Global fixed income update: Separating facts from alternative facts

Alexandra Florescu's picture

“The truth will set you free, but first it will make you miserable.”

At the end of last year, an investor poll conducted by J.P. Morgan, one of our largest broker-dealers, showed that nearly 50% of those surveyed expected the U.S. 10-year rate to be 2.5% or higher by the end of the second quarter of 2017, while other broker-dealers forecasted 3% or higher in U.S. 10-year rates by mid-year. The reality has been very different with the U.S. 10-year rate trading in a very tight range year-to-date and currently yielding 2.25%. The move above 2.6% in mid-March was very brief and not seen again since (see Figure 1 below.) That market participants are horrible at forecasting interest rates is not new news. However, presuming that duration positioning reflects expectations (that is, investors are underweight portfolio duration or, more broadly, fixed-income), the year-to-date experience in rates has likely been painful.

Figure 1: 10-year U.S. interest rate

Source: Bloomberg, Signature Global Asset Management

Signature has documented, on a number of occasions, the reflation euphoria and regime change that took hold of markets in the second half of last year, which were reinforced by the outcome of the U.S. presidential election. The subsequent rise in inflation breakevens and nominal interest rates were significant and swift, but have faded year-to-date, leaving investors at the mercy of headlines and tweets and forcing them to re-think their underweight fixed-income exposures.

“The only thing that is constant is change.”

Much of portfolio construction requires looking through the biases (be it in news or strategy reports) to distinguish between facts and myths (apparently known as alternative facts nowadays.) Politics, societies, economies and markets are constantly changing, so we must constantly review our exposures and determine what changes, if any, must be made. As we have communicated before, Signature’s approach to fixed-income portfolio management begins with dissecting the investable set of fixed-income assets into identifiable risk factors, which are individually analyzed and discussed prior to repositioning portfolios. The most significant factors under consideration are currency, duration, yield curve, spreads, volatility, and inflation. We then optimize the risk factors with the goal of maximizing return potential while minimizing portfolio risk.

Turning to the Signature Global Bond Fund strategy specifically, the benchmark is the J.P. Morgan Global Government Bond Index, currency unhedged. The index is made up of federal government debt from thirteen investment grade developed markets: Canada, U.S., U.K., Germany, France, Netherlands, Belgium, Italy, Spain, Denmark, Sweden, Japan, and Australia. As it is currency unhedged, it has exposure to all aforementioned countries’ currencies: CAD, USD, GBP, EUR, DKK, SEK, JPY, and AUD. This means that when we position our strategy, we must develop an outlook for all risk factors for each currency and country. The figure below summarizes the strategy's positioning relative to its benchmark for the major currencies, countries, and asset classes.

Figure 2: Current Signature Global Bond Fund strategy positioning

Source: Signature Global Asset Management

The trade-offs that occur in the portfolio discussion process makes it difficult to discuss any one risk lever on its own; however, I will do my best to shed some light on our considerations and outlook for each one.

Currency

The Fed wants to hike rates two more times in 2017. However, the “hard data” in the U.S., such as gross domestic product (GDP), inflation, and jobs numbers, have been mixed year-to-date with the first two (GDP and inflation) disappointing expectations while the last (jobs) continues to chug along. In addition, strong “soft data,” such as high business and consumer confidence, has not translated into economic activity as the country awaits clarity on government policy initiatives. If we look beyond the scandals and headlines of the Trump administration, we see that the market is in line with the Fed’s outlook for 2017. Beyond that, however, there is too much uncertainty, and currently, investors only anticipate one more interest rate hike in 2018 (refer to Figure 3 below.) The currency is very closely linked to monetary policy expectations so in the absence of inflationary pressures (more on that later), higher nominal interest rates, due to Fed tightening, should result in higher real rates, which in turn will put upward pressure on the currency (USD.) 

