Averting crisis, but anxious about credit.

The US Federal Reserve (Fed) and Bank of Canada (BoC) have raised their overnight rates at the fastest pace since the 1980s. As we passed the one-year mark since the start of this rate hiking cycle, the economy and financial system appeared stable and even resilient, and markets bore the scars as higher rates led to declines in valuation multiples throughout 2022. While there have been some signs of strain, such as UK pensions, the Bank of England’s (BOE) rapid response curtailed negative outcomes. Additionally, the collapse of cryptocurrency exchange, FTX, was less related to interest rates than fraud. However, this past month’s failure of three banks: Silicon Valley Bank (SVB) and Signature Bank in the US, followed by Switzerland’s Credit Suisse being forced into a merger with its long-time domestic rival, UBS, marked somewhat of a turning point.

In comparison to prior crises, today we are at a better starting point. Issues with US regional banks are not the same as during the Great Financial Crisis (GFC), when banks held assets that were complex, massive, interlinked and then severely impaired. The legacy of those problems was a shift to tough regulatory requirements for large global banks. They now have deeper capital bases that can better withstand inevitable recession-induced asset write-downs. However, recent instability is reminiscent of more classic problems, such as outflows of deposits from banks when the rates paid do not rise in line with policy rates, combined with an inverted yield curve that impacts bank margins.

Over the weeks surrounding the stresses on the US regional banks, data releases showed depositors moved more than US$400 billion out of bank deposits (see Chart 1), with two-thirds of the outflows coming from small and mid-sized banks. Most of those flows went into financial assets that now yield higher returns than bank accounts (see Chart 2), notably money market funds. This outflow of deposits is forcing banks to sell assets and recognize losses in bond holdings due to the rise in interest rates. The Fed has taken steps to prevent the situation from worsening. Banks are now borrowing at the Fed’s discount window or using the newly established Bank Term Funding Program that was created to provide banks with a liquidity backstop. Although the rate of borrowing at the discount window remains elevated, the exodus of bank deposits slowed by the end of March and the problems have become less acute. This turmoil will require banks to bolster deposits. One way to do that is to raise interest paid on deposits, which may result in a higher cost of funding and pressure on profitability.

Chart 1: Deposits have been leaving banks at a rapid clip

Source: Federal Reserve, Macrobond

Chart 2: Deposit rates not keeping up with policy rates

Source: Federal Deposit Insurance Corporation, Federal Reserve, Macrobond

Following the banking instability, central banks seemed to face a choice between price stability (raising rates to combat stubbornly high inflation) or financial stability (injecting stimulus to save a precarious financial system). Separating out tools to deal with these two problems, they have continued to raise rates even in the face of the bank failures. What has made this whole situation a turning point, however, is that this turmoil has brought markets into a position where they are now working with the Fed rather than against it. The Fed has persistently stated that inflation remains high and financial conditions will need to tighten, and markets rallied and credit spreads stayed tight allowing for the economy to remain supported rather than constricted. Now, markets appear to be heeding the warning signs. Credit markets have seen decreased issuance and wider credit spreads.

It is worth noting that a key link in the transmission of central bank actions and the economy is through bank lending. The Fed’s Senior Loan Officer Survey shows that banks have been tightening lending standards for months now (see Chart 3). Given concerns about liquidity, outflows of deposits into money market funds, costlier sourcing of funds, net interest margin pressures and weakening demand, banks are likely to pull back further on lending activity in coming quarters. This will directly dampen prospects for business investment and consumer spending to varying degrees. One sector that may be particularly impacted is commercial real estate lending. While shifting demand for office space is one factor, it is notable that smaller US regional banks with assets under US$250 billion hold about three-quarters of total commercial real estate loans. While this segment represents approximately one quarter of overall loan books, the combined supply and demand pressures imply a vulnerable sector. Overall, the message is clear: lending will be scarcer economy-wide, and an economic slowdown to recessionary levels is now looking increasingly likely.

Chart 3: Lending standards tightened to levels typically preceding recessions

Capital Markets

Both riskier equities and safe-haven bonds have performed well over the past six months, benefiting from a sharp repricing of short-term interest rate expectations. However, this does not necessarily signal that all is well as there has been considerable volatility in the interim. Persistently high inflation led Fed Chair Powell to assert in March’s semi-annual congressional testimony that the Fed may increase the pace of rate hikes, resulting in expectations of a 50 basis-points (bps) move that pushed yields to a high of over 5% and the endpoint of rate hikes to 5.69%. After the recent bank events unfolded, expectations flipped. Two-year Treasury yields posted their single-largest, one-day drop since 1982 with Canadian yields closely following suit. For March overall, two-year yields declined by 48 bps and 10-year yields by 43 bps. This helped the FTSE Universe Bond Index rise 2.16%.

The flight to safety that was triggered by the US bank run similarly helped gold prices surge by 7.8% and silver prices by 15.2% in March. Meanwhile, energy prices declined, especially oil prices, which fell by 7% for the quarter. Natural gas prices experienced a sharp retreat, especially in Europe despite strong economic activity data and the reopening of China’s economy. The softening in energy prices was short-lived as oil rebounded within the first days of April due to OPEC’s surprising announcement of a material cut in supply.

Risk assets posted strong performance in March, with the MSCI ACWI Index up 2.5% and the S&P 500 Index closing up 3.7% in local currency terms despite regional bank stocks plunging 35.6%. Notably, even though the epicenter of the bank failure was in California’s Silicon Valley, the tech-heavy Nasdaq Index was up 9.5% in March as tech stock valuations benefited from the fall in rates. On the other hand, the S&P/TSX Composite Index was nearly flat, declining 0.2% during the month. The large weight of banks and energy in the Index was a drag on overall gains.

Portfolio Strategy

In light of the continuing effects of aggressive tightening by central banks over the past year and the recent turmoil in the US’s and Switzerland’s banking sectors, we anticipate even tighter lending standards than already posted in the second half of 2022. An economic downturn seems now more a question of “when” rather than “if”. Even as we approach the period of recession, the equity risk premium (ERP), which is the additional return demanded above lower-risk bond yields, has remained surprisingly unchanged despite recent events. While the ERP is holding in at recent average levels in Canada, it remains low in the US. As the ERP rises in response to slowing economic activity, valuation multiples will be pressured lower, compounding lower earnings. As a result, we maintain an overall underweight position in global equity markets in our balanced portfolios. We also have a modest underweight position in fixed income and are overweight in cash. In our fundamental equity portfolios, we continue to favour companies that offer stability with resilient earnings and dividend profiles.

The recent volatility in fixed-income markets has reflected a high level of uncertainty, with narratives that oscillate between expectations of further central bank rate hikes, or rate cuts mid-year. Our fixed-income portfolio decisions have been guided by valuation forecasts in line with our unwavering outlook for a mild recession, and our belief that central banks are nearing the end of their tightening cycles, although we do not foresee interest rate cuts in the near term. We remain underweight credit and have a modestly short duration position.

We anticipate that contracting lending standards will support central bankers’ goals of slowing the economy. We will closely monitor and assess the conditions around the economic slowdown to gauge what the recovery may look like and position portfolios accordingly.

Lessons of history must sometimes be learned, unlearned and relearned.

The recent market cycle can be characterized by numerous unusual aspects. Many of these relate to being in a highly inflationary environment for the first time in more than 40 years, a climate that predates the majority of today’s market participants. For instance, the pace of rate hikes in the past 12 months by both the US Federal Reserve and the Bank of Canada has been among the fastest since 1980, but by some metrics has done little to quell inflationary forces. The most recent strength of activity data in January cast doubt on the likelihood of a recession scenario; however, we remain confident that the tightening in policy will bring the current high levels of inflation to heel with a modest recession. In addition to the direct impact on the economy, we are also seeing unintended strains in areas such as UK pension and US regional banks, the latter of which took excessive unhedged risks with safe assets like US Treasuries! We believe the process to get to the recession will be non-linear and repeat history lessons that investors must unlearn before relearning the signals and correlations under high inflation.

Inflation is acting as a moderator 

Counterintuitively, some features of inflation seem to be acting as a cushion to growth and auger for the delayed onset of a recession. As an example, those receiving inflation-indexed incomes, such as retirement planholders, just saw their monthly payouts increase and could have temporarily boosted their spending in nominal terms. Moreover, inflation rates are, very unusually, coming down before a recession has set in. Inflation typically lags, falling only after corporate profits are squeezed, workers are laid off and a recession starts. This year is different, with the clearing of supply chains helping headline inflation fall from high single-digit peaks to the most recent three-month trends of just over 3%. Thus, even before the full effects of policy are felt, an easing of inflation could provide some support to real labour income in this late-cycle period.

For companies, it is worth noting that earnings-per-share contractions during the 1970s and 1980s recessions were milder than those in the 1990s and beyond. The worst post-war recessions averaged declines of approximately 16% whereas since the 1990s, a period of substantial economic and inflationary moderation, earnings plunged 30% to 35% on average (see chart 1). Undoubtedly, these more recent precipitous drops resulted from the multiple financial crises compared to the more standard policy-induced recessions from previous decades. Nevertheless, inflation provides some cover for firms to raise prices and guard some of the profit margins and earnings that come under pressure during downturns. Inflation also reduces the future value of corporate and personal debt, and higher rates may encourage the paying down of some debt with excess savings, helping overall balance sheets.

