Sector Watch: Caution rules the roost in global bonds

“Both of these [measures]would lead to higher issuance of debt,” she adds. “Without any details, negative sentiment prevailed in the market.”

The two key questions are: how much can Trump deliver?; and how long will it take for the infrastructure stimulus to trickle into the economy?

“There is also the issue of border adjustability and tax code [changes], which is a form of protectionism and trade constraints on imports,” says Fijalkowski, who shares portfolio management duties with Soo Boo Cheah, senior portfolio manager in RBCGAM’s London office.

“In theory, this can create an incentive for companies to bring jobs back to America. But it would also mean that prices on consumer goods in America would be higher,” Fijalkowski says. “That may create a negative loop in the economy and would have an inflationary impact before the growth impact.”

There are also a host of geopolitical risks in 2017, such as uncertainty about elections in the eurozone, she adds: “In the short term, we have priced in all the benefits of Trump’s policies, and then some. But we have not priced in any drawbacks or worries that can come with these policies.”

In the long term, Fijalkowski says, the question remains about whether Trump’s policies can revive American productivity and lift its growth potential.

“If this were to happen, then higher yields would be appropriate. It’s too early to tell and the market has probably sold off enough in the near term based on what we know,” she says. “But if Trump’s policies are successful, then the market may be at the beginning of a longer-term adjustment.”

Looking at global macroeconomic factors, demand from an aging population and its preference for savings vehicles will act to push yields lower, Fijalkowski notes: “We have a push and pull dynamic in effect. On the one hand, we have a new U.S. administration that is expansionary. But on the global side, we have a large stock of savings that is looking for a place to park. The prospect of fiscal expansion [in the U.S.] for now has dislodged deflationary expectations. There is hope that inflation expectations will normalize toward the long-term targets held by central banks.”

From a strategic viewpoint, Fijalkowski remains slightly defensive. The RBC fund’s portfolio has an average duration of 7.1 years vs 7.5 years for the benchmark Citigroup world government bond (C$) index. As of December, about 70% of assets under management (AUM) were in sovereign bonds; 11% were in so-called agency bonds (those issued by a government agency or goverment-sponsored entity); 10% were in investment-grade corporate bonds; 7% were in investment-grade emerging markets; and 2% were in high-yield bonds. The fund is about 90% hedged back into the Canadian dollar.

In the short term, the bond market has overreacted, argues Kamyar Hazaveh, vice president, Signature Global Asset Management, a unit of Toronto-based CI Investments Inc., and lead portfolio manager of CI Signature Global Bond Fund.

“Bond yields look attractive relative to equity dividend yields, so it’s an overreaction,” he says. “Yet there are two things happening: global growth and inflation have actually been improving since last summer. In terms of a major collapse in bond yields in the future, I don’t see that happening.”

In the near term, Hazaveh adds, it’s unlikely to see 10-year U.S. treasuries below 2%: “Cyclically, and not just in the U.S., economies are improving.”

However, the longer-term direction is unclear, he says: “My initial answer is that the trend to lower yields has not changed. If infrastructure spending and tax cuts were the way to stimulate economies, Japan would have been ahead two decades ago – and [Japan is] still dealing with zero interest rates. Longer term is a big question mark. Taxes and infrastructure are not the reason why interest rates are so low. You cannot fix this problem through tax cuts.”

But if the Trump administration puts tariffs on imported goods, higher inflation in the U.S. will result, which would push bond yields higher, says Hazaveh, who shares portfolio management duties with John Shaw and Matthew Strauss, vice presidents at Signature: “I don’t think those [higher yields] are something we would welcome.”

Hazaveh’s response to current conditions is to trade the bond market based on an evaluation of cyclical metrics: “People put too much focus on politics and policies. There are risks that the world [economy] can change a lot cyclically.” He adds that people overestimate the impact of the Trump government’s plan to spend US$1 trillion over 10 years given that U.S. gross domestic product is about US$19 trillion.

Turning to Europe, Hazaveh says that he has been selling that region’s government bonds.

“We were holding long bonds because we anticipated more quantitative easing from the European Central Bank. But [it has] changed the composition of [its] program and are not adding to the plan,” he says. “If yields are not making new lows and there are no capital gains in that market, we have no interest and have pulled money out of Europe, bringing it back to Canada, where we have better yields and a better political structure.”

Hazaveh has grown defensive and set the portfolio duration at 7.5 years, although it’s effectively 5.5 years when the zero yielding Japanese bonds are taken into account. About 41% of the Signature fund’s AUM is in the U.S.; 12% is in Europe; 26% is in Canada; 6% is in Japan; 7% is in U.K.; 7% is in emerging markets; and 1% is in cash. The bonds are all sovereign or investment-grade corporate issues.

Trump’s policies are pro-growth and less reliant on monetary policy, maintains Alfred Lee, vice president with Toronto-based BMO Asset Management Inc. (BMOAM), and portfolio co-manager of BMO World Bond Fund.

“As a result of that, the yield curve has steepened,” he says. “With monetary policy and fiscal policy working together, there is an expectation for inflation, as well. There are [many] reasons why bond yields should be higher.”

Now that the U.S. Federal Reserve Board raised interest rates in December and announced it plans to hike rates up to three more times in 2017, the environment has certainly changed.

“I think [the Fed] will come in at two rate hikes because all we need is one bad jobs number, which we likely will get over the course of 12 months,” says Lee, who shares portfolio management duties with Rob Bechard, senior vice president, and Matt Montemurro, portfolio manager, with BMOAM.

“That being said, the yield curve deserves to be steeper,” Lee says. “I believe we are heading into a new regime, in which interest rates in the U.S. deserve to be higher.”

Nevertheless, he anticipates some hiccups as Trump tries to deliver on his promises. “Policies on paper are easy to put in place. In reality, there are a lot of roadblocks. So, some expectations may have to be dialed back a little bit,” says Lee, adding that 10-year U.S. bond yields may eventually settle around 2.6%.

“Do interest rates deserve to be higher than where they were in November? Absolutely. But will we see the same kind of rate increases across the yield curve that we’ve seen lately, in the next 12 months? I don’t believe we will keep moving at that pace. At some point, it will have to be dialed back.”

Lee doesn’t believe that the global bond party is coming to an end after many years, as yields may reverse the downward trend of the past. “I think we are seeing a rebalancing. Over the past couple of years, a lot of people got exposure to the long end of the curve. There were some pretty solid returns from bonds and a lot of that came from duration risk.

“For instance, the duration for the Canadian bond universe is about 7.5 years and the yield is 1.7%. You are taking a lot of duration risk, but getting little in the way of interest,” says Lee.

“We are warning investors that if interest rates swing the other way -that is, up – those positive returns could become negative. The party is not coming to an end, per se. But investors have to be more specific [about] where they want to be and be more tactical rather than get exposure to a broad fixed-income mandate.”

The duration of the BMO fund is 5.9 years vs 6.9 years for the benchmark Barclays Global aggregate bond universe (C$) index. About 31% of the BMO fund’s AUM is in U.S. bonds; 22.2% is in the eurozone; 9.6% is in Japan; 5.9% is in U.K.; 2.9% is in Canada; and the balance is in a mix of developed and emerging markets.

The currency exposure is somewhat different, as 40.5% of the bonds are U.S. dollar denominated, 22.2% are in euros, 9.6% are in yen, 5.9% are in pound sterling and the 20% remainder in a wide range of currencies.

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