Figure 3: Market’s view of the Fed funds target range to end of 2018, as of May 24, 2017

Source: Bloomberg, Signature Global Asset Management

In Canada, the central bank has taken the middle of the road approach. While it has acknowledged the adjustment of Canada’s economy to lower commodity prices as well as the signs of improvements in the labour market and business investment, U.S. policy uncertainty has continued to hang over Canada’s medium-term growth prospects. As monetary policy remains accommodative and interest rates are expected to remain relatively stable, our strategy remains overweight CAD-denominated assets to capture provincial government bond risk premia. In the U.K., it’s all about Brexit. Economic data has been better than expected, in large part because nothing has changed since the Brexit vote last year—at least not yet. Forecasting how divorce negotiations will proceed with the European Union (EU) is futile. Instead, we see a central bank that, despite higher than targeted inflation, is compelled to remain accommodative (i.e. in easing mode) for much the same reason as the Bank of Canada: uncertainty. We recently re-positioned the GBP currency exposure from neutral to a small underweight to take advantage of a short-term tactical opportunity. In the medium term, we remain neutral on the currency.

In Europe and Japan, central banks continue with their monetary policy easing operations (QE, QQE, CE, and yield curve control.) Not surprisingly, investors there continue to have an appetite for higher yields and risky assets abroad, helping to maintain accommodative global financial conditions. In the February webcast, we mentioned that the Japanese yen (JPY) was the best proxy for risk appetite and tended to perform well in a deflationary environment. As global risk appetite remains healthy and the economy is still in a cyclical upturn, the strategy continues to be underweight JPY and EUR exposures to fund overweight exposures in USD and CAD. Below, we see the Signature Global Bond Fund’s currency exposures over time.

Figure 4: Signature Global Bond Fund benchmark relative currency positioning over time

Source: Bloomberg, Signature Global Asset Management

Duration and yield curve

Although the Fed’s tightening cycle puts upward pressure on U.S. interest rates, the strategy maintains a large overweight in U.S. duration relative to its benchmark to capitalize on attractive spread premia found in USD-denominated bonds. In addition, it also behaves as a stabilizer to the strategy’s underweight JPY exposure. Following the U.S. election, the strength of the positive correlation between the USDJPY and U.S. interest rates (represented in Figure 5 by the 10-year treasury rate) has intensified. The most recent three-month correlation (roughly 80%) tells us that over the past three months, 80% of the time, U.S. interest rates rose when JPY depreciated and fell when JPY appreciated. Therefore, we maintain a large overweight in U.S. duration relative to Japanese duration.

Figure 5: The relationship between U.S. interest rates and USDJPY

Source: Bloomberg, Signature Global Asset Management

In terms of curve positioning, the Bank of Japan’s yield curve control policy keeps the Japanese bond curve anchored from two to ten-years. Beyond that, in the absence of additional easing expectations, long-dated Japanese interest rates will move in response to global economic conditions and inflation expectations, which have been positive. As such, long-dated Japanese government bond yields have risen noticeably, and the curve has steepened materially since the middle of last year. We continue to maintain our modest curve steepening exposure. In the U.S., inflation expectations have stagnated year-to-date, so we have migrated some of our five-year curve exposure to long-dated bonds. In the absence of inflationary pressures, the Fed’s tightening policy should put more upward pressure on shorter interest rates rather than longer interest rates. For the time being, we maintain a modest curve flattening exposure in U.S.

Meanwhile, in Europe, investor expectations are mounting that the European Central Bank (ECB) will begin to taper its bond purchase program, gradually reducing its accommodative stance. Interest rates in Europe have reacted accordingly and moved higher. With the front-end of the European curve anchored by the target ECB deposit rate, the upward pressure on interest rates has resulted in a steepening of the yield curve, with longer-dated interest rates rising faster than shorter-dated interest rates (particularly for the core, German bund market). As such, we maintain a large underweight in European duration and a modest curve steepening exposure relative to our benchmark, to fund a large overweight in duration in CAD-denominated bonds. Figure 6 below shows the duration positioning in the Signature Global Bond Fund strategy by currency.