Chart 1: Earnings contractions during recessions

So, are we going to avoid a recession?

In our view, a recession is within our forecast horizon and we believe that the market is currently seeing a reversion to norms that is sending important but confusing signals. Predictive data on recessions tends to draw from goods-producing sectors. Business cycles that are driven by tightening monetary policy are led into recession by borrowing-driven sectors, such as homes, automobiles and major appliances. Unsurprisingly, about half of the world’s purchasing managers’ indices are in contractionary territory, as are developed markets’ housing resales, and auto and retail goods sales.

A classic predictive data point is The Conference Board Leading Economic Index (LEI, see chart 2). Since 1960, the LEI has never given a false recession signal, after declining year-to-year for three consecutive months. As of January, it has declined for seven months. This seems at odds with the current bout of strong activity data. Of the 10 components that make up the LEI, four relate to goods sectors: manufacturing hours worked, manufacturing new orders, non-defense capital goods orders and building permits. The rest are financial or consumer expectations. Yet in the last couple of years, personal consumer spending in the US has swung first toward goods and now services, with a focus on hotel and travel, personal care, health care, air travel and recreation, public transportation and restaurant dining over the last six months. Similarly, in that blockbuster January employment gain of 517,000 new jobs, all services sectors posted monthly gains, led by leisure and hospitality that accounted for 128,000 (25%) of those jobs. Notably, goods-producing sectors have declined in importance as the economy has matured, with their proportion of gross domestic product down about five percentage points in both the US and Canada over the last decade (see chart 3). Some signals, while not wrong, may instead be skewed by the unusual normalization of spending and delay the arrival of the business cycle ending recession. Nonetheless, for us, this remains a key indicator to be attentive to.

Chart 2: Never seen annual decline in LEI without recession

Chart 3: Goods-producing sector on the decline

Two more comments are worth noting. First, the last few market cycles have created an expectation that central banks will act and that information is absorbed and reacted to instantly. Impatience stands at odds with the long lags associated with monetary policy actions, especially during periods when it seems like we are collectively working to limit the damage. Some companies appear to be holding on to workers, fearful of being unable to hire again. Chartered banks in Canada are now extending variable-rate mortgage terms to over 35 years to help keep payments unchanged in the short term. Secondly, the path to a recession can closely resemble a soft landing. It is common for investors to operate on the hope of escaping a recession through the late-cycle period. This becomes especially true when data signals are skewed by extraordinary pandemic policy or an unfamiliar inflation environment. Synthesizing the available information, we continue to believe that policy will be effective eventually and thus remain cautious in our approach.

Capital Markets

What January gave, February at least partly took away. Positive market sentiment about the potential end to rate hikes turned to fear that exceptionally strong economic momentum is a sign that the rate hikes to date have been insufficient. While inflation over the last three months has eased, sustained strength in wages combined with anemic productivity demonstrate the continuing fight. Concerns remain even in Canada, where 5.9% headline inflation year-over-year currently represents one of the lowest rates among developed countries.

As a result, 10-year yields pressed higher in February, up 41 basis points (bps) in Canada and 43 bps in the US, more than reversing January’s decline. Corporate and provincial credit spreads help up well, leaving the FTSE Canada Universe Bond Index down approximately 2%, although year-to-date returns are up 1%. Equity market volatility contributed to the month’s 2.4% decline in the S&P/TSX Composite Index. Year to date, the Index is still up 4.8%. February’s caution was evident through more defensive leadership as consumer staples, utilities and real estate outperformed while materials, technology and energy underperformed. Notably, milder weather eased the energy complex, softening commodity prices across the board. Despite European inflation pushing higher, at 8.6% year-over-year in January, and U.K. inflation still stubbornly above 10%, the MSCI EAFE Index outperformed, led by Europe-based stocks. The MSCI EM Index fell 4.6%, giving up some of its late-2022 advances. The S&P 500 Index fell 2.4% but remains up 3.7% year to date. The potential shift in central bank sentiment to renewed hawkishness helped stabilize the U.S. dollar. After declining for four consecutive months, the US Dollar Index was up 2.7% in February.

