mix should be made in conjunction with a fulsome discussion about the risk and return tradeoffs. We are here to help clients navigate a more challenging market environment and position their portfolio to meet their objectives while considering any unique circumstances. We can help you determine if adding frontier markets is right for you.

This post is for information only and is not intended as investment advice. The views expressed are those of the author at the time of publication and are subject to change at any time.