Figure 6: Signature Global Bond Fund benchmark relative duration positioning over time

Source: Bloomberg, Signature Global Asset Management

Spreads and volatility

Referring to Figure 7 below, given comparable duration risk, which 10-year government credit spread risk looks most attractive? In assessing solely the spread component, the Italian 10-year spread probably looks quite juicy. However, it tells you nothing of the experience (volatility) you would have had holding that position. As the charts in Figure 7 demonstrate, the current spread for 10-year Province of Ontario bonds is far superior when adjusting for its significantly lower volatility. In addition to valuations, the European story is still fraught with political and financial risk. That the Italian banking crisis has been eerily quiet (missing from headlines) should not distract from the fact that the situation has not been resolved and banks are still struggling with non-performing loans on their books. This uneasy state is likely to persist until after German elections in September, possibly longer—after Italian elections expected in early 2018. With sclerotic real GDP growth in recent years, and in the absence of sustained inflation, the perceived hawkishness of the ECB could push Italian real yields higher, making it more expensive for the country to finance its already massive government debt (approximately 130% of GDP.) For these reasons, we prefer remaining underweight European sovereign spreads and overweight Canadian provincial government spreads.

Figure 7: Government credit spreads for France, Italy, and Province of Ontario

Source: Bloomberg, Signature Global Asset Management

As the global risk appetite remains strong, we maintain exposure to pro-cyclical fixed-income. In terms of spreads, higher yield (HY) and emerging market (EM) spreads are the most efficient way to express risk-on/off sentiment. In the Signature Global Bond Fund strategy, we use EM sovereign bonds to express our bullish economic view. As per our EM fixed income update in April, we believe EM spreads are an effective portfolio diversifier and generators of excess returns. After the U.S. election, interest rate volatility spiked noticeably (see Figure 8 below). Since then, however, the market’s expectation for persistently higher interest rate volatility has not materialized. In fact, quite the opposite is true. As implied interest rate volatility has fallen, fixed-income spreads have performed very well. If volatility remains subdued, EM spreads will be a great contributor to portfolio returns and generate superior risk-adjusted returns.

Figure 8: HY and EM credit spreads versus implied volatility

Source: Bank of America Merrill Lynch, J.P. Morgan, Bloomberg, Signature Global Asset Management

As seen below in Figure 9, we have increased exposure to EM spreads in the Signature Global Bond Fund over the last two months and continue to do so opportunistically.  Finally, as implied volatility remains low, U.S. agency mortgage-backed securities (MBS) remains a good source of extra income, and we have maintained our allocation in the strategy to the tune of 10% of the market value.

Figure 9: Signature Global Bond Fund EM positioning over time

Source: Bloomberg, Signature Global Asset Management

Inflation

The pro-cyclical upturn that Signature communicated on a number of occasions last year also prompted us to discuss inflation-linked bonds and to ramp up our strategy’s exposure to in the U.S. (using treasury inflation-projected securities, or TIPS) in a meaningful way. However, roughly three months ago, we noted in a recent fixed-income blog that the balance of risks warranted a decrease in TIPS exposure across our strategies, including the Signature Global Bond Fund. Fast-forward to the present day and our exposure to inflation risks have decreased further (refer to the figure below) along with the market’s inflation breakeven expectations.

Figure 10: Signature Global Bond Fund inflation positioning over time

Source: Bloomberg, Signature Global Asset Management

The analysis communicated above aims to summarize some of the considerations that go into determining and sizing appropriate exposures to major risk factors with the goal of building a well-diversified, risk-adjusted fixed-income portfolio. As has been demonstrated, the Signature Global Bond Fund has enormous flexibility in terms of its fixed-income investable universe and levers and, therefore, enables us to leverage many of Signature’s best fixed-income ideas in order to maximize returns.

Year-to-date performance

Our Signature Global Bond Fund strategy has returned roughly 3.69% year-to-date, which is approximately -0.08% less than its benchmark. As per Figure 11 below, although the strategy has underperformed its benchmark some -1.57% due to currency exposures (especially being underweight JPY), it has outperformed the benchmark roughly 1.09% due to an overweight duration exposure in Canadian and U.S. bonds. The asset allocation decisions have contributed some 0.39% to alpha performance.

Figure 11: Signature Global Bond Fund Class F year-to-date performance (gross of fees, taxes, and expenses)

Note: Class F returns net of fees are discussed in Figure 13 below.

Figure 12: Suite of fixed income products managed (advised) by Signature Global Asset Management

Figure 13: Standard performance data, as of April 30, 2017

This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein.  This commentary may contain forward-looking statements about the funds referenced herein, their future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments.  Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Unless otherwise indicated, the indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. First Asset Investment Management Inc., manager of First Asset Long Duration Fixed Income ETF, is an affiliate of CI Investments Inc.

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