As we headed into March, multiple crypto and tech related financial institutions (First Republic, Silvergate, Silicon Valley Bank (SVB) and Signature Bank) reported distress related in part to the withdrawal of liquidity and the rapid rise in interest rates as central banks tightened policy aggressively. Of these, the US$319 billion in assets at SVB is particularly notable as it represents the second largest bank failure in US history. The confluence of reduced demand for loans, elevated withdrawals, and challenging capital raising circumstances forced the bank to sell what were formerly risk-free assets, ie. US Treasuries. Ultimately, SVB ran into liquidity problems and was shut down by regulators. The Federal Deposit Insurance Corporation (FDIC), Treasury Department and Federal Reserve have acted swiftly to ensure depositors would have access to all their funds signalling their support to the beleaguered regional bank industry in the US. Equities globally were hit, though the declines were felt most significantly in regional bank stocks in the US; the S&P 500 is down over 5% since its early March peak. Bond markets, meanwhile, have now significantly repriced expectations for Fed rate hikes for the fourth time in about four weeks. In the aftermath of the first few days of the crisis, two-year Treasury yields plunged 75 bps, and it is no longer clear the Fed will put through any more rate hikes.

Portfolio Strategy

In terms of asset mix, balanced portfolios continue to hold an underweight in equities against cash. The equity market surge earlier this year was supported by optimism about a soft economic landing. Equity gains were led by multiple expansion as corporate earnings softened as expected. Following January’s rally in risk assets, we added to the equity underweight, reducing global equities exposure in favour of bonds. Some of the positive influences of inflation discussed above serve to highlight that the path can include skewed signals and red herrings. With policy only beginning to tighten a year ago, we may have yet to feel its full effects and are only now seeing consequences of the sharp drop in Treasury prices on various parts of financial markets. We reduced the underweight in fixed income based on improved valuations and the interest-rate backup that now provides a decent yield. Bond portfolios continue to be traded tactically, extending duration through the backup in yields, particularly in Canada. Equity portfolios maintain their focus on stability and resilient earnings, particularly through the current turmoil. Recognizing the positive impact globally of the reopening of China’s economy, exposure to companies in the commodities and industrial sectors has been increased. We continue to see opportunities through the volatility and the market’s relearning all of the various challenges of inflation.

We recently published our 2023 Financial Markets Forecast, which presents a comprehensive review of our investment thinking for the year to come. Therefore, as in years past, we devote the February edition of Outlook to providing an annual update on organizational developments at Connor, Clark & Lunn Investment Management (CC&L).

President’s Message

During COVID, governments and central banks introduced synchronized, unprecedented stimulus via both fiscal and monetary policy.  At the same time there has been a seismic shift in the global geopolitical climate with the U.S. no longer being the single dominant global superpower. As an outcome of this, we are witnessing increased tensions in many regions and the largest armed conflict in Europe since World War II. This is reshaping political alliances globally, with an increased focus on national security. Additionally, inequality and dissatisfaction with the current economic model is increasingly giving rise to populist governments.  This is resulting in policies that are more inward focused. They include a trend toward onshoring and regionalization – deglobalization.  This is also resulting in reduced immigration in most of the developed world.  Finally, we are undergoing a significant period of investment in infrastructure as countries strive to transition toward clean energy solutions.

All of these macro events have contributed to higher inflation. Central banks have responded to the threat of unhinged inflation with the most aggressive rate hiking cycle in a generation. While there are some signs that inflation is moderating, the changes to the secular landscape will remain in place.  Going forward, we believe we will continue to experience upward inflationary pressures and higher interest rates, a dramatic shift from the last 40 years. Throughout the last several cycles, investors benefited from an extended period of ultra-accommodative monetary policies as central banks prescribed lower and lower interest rates to mitigate the risk of deflation and to sustain growth. This environment provided incentives for risk taking as the cost to borrow was cheap. It resulted in the steady expansion of valuations for risk assets.

Over the next few years, inflationary pressures and higher rates could result in headwinds for markets as adjustments are made to asset valuation levels. As we look forward to the next cycle, we are anticipating more volatility and policy actions that will result in shorter cycles accompanied by lower asset valuations. In this environment it will be important to be nimble. We see attractive opportunities for active management and expect manager added value to become an increasingly important contributor to achieving client investment objectives.

While we have faced a broad range of investment environments in the four decades since our company’s inception in 1982, at the very heart of our organization is a commitment and desire to provide superior performance and service to our clients. Our ability to deliver on these commitments starts and ends with the quality of our people and the strength of our relationships. This requires that we keep the business narrowly defined and intently focused on what we do best while endeavoring to remain at the cutting edge of research and development initiatives within the financial markets. Importantly, our business structure provides stability and keeps us focused on maintaining a long-term horizon. Despite the challenging operating conditions over the past year with negative returns across markets and high levels of employee cost inflation, we continued to invest in our teams and expanded the resources we are employing in the business.

