This article appears in the November 2020 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
Low interest rates will be here for years as central bankers cope with the aftermath of the massive economic collapse triggered by the Covid-19 pandemic. The dismal interest rate outlook has major ramifications for your clients’ portfolio construction.
The U.S. Congressional Budget Office recently forecast that the output gap — the difference between actual and potential GDP — will be elevated for most of this decade in the U.S. This is a complete reversal from the office’s January forecast, when actual GDP was expected to run above potential GDP into the mid-2020s.
The U.S. Federal Reserve Board recognizes that stubbornly low inflation can collapse into deflation and has shifted to a policy of average inflation targeting. In other words, the Fed will allow inflation to run above 2% following periods in which inflation runs below that level. In practice, this means the Fed will be less inclined to raise rates until much later in the current economic recovery.
Members of the Fed also are considering yield-curve control to counter protracted economic weakness. Under such a policy, the Fed would target a longer-term rate and promise to buy enough bonds to keep that rate from rising.
(Japan introduced yield-curve control in 2006, targeting a 10-year government bond rate of about 0%. Recently, Australia’s central bank adopted a form of yield-curve control that targets a three-year yield of 0.25%.)
Yield-curve control would put additional downward pressure on targeted longer-term rates. Add in the rate-suppressing impact of mammoth debt burdens and aging demographics, and the mantra of “lower for longer” becomes “a lot lower for a lot longer.”
Traditionally, financial advisors have used investment-grade bonds both as a source of income return and to reduce portfolio volatility and drawdowns. But low rates have eviscerated the income generated by these bonds. In 2010, 10-year Canadian government bonds averaged a yield to maturity of 3.2%. Today, that figure is about 0.6%, which translates as a stunning haircut of more than 80%.
Investment-grade bonds will continue to reduce portfolio volatility and drawdowns. However, this diversification comes with heightened interest rate risk. Extraordinarily low interest rates have extended the duration of Canadian investment-grade bonds to more than 8.0. A mere 0.15% uptick in rates would be enough to cause price declines that would offset the income return for approximately an entire year.
Many advisors need to retool their portfolios in response to these economic conditions. The income role can be fulfilled by a mix of asset sub-classes, including preferred shares, high-yield bonds, mortgages, high-dividend-paying stocks and REITs. Volatility can be reduced through judicious allocations to market-neutral funds, low-volatility equities and gold bullion. For example, Toronto-based Purpose Investments Inc.’s Gold Bullion Fund has a management expense ratio of 0.26%, thus offering a low-cost means of diversification. Publicly traded infrastructure can play the dual role of providing income and dampening volatility.
There is a growing array of products to meet clients’ expanding portfolio needs. For example, alternative mutual funds deploy a broader range of investment techniques, including short-selling. And ETFs offering new strategies continue to be introduced, such as Fidelity Investments Canada ULC’s suite of low-volatility global ETFs.
Low interest rates will be here for years. Real returns are negative for bonds. As a result, you must build more robustly diversified portfolios for your clients.
Michael Nairne, CFP, CFA, is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm.