Fixed income – The year ahead and how we plan to manage it

Kamyar Hazaveh's picture

A look back on 2016

Last year was a volatile environment for both safe haven and risk assets. Deflation and risk-off dominated the first half damaging credit markets that led to new lower lows in global sovereign bond yields. Since mid-summer, indicators of U.S. and global growth and inflation have been in an uptrend lifting bond yields. This note lays out our fixed income outlook1.

The environment – We focus on cyclical developments in the economy

Markets remain fixated on the implication of the U.S. policy changes under the new administration. We have written about the election and “Trumponomics” in the past. The impact of policy changes on long-term trajectory of the U.S. economy is uncertain or may turn out to be limited. What is certain is that free market economies experience recessions and recoveries or downturns and upturns. Our focus in fixed income remains on tactically positioning the portfolios based on our cyclical view.

In our assessment, the U.S. and global economies remain in cyclical upturn in both growth and inflation for the time being. The same indicators that were pointing to decelerating growth from 2015 to mid-2016 are now telling us that there is a recovery in place.

Figure 1. The cyclical uptrend in inflation expectations at the 10-year horizons

Source: Bloomberg

This positive backdrop has and will continue to allow the central banks in Europe and Japan to play down the prospects of additional QE. This pressures the term premium in the yield curve higher resulting in steeper yield curves and higher yields for long bonds globally. The same backdrop gives the U.S. Federal Reserve more confidence to deliver on the forecasted hikes in 2017 (two or three). There has even been talk of the Fed stopping its re-investment program in its portfolio which further puts pressure on term premiums globally.

The bottom line is that the broken clocks that have been right twice a day for the last six years will have their day in the sun and eventually see higher interest rates for the time being. The same goes for the U.S. Federal Reserve. After its policy mistake in December 2015, hiking interest rates in the middle of a global deflationary slowdown causing a downward spiral in credit markets and emerging market currencies, they can finally claim mission accomplished and deliver rate hikes.

Figure 2. Yield curves globally are pushed steeper as the BoJ and ECB QE programs stabilized

Source: Bloomberg

It’s important to note, that long duration has been one of the best trades over the last few years as interest rates fell globally to multi-decade lows and chronically positioning for higher rates would have resulted in substantial underperformance in the past.

Market valuations – tight risk premiums

Against this relatively upbeat assessment of the economy for this quarter, there is the issue of extended valuations and extreme positioning. Public liquid markets react to shifts in the environment quickly and efficiently. At the moment, equities are flirting with all-time highs, credit spreads are within narrow distance of post-crisis lows and sovereign bond yields have corrected higher anticipating two or three rate hikes in 2017. This setup leaves little room for error or disappointment. Short positioning in sovereign bonds is also overextended by some measures of levered speculative positioning.  

Positioning – duration risk management dominates

We remain focused on the cyclical developments in the U.S. and global economy and have positioned our various fixed-income portfolios accordingly. In this section we focus on Signature Tactical Bond Pool but our various other fixed-income strategies are positioned similarly albeit with different magnitudes. This pool is our best solution for a comprehensive stand-alone global fixed-income portfolio. It is a globally diversified fixed-income portfolio that has the flexibility to respond tactically to shifting market conditions and find the best opportunities to add risk-adjusted alpha. Our goal is to provide better returns than the FTSE/TMX Canada Universe Bond Index with less volatility.

  • We are modestly underweight duration relative to respective portfolio benchmarks. The outright duration positioning is actively managed with targets for either further shortening the duration of the portfolio in the event of further bond market sell-off or closing the duration underweight in the event of a bond market rally.
  • We are modestly long credit spreads in various products including high grade and high yield credit, emerging market USD-denominated bonds and preferred shares.
  • Portfolios maintain a substantial allocation to inflation-linked products as cyclical inflationary pressures are on the rise. In addition, fiscal policy proposals that are being discussed are first and foremost inflationary especially given the current output gap in the U.S. economy.

We are tactically trading the portfolio around the above central themes. Table 1 shows our estimate of tactical bond strategy performance against the Canadian broad high grade universe. Figure 3 shows our tactical positioning in duration, inflation and credit spreads.

Table 1. This table shows Signature Tactical Bond Pool's strategy performance, gross of fees and taxes, against the Canadian broad high grade universe.

Source: Bloomberg, Signature Global Asset Management (data as of December 31, 2016; QTD = Q4 end of 2016.) The Q4 net return for Signature Tactical Bond Class F is -3.4%. The historical annual compounded total rate of return for Series F units of Signature Tactical Bond Pool as of December 31, 2016 is: 1 year 2.3%.

Figure 3. Tactical shifts in duration, inflation and credit spreads

Source: Signature Global Asset Management

Source: Signature Global Asset Management

Source: Signature Global Asset Management

1On January 24, we provided our firm’s macro outlook including positioning of our multi-asset and equity portfolios as part of a Digital Roadshow for advisors.

 

Disclaimer:
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 report may contain forward-looking statements about the fund, its 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. The historical annual compounded total rates of return for Series F units of Signature Tactical Bond Pool as of December 31, 2016 are: 1 year 2.3%; 2.0% since inception of December 17, 2015. The indicated rate[s] of return include changes in unit value and reinvestment of all distributions and does 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.

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