To this end, we have been focused on several initiatives at CC&L:

• As always, we are investing in our people and through career development planning and leadership programs, we strive to enhance skill sets, the depth of our teams, investment processes, and plan for succession.
• We continue to focus on fostering a team-oriented culture of collaboration with a particular emphasis on continuing to improve diversity and inclusion. There are numerous projects underway to ensure our objectives are met. The Women in Leadership (WiL) initiative has been a key priority at CC&L over the past two years and a significant number of recommendations were brought forward to our Board in 2022. We began implementing these ideas in 2022 and have plans that will continue through 2023, 2024 and 2025.
• We have expanded our Corporate Social Responsibility (CSR) activities supporting the health and wellness of both the people who work at CC&L and continuing to create a positive impact in the communities where we do business. We implemented a number of new policies aimed at supporting our employees and their families’ well-being, and the CC&L Foundation awarded a broad range of scholarships and financial support during the year.

Thank you for your partnership and as always, I welcome your feedback and invite you to contact me directly at any time.

Martin Gerber
[email protected]

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Team Updates

We are pleased to report our teams continued to expand in 2022. CC&L welcomed 20 new hires, resulting in a net increase of 13 employees for the full year, bringing CC&L’s personnel count to 117. Our business is further supported by over 350 people employed by the CC&L Financial Group, responsible for business management, operations, marketing, and distribution.

The stability and focus of each of our teams continues to be a primary driver of our business. One of the key tenets to ensuring continued success has been thoughtful and comprehensive succession planning across the organization and a disciplined approach to career development.

A number of employees were promoted to principals of the firm in recognition of their important and growing contributions to our business bringing the total number of principals to 27.

Principal Appointments in 2022 and 2023

Fixed Income	Fundamental Equity	Quantitative Equity	Client Solutions
Joe Dhillon	Jack Ferris	Piper Hoekstra	Lisa Conroy
Kyle Holt	Haley Mayers	Derek Moore	Monica Demidow
Kevin Malcolm	Joe Tibble	Isaac Ho	Mandy Powell
TJ Sutter		Nolan Heim

 

Below we highlight a number of personnel developments within our organization.

Fixed Income

• We are pleased to announce Brian Milne, Senior Credit Analyst, was appointed a business owner at CC&L in 2022. Brian joined CC&L in 2018 and became a principal in 2020. He brings 15 years of capital market experience. Brian is responsible for credit research and has been a member of the CC&L’s ESG Committee since 2019.
• Succession planning is an important process at CC&L and we are in the process of implementing a longer-term succession plan within the Macro Strategy group. TJ Sutter joined CC&L in 2021 working alongside Brian Eby. Over the past year, TJ has taken increasing responsibility for portfolio decision-making. He was appointed a principal at CC&L in 2022 and a business owner in 2023. Brian Eby continues to be an active member of the team contributing to investment strategy and mentorship within the team.
• There was one new addition to the team in 2022. Catherine Clarke joined as an analyst on our Portfolio Analysis and Design team.

Fundamental Equity

• In March 2022, Steven Vertes, Portfolio Manager, retired after 20 years with the organization. We are pleased to report that his responsibilities were seamlessly reallocated to other members of the team.
• We are pleased to announce Ryan Elliott, Senior Research Associate, was appointed a business owner at CC&L in 2022. Ryan joined CC&L in 2012 and has been a principal since 2013. Ryan has responsibility for coverage of the technology and health care sectors.
• Mark Bridges, Portfolio Manager, is responsible for covering the energy sector research and his responsibility on the team expanded with the newly created role of Research Director in 2022. He is responsible for working closely with all sector specialists to ensure the optimal level of structure, rigour and consistency in the team’s research process. The research team expanded with the addition Chang Ding, a research analyst in 2022. We are also pleased to welcome Haley Mayers, as a Senior Research Associate in January 2023. Haley has over a decade of experience as an equity research analyst within the asset management industry.
• Simon Mo took on the newly created role of Senior Portfolio Management Analyst in 2022. Simon is responsible for portfolio management operations, administration and modeling. Simon has been an important contributor to the CC&L quantitative equity team’s success in his 16 years with the team, and we are excited to have Simon apply his skills and experience to the fundamental equity team.

Quantitative Equity

We are continuing to make investments in the expansion of our capabilities, including the net addition of seven new team members in 2022, bringing our team count to 65 dedicated investment professionals.

