Bonds make the world go round
By the turn of the 20th century, W.S. Gilbert’s famous expression, “love makes the world go round” infamously morphed into “money makes the world go round.” The latter withstood the test of time and was even cleverly adapted into a song for an American musical in the early 1970s: “Money makes the world go around…a mark, a yen, a buck, or a pound…is all that makes the world go around…” Some 40 years later, the nod to Germany, Japan, U.S. and U.K. remains relevant but the expression is arguably long overdue for an overhaul in today’s fiat currency world. Although far less catchy, the song should sing more like “bonds make the world go round.”
Barely a decade after the musical, 10-year U.S. interest rates peaked at around 15% in the early 1980s and have since given way to the biggest bond bull market any of us have ever seen (including my 90-year old grandfather.) With it, came financial innovation like asset securitization, greater sophistication of bond markets in the developing world and an explosion in the size and importance of debt (leverage) in the global financial system. So much so that by the early 1990s, James Carville, an advisor to the U.S. president at the time, told the Wall Street Journal, “I used to think if there was reincarnation, I wanted to come back as the president or pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” Endless rounds of global central banking hocus pocus (QE, QQE, CE, etc.) later and Carville’s words appear to resonate far more true today than they did 20 years ago. I would not be surprised if even the pope agrees…
Defining and designing a fixed income strategy
As with any asset class, the process of constructing a fixed-income investment strategy begins with defining investment goals. How investors maximize the utility of their fixed-income portfolios will depend on what they want to achieve. In the symmetric pyramids below, we can see the desired fixed income attributes on the left and the corresponding investment levers on the right. The size of each pyramid tranche reflects our assessment of the importance of each attribute to fixed-income investors. I will briefly review the top three investment goals (which are in fact the bottom three tranches in the pyramid on the left).
Most investors see fixed income as the portfolio anchor – it safeguards against poor risky asset performance. Looking at the corresponding tranche in the pyramid on the right, the most effective and efficient way of achieving this diversification is to buy global (developed market) government bonds. This approach also has the added benefit of increasing the liquidity of the portfolio – a desirable feature for many investors who seek investment flexibility. Income generation is another top-of-mind concern for investors. Gone are the days when 10-year U.S. treasuries yielded 15% so the best way to generate income these days is to invest in corporate bonds, emerging market (EM) bonds, and mortgage-backed securities (MBS), to name a few.
Investors usually ask for a single steady-state solution for the “optimal” set of the fixed income levers identified above. However, the optimal strategy is one that has the potential to tap any of the levers at opportune moments in each risk factor’s cycle. Investors should strive to have maximum flexibility to tactically capitalize on the best risk-adjusted opportunities available in fixed-income markets at any point in time. This means that the optimal strategy is one that adopts both strategic decisions (e.g. diversification of the opportunity set) as well as tactical decisions (e.g. relative valuation of the levers in the opportunity set.) Although strong correlations (positive or negative) may exist between the different levers, those correlations are dynamic and change over time. Furthermore, whether it is on a historical or forward-looking basis, some levers may appear more expensive than others at different points in time. Building a comprehensive framework to analyze fixed-income markets along all of these dimensions on an ongoing basis will give investors the opportunity to be continuously invested in an “optimal”, risk-adjusted portfolio that has the ability to diversify risky asset exposure. Our duration-anchored solution, launched at the beginning of this year, is Signature Tactical Bond Pool.
Positioning in Signature Tactical Bond Pool
In recognition of the impact that the changing investment and regulatory landscape has had on limiting liquidity across various asset classes, we construct and implement our global fixed income views using large, frequently traded, on-the-run benchmark bonds and instruments. Although the strategy is benchmarked to the FTSE TMX Canada Universe, our preference for greater liquidity naturally results in more exposure to global bonds than Canadian bonds. This is due to the fact that the Canadian fixed-income market is far less diversified in terms of number of issues, issuers, sectors and market participants. Given that liquidity considerations are embedded into every aspect of our strategy, I will focus on the tactical decisions we have made this year across the remaining fixed income levers: currency, duration, spreads, volatility and inflation.
Signature Tactical Bond Pool’s currency positioning (relative to its benchmark) began the year with a combined 7.5% exposure to the U.S. dollar (USD) and the U.K. pound (GBP), net of currency hedges (the strategy maintains an 80% (+/-20%) hedge rate on foreign currencies.) Those currency exposures were allowed to drift lower after U.S. and U.K. bonds significantly outperformed Canadian bonds in January. At the end of June, USD exposure was increased on the back of an increased allocation to high yield (HY) after the U.K.’s vote to leave the European Union (Brexit). USD exposure subsequently increased at the end of August after an increased allocation to U.S. Treasury inflation-protected securities (TIPS) and U.S. MBS.
Year-to-date, the pool’s overall duration has not deviated significantly from the benchmark duration. Within different currencies, the strategy began 2016 with duration exposure to 5-year to 10-year bonds in the U.S. and U.K. As currency volatility and uncertainty spiked (particularly for the GBP prior to Brexit), global duration exposure was migrated to 10-year bonds. At present, following a significantly rally year-to-date in global interest rates, the strategy maintains a modest underweight in duration exposure relative to the benchmark.
Signature Tactical Bond Pool began the year with a combined 8% exposure to EM sovereigns and HY spreads – most of it in USD. As risky assets continued underperforming global government bonds in January, HY was reduced until the end of February when it was subsequently ramped up along with U.S. and Canadian investment grade allocations. The lead-up to and fall-out of Brexit brought about a new round of central bank easing expectations and we thus increased our allocation to risky assets by increasing the HY allocation.
The first quarter of 2016 saw implied U.S. 10-year interest rate volatility rise, then fall noticeably. When the U.S. Federal Reserve Bank (Fed) finally relented on its tightening monetary policy in March, implied interest rate volatility stabilized. Soon after that, we added U.S. agency MBS to the tactical bond strategy. The asset class enables us to take a view on the volatility of interest rates. The 10% allocation (which was increased at the end of August from 7.5%) will outperform U.S. Treasury bonds if interest rates remain range-bound.
On the back of a pronounced drop in energy prices, breakeven inflation rates came under substantial pressure during the first quarter of the year. Throughout the second quarter, we tactically added exposure to inflation-linked bonds as the carry profile of linkers turned more positive. As we entered the final month of the third quarter, we turned our attention to the contentious U.S. presidential election and chose to partly Trump-proof the tactical bond strategy via an increased allocation to U.S. TIPS.
This strategy is designed to beat the broad Canadian bond universe with more levers and less risk. As such, we remain convinced Signature Tactical Bond Pool is a better mousetrap to diversify risky assets (i.e. equities) than Canadian-centric bond portfolios and ladders.
Commissions, trailing commissions, management fees and expenses may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This report may contain forward-looking statements about CI funds, 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.