With low interest rates all but locked in for the next few years, some investors are rethinking portfolio allocation and getting more adventurous with fixed income strategies. But with different approaches comes risk.
“It doesn’t seem — given the central bank stance and what’s been going on — that we will get a return to higher interest rates anytime in the near future or, potentially, ever again,” said Greg Taylor, chief investment officer with Purpose Investments in Toronto.
Government bonds provided reliable ballast earlier this year when equity markets tanked in response to the Covid-19 pandemic. Government of Canada seven- to 10-year bonds returned 9.5% in the first three quarters of the year, and long-duration (20+ years) Government of Canada bonds returned almost 20%, according to a report from FTSE Russell.
Seven- to 10-year U.S. Treasuries returned 11.5% as of Sept. 30, while long Treasuries returned 20.8% (in USD).
“It’s going to be really hard to extrapolate that going beyond this,” Taylor said, since he doesn’t see North America moving to negative rates anytime soon.
Phil Mesman, head of fixed income with Picton Mahoney Asset Management in Toronto, said strategies need to shift now, even though the 40% fixed income part of portfolios served investors well this year.
Replicating the benefit from government bonds this year would require a -10 basis point U.S. Treasury yield, he said.
“All of the backward numbers look great in fixed income,” Mesman said. “The typical advisor portfolio looks amazing but, at current yields and current duration, it makes sense to be a little more creative.”
Taylor said investors can look to investment-grade corporate bonds to find yield through active management. Beyond that, he said investors will have to consider alternative strategies such as options writing and private debt, as well as hard assets such as real estate, infrastructure and precious metals.
“We think there’s going to be a rework of the traditional 60-40 portfolio,” he said.
Mesman said he’s focused on long and short opportunities in developed-market BBB- to B-grade bonds.
The Federal Reserve’s willingness to purchase corporate bonds has made the market more expensive and masked credit risk, he said. This has created opportunities on the short side to both protect the portfolio and provide alpha in cases “where the real economy’s impact on financial assets has yet to be felt,” he said.
Jonathan Hausman, managing director and head of global strategic relationships with the Ontario Teachers’ Pension Plan, warned about the risks of wading into high-yield credit.
“That works until it doesn’t,” he said earlier this month on a panel at the Global Risk Institute’s summit.
Rating agency Moody’s warned investors this week that a record number of companies are in danger of slipping from investment grade to junk territory due to the uneven economic recovery.
Speaking on a webinar earlier this month, FTSE Russell director of fixed income research Robin Marshall also expressed concerns about a “high-yield value trap.” Canadian credit spreads were wider during the economic downturn in 2015-16 than they are now, he said — a “conundrum” given the depth of recession investors are now facing.
High-yield valuations have moved to “demanding” levels relative to current default risks, he said.
Hausman also pointed to strategies such as infrastructure and real assets to provide protection as well as some return on the fixed income side, which is hard to come by.
“That requires some creativity,” he said, “but not much creativity because that’s how folks get into trouble.”
A report from Richardson GMP this month also warned against relying on government bonds and made the case for long-short credit strategies. It pointed to Japanese and German bonds, which started the year with lower yields and “provided nearly no ballast at all” in March.
“With the U.S. and Canada yields now at similarly low starting points, it is unlikely that they can provide anywhere near the same historical hedging properties as in previous downturns,” the report said.
Rather than diving into lower-quality assets to find yield, the report recommended long-short strategies for investment-grade credit.
Mesman also warned about duration risk on government bonds.
“I think the risk of government bond yields going higher, particularly in the long end of the market — longer-dated government bond yields — that’s something that’s underappreciated,” he said.