All of the new hires joined either our Investment Process Management (IPM) or Investment Management Systems (IMS) groups, which bridges research and portfolio management, creates all of the investment technology infrastructure, collects and processes all of the roughly 45 million data points that flow into our models every day, and oversees all of our operational processes.

We place high value on continuous career development, including the movement of people across different functional roles within the team. Gaining exposure to different investment functions provides career path options and enables employees to bring broader investment context to their roles. In 2022, two individuals transitioned from the IPM and IMS groups to trading and portfolio management. Overall, on net, the proportionate breakdown of functional roles within our team has remained relatively stable over the years.

With team expansion also comes the need for more specialized leadership. We are pleased to announce five individuals—spanning various groups within the team were promoted to business owners in 2023, in recognition of the development of their investment leadership over their time with CC&L:

Portfolio Management: Brian Bardsley joined CC&L in 2007 and has been a principal since 2013. His primary responsibilities include the implementation of new strategies, mandates and model changes.

Research: Glen Roberts joined CC&L in 2007 and became a principal in 2015. Steven Li joined CC&L in 2015 and became a principal in 2020. Both Steven and Glen are senior members of the research team. In addition to conducting their own quantitative research, they also have leadership roles in managing research projects and the research process.

Investment Management Systems: In January 2020, 19 members of the Connor, Clark & Lunn Financial Group portfolio management and research systems team became direct employees of CC&L. Dan Cook and Richard Au have led the members of the team since and became principals of the firm in 2020. They continue to operate in a co-lead model, with Dan providing technical leadership and Richard focusing on people leadership.

Client Solutions

• Our Client Solutions team has grown with the arrival of Diana Prenovost in January 2023. She works out of the Montreal office and will be responsible for client relationship management.

Responsible Investing

In 2022, the ESG Committee undertook a review of industry practices in all aspects of responsible investing including integration, active ownership and communication. The outcome of this project validated our approach to ESG and has led to the prioritization of several areas for improvement in 2023. These generally relate to the improvement of the communication and tracking of our RI activities. We also committed to formalize our climate strategy in 2023 with a key focus on advocating for greater transparency in company disclosures regarding emissions and transition plans.

Business Operations

In the fourth quarter of 2022, we formally implemented our return-to-office policy. This new hybrid policy provides all employees with flexibility and has everyone working together in the office a minimum of three days a week (Tuesday to Thursday).

Business Update

Assets Under Management

CC&L’s assets under management (AUM) declined by approximately $5 billion in 2022 to $54 billion. The decline in AUM was driven by the negative returns experienced in both equity and fixed income mandates as a result of declines in market levels. We are pleased to report that our business continued to grow through new client mandates across all of our investment teams. In 2022, CC&L gained 17 new clients and nine additional mandates from existing clients totalling $2.5 billion. The majority of the new mandates were quantitative foreign equity mandates from institutional investors outside of Canada, which now represent approximately 20% of our total AUM.

Final Thoughts

We would like to thank our clients and business partners for their partnership and support. We look forward to continuing to work with you and provide support in achieving your investment objectives in the coming years.

For decades, traditional fixed income assets served investors well, whether as a source of diversification and portfolio stability, or providing a liability hedge for defined benefit pension plans. As bond yields experienced a multi-decade decline, the prospects for lower returns became a concern. Investors responded by searching for higher yielding assets, such as those with more credit exposure, and switching out of fixed income to private market assets to harvest the illiquidity premium, particularly real estate and infrastructure.

For investors with more of an absolute return focus, the recent sharp rise in interest rates and subsequent negative returns has also revealed the challenging dynamics associated with low yields and high sensitivity to changes in rates (duration). However, the rapid rise in yields has also reset the longer-term outlook for fixed income.

This article discusses the implications from historically low fixed income yields and lessons from the recent rapid rise in yields. Now, by rethinking their approach to delivering returns from fixed income, it is possible to provide solutions that are less sensitive to changes in interest rates, do not simply add correlated credit, nor require reduced liquidity.

Past Practices

As fixed income yields declined, investors typically adopted two approaches in pursuit of higher returns:

1. Added higher yielding fixed income assets with more credit exposure; and
2. Introduced allocations to private markets that generated a higher income stream, albeit at the expense of less liquidity.

While the introduction of higher yielding assets can drive incremental return through the addition of yield, it also implies stacking credit on top of credit, which typically exacerbates portfolio risk. For example, there is a high degree of correlation between high yield and emerging market bonds with stocks, which reduces diversification benefits right at the time investors need it, such as during stock market corrections. The high correlation is highlighted by the drawdowns for each of the assets over the past 17 years (see Figure 1).

