Fixed income may not be dead, but check its vital signs
The benefits of holding fixed-income assets in your portfolio
With the rise of meme stocks, continued pandemic-related economic shocks, and building inflationary pressures, 2021 was quite a year. Add a rollicking real estate market and ever-increasing pressure on central banks to raise interest rates and you’d be forgiven for asking yourself, “Is fixed income dead?” While it’s true that some lower-yielding bonds like North American and European sovereign debt will face headwinds in a rising-rate environment, there’s a whole sandbox out there when it comes to fixed income. But it helps to know where to look.
You might be wondering if it makes sense to allocate a portion of your client’s portfolio into a struggling asset class when equities are doing so well, and when the Bank of Canada and the Federal reserve are eyeing increases to their funds rate this year. The simple answers are risk and diversification. And if we take a closer look under the hood, maintaining flexibility for the road ahead is another compelling reason.
The fixed-income sandbox
With the current yield on government of Canada 10-year bonds at 1.74%[1] and annual inflation in Canada running at a 30-year high of 4.8%,[2] this presents a problem for fixed-income investors looking to allocate capital. But if the safety of sovereign debt is important, casting a wider net could be the answer. Consider the government of Indonesia, which has a 6.5% yield on their 10-year debt. If we look at yields around the world, what’s happening in our own back yard doesn’t have to be the only option.
Source: Bloomberg as of Feb 28, 2022. Ratings are from Standard & Poor’s, and are subject to change. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. The commentary on this page is that of Manulife Investment Management. Performance histories are not indicative of future results.
As this graphic shows, there’s some higher-yielding AA debt out there. But how do you gain exposure to Indonesian government bonds? Or any other sovereign bond offering for that matter. That’s the cue to investigate your fixed income product. Although there’s the world’s biggest sandbox for fixed income managers to explore, they may be limited by the parameters of their fund. A true, unconstrained mandate with the freedom to examine global opportunities may be the answer. However, government debt isn’t the only option for yield in this environment.
Credit: an issue pickers’ market
A lot has happened over the past 24 months. Companies that otherwise would be in excellent shape have suffered from restrictions and staff shortages caused by the pandemic. Free-flowing economic stimulus has allowed for massive market gains, as a rising tide tends to lift all boats.
But that financial support may be coming to an end. Central banks are feeling pressured by inflation and are there’s more talk about raising rates in 2022, with both the equity and fixed-income markets feeling the pinch. When equity investors take a flight to quality, looking for solid earnings and lower price-to-earnings (P/E) ratios, fixed-income managers must focus on quality companies with bright prospects.
Companies that have high-yield debt but strong fundamentals may be upgraded to investment-grade quality, which can provide a unique opportunity for an issue picker. Likewise, companies that may have suffered a debt downgrade by the ratings agencies because of the pandemic may provide excellent buying opportunities for a fixed-income manager with a sharp eye, picking up high-quality bonds at a reduced price as we gradually return to normal.
Broader economic themes can help with security selection during volatile times. Think of the commodity supercycle taking place right now. One of the commodities that’ll benefit either because of or despite market conditions, will likely be copper. If the economy picks back up, “Doctor Copper”[1] is usually the first to reflect the positive market conditions because of its demand for manufacturing inputs. But a broader, longer-term trend for copper is electronic vehicles (EVs). EVs require 183 pounds of copper on average, which is 277% more than internal combustion engines. With that in mind, sharp-eyed portfolio managers have been able to pick up high-yielding debt from some of the largest copper miners over the past 24 months, which has since been upgraded to investment-grade debt.
The ability to identify these types of opportunities can take years of experience and a large team to quantify risks and uncover opportunities. Fund managers must have a global footprint and an unconstrained mandate to find such opportunities.
Managing for the future
With a mandate to scan the world looking for attractive sovereign bonds, a global team of issue pickers can turn over rocks and find some good deals in the corporate market. This team also needs the ability to identify the benefits from big macro events through portfolio positioning. Is there anything else?
“I think the big theme this year is substituting credit risk for interest-rate risk. As rates go up, that naturally take the price of high-quality bonds like Canadian government debt down. But selective credit opportunities really benefit bank loans, for example,” says Tom Goggins, Senior Portfolio Manager at Manulife Investment Management.
Being able to move up and down the credit structure may also help a bond manager find yield in tough times. With interest rates expected to be on an upward curve, it’s important to find a fixed income product that can respond to the current yield environment. Substituting some interest-rate risk for credit risk may be a solid strategy going forward. Short-term bank loans and higher-quality high-yield debt (BB-rated bonds) tend to do well in a rising rate environment. The short duration of bank loans helps to offset the interest-rate risk, and the higher yield of BB debt helps absorb some of the interest-rate increases that may be detrimental to lower-yielding sovereign issues.
Don’t go it alone
Fixed income is a tricky asset class to manage for your clients. It can be hard to gain access to debt issues, and even harder to uncover opportunities. But a fund team that’s skilled in identifying the best global opportunities may be a suitable option for the coming economic climate.
A global, multi-sector, fixed-income strategy that can access any fixed-income asset class from anywhere in the world. Coupled with a focused, active currency management, would be flexible enough to navigate today’s tough fixed income landscape. The option to look outside the confines of traditional fixed income may be an advantage too.
“We have the flexibility in our strategy, where we can own preferred [shares], mandatory convertibles, convertible bonds, and a number of different hybrid instruments—and this environment really puts a premium on security selection,” Tom says.
Portfolio construction is a collaborative effort between experienced portfolio managers, research analysts, and traders. Active currency management employs strategic positioning intended to capture medium to long-term currency trends and tactical positioning to take advantage of short-term volatility and dislocations.
To hear Dan Janis and Tom Goggins discuss this and other topics, listen to episode 67 of the Investments Unplugged podcast here. For additional information, visit Manulife Investment Management.
[1] https://www.investopedia.com/terms/d/doctor-copper.asp
[1] https://www.marketwatch.com/investing/bond/tmbmkca-10y?countrycode=bx. Accessed on Jan 24, 2022.
[2] https://www150.statcan.gc.ca/n1/daily-quotidien/220119/dq220119a-eng.htm. Accessed on Jan 24, 2022