Figure 1 – Market Drawdowns – 2005 to 2022

In the aftermath of the 2008 global financial crisis, a tremendous amount of capital flowed into private markets from public markets, including fixed income. The harvesting of illiquidity premiums combined with the low correlation of private market assets with public market investments has provided diversification and improved returns. However, this low correlation of private market and public market returns may prove to be primarily a timing mismatch, with private market asset pricing taking a much longer time to reflect changing market realities. The lagged valuation of private investments could potentially raise issues.

For instance, with the recent concurrent decline in public equity and fixed income markets, the less liquid nature of private market allocations may be testing investors’ upper limits for such assets. Depending on the extent of the public market set back, and the level of liquidity for specific private market assets, there are likely unintended wide deviations from the strategic asset mix for many investors. The deviations will be exacerbated by future cash flow requirements that need to be sourced from public markets over shorter time horizons. If numerous market participants look to rebalance their private market allocations at the same time, the repercussions for private asset prices may be sobering for some.

Implications From the Rapid Rise in Yields

Notwithstanding that 2022 is on track for negative returns, with both equities and fixed income declining year-to-date to the end of November, the rapid rise in fixed income yields has materially changed the longer-term outlook for fixed income for the better. This is because there is a strong relationship between the actual return investors earn and the current yield.

For example, for the FTSE Canada Universe Bond Index, Figure 2 illustrates how its current yield provides an indication of the expected return for the next 10 years, as well as the direction of returns. The chart plots the universe bond yield over time (blue line), as well as the actual subsequent annualized 10-year returns represented by the gold line.

Figure 2 – Universe Bond Yields versus Subsequent 10-Year Returns

The yield on the FTSE Canada Universe Bond Index in the fourth quarter of 2022 had risen to 3.7%, suggesting the expected return over the next 10 years would be similar, although with the potential for further interest rate hikes, there could still be shorter-term periods of negative returns.

While the outlook has improved, the lessons from the recent experience have highlighted:

• High sensitivity to interest rate changes can imply a volatile journey to achieving the longer-term return expectation;
• No guarantee that traditional fixed income will provide a diversification benefit when equity markets decline; and
• Investors need to be mindful of private market liquidity consequences in an environment of declining equity and fixed income markets.

What Is the Alternative?

Higher long-term return expectations from traditional fixed income will be welcomed by investors, some of whom may prefer to maintain their current fixed income portfolio structure, while appreciating the associated risks noted above. For others, it will be important to manage the sensitivity to interest rates, have a more reliable source of diversification, while not impacting portfolio liquidity. These objectives can be achieved by relaxing constraints and using non-traditional approaches such as shorting.

The concept of relaxing the constraints on an equity manager to allow for the shorting of stocks is not new. Most stocks in public market equity indices are less than 0.5 percent of the market capitalization, meaning that in a long-only portfolio, the ability to add value by underweighting companies is very constrained. Introducing shorting takes full advantage of an investment manager’s insights, positive and negative, and contributes to producing a better risk and return outcome.

Notably, when shorting is incorporated into a market neutral strategy that seeks to profit during both increasing and decreasing equity markets, the risk and return dynamics can change materially, as illustrated in Figure 3. This example assumes a two-stock universe where Stock A is correctly anticipated to outperform. It considers the return implications for the benchmark, a long-only portfolio where the manager takes active positions versus the benchmark, and a market neutral strategy that utilizes shorting.

Figure 3 – Merits of Shorting

The example highlights that when shorting is allowed, the return outcomes can still be positive regardless of market direction. Shorting securities allows the capture of alpha from a manager’s positive and negative insights, compared to long-only strategies where only the positive alpha insights are impactful. While leverage is employed to enable shorting in this example, its use is clearly distinct from a strategy of using leverage to transform a low market return into a higher return. 

Providing a fixed income manager with the same flexibility to use these tools can also drive incremental return, reduce risk, and still maintain liquidity. Moreover, there is an important difference between shorting bonds versus shorting stocks (see Figure 4). When shorting a stock, the downside, or potential for loss, is theoretically unlimited.  Stocks can in practice go up in price infinitely, creating significant losses.

However, as shown on the chart on the right side of Figure 4, when shorting a corporate bond, there is a lower bound. Spreads can in practice only tighten so much, and as a result, the potential loss from shorting a corporate bond is constrained. In other words, the cost of being wrong when shorting a bond is much lower.

This results in an asymmetric skew to the payoff on the fixed income side that makes shorting credit a less risky proposition than shorting stocks.

Market neutral strategies can deliver positive returns independent of market direction, however such returns depend on the investment manager’s skill to pick the right securities.

Figure 4 – Asymmetric Risk for Shorting Bond Versus Stocks

Tapping into Additional Tools

Incorporating the use of leverage and shorting enhances the opportunity set for an investment manager to meet investor needs within fixed income.  Two case studies are presented below:

1. Maintain liability matching characteristics, but seek higher return
2. Achieve positive returns, independent of bond market direction

Case Study 1 – Liability Matching Characteristics

For defined benefit pension plans, fixed income assets can provide an important hedge to the changes in the value of the liabilities. The rapid rise in fixed income yields has contributed to improved funded positions for most plans due to the decline in the value of liabilities being greater than the decline in the assets. The improved funded position may result in plans de-risking and increasing the allocation to matching fixed income assets.

However, rather than simply allocate to a fixed income strategy that provides the matching characteristics, an alternative is to allow for the inclusion of a market neutral overlay strategy to generate additional returns. Unlike adding higher yielding fixed income assets, the market neutral strategy provides an uncorrelated source of additional return. When fixed income represents a large component of a total portfolio, the added value can be meaningful. Figure 5 highlights how the strategy works in practice.

Figure 5 – Long Bond Overlay Illustration

In this example, the FTSE Canada Overall Long Term Bond Index provides the hedge characteristics. The majority of the assets (70%) are invested in a traditional active fixed income fund, while the remaining 30% fixed income exposure is gained synthetically and earns the return of the index. This structure allows 30% of assets to be invested in a market neutral strategy, which can include a range of active and uncorrelated strategies designed to limit market exposure in delivering their returns.

Connor, Clark & Lunn Investment Management has managed a long bond overlay strategy with a track record of over 16 years, which has met our 2% added value target over the last 10-year period[1].

Since fixed income can represent a large portion of total assets, this strategy provides several merits:

• Greater added value potential in an asset class where the sources of added value in long bonds can be somewhat more constrained. The median manager for traditional active management in long bonds, for instance, has sometimes been challenged to deliver added value;
• An added value source that has a low correlation to the fixed income component; and
• A solution that maintains the important duration matching characteristics.

Case Study 2 – Positive Returns, Independent of Bond Market Direction

Many investors, including endowments and foundations, have an absolute return focus. As well, other investors can benefit from a diversified source of return from their fixed income assets without being concerned about the risk of rising interest rates and the adverse impact on returns. This is where a fixed income market neutral strategy can play a role and is also able to benefit from the asymmetric skew to the payoff that makes shorting credit a less risky proposition than shorting stocks, as noted earlier.

Figure 6 highlights how long-short positions work in practice, with individual positions risk-managed to an overall net zero portfolio exposure.

Figure 6 – Fixed Income Long-Short Positioning Illustration

The use of long-short provincial and corporate credit strategies, together with long-short interest rate strategies, provides the opportunity to produce returns that are entirely independent of bond market returns themselves. In the case of Connor, Clark & Lunn Investment Management’s fixed income absolute return strategy, the target return is 6% to 8% with a similar range of return volatility.

For investors requiring a source of monthly income and wanting to take advantage of today’s higher fixed income yields, another solution is to combine the absolute return approach with a portfolio that taps into higher yielding corporate bonds. Such a combination can achieve monthly income and with the absolute return component decoupled from the market direction, can cushion returns in a down market, thereby providing a liquid source of portfolio diversification. 

In the case of Connor, Clark & Lunn Investment Management’s Alternative Income Strategy, the target return is 5% to 7% with a similar range of return volatility and a positive credit duration.

More Flexibility, More Opportunity

The search for higher yielding assets has seen a switch from traditional public fixed income to some combination of more and different types of credit, or the harvesting of illiquidity premiums.  However, the rapid rise in fixed income yields has reset the longer-term outlook for fixed income assets, which when combined with the lessons from the recent market experience provide an opportunity to revisit the type of fixed income solutions that best meets your needs. By rethinking the approach to delivering returns from fixed income, and allowing investment managers more flexibility, it is possible to provide fixed income solutions that can derive a return stream independent of market returns, and importantly without sacrificing liquidity. This provides the opportunity to improve returns while reducing risk regardless of market direction, while at the same time taking advantage of the improved longer-term outlook for fixed income returns.

Investors should be aware that the material risks of the investment strategies include, but are not limited to credit, high yield securities, interest rate, market and performance risks. An investment in the investment strategies is suitable only for persons who are in a position to take such risks. For more information on risks, please contact CC&L.

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[1] The 10 year annualized added value of the CC&L Long Bond Alpha Plus Composite relative to the FTSE Canada Long Term Overall Bond Index is +2.0% (net of fees) as of September 30, 2022. Please contact CC&L for additional information.