Global fixed income – our latest thoughts and strategy updates

Kamyar Hazaveh's picture

Background

Global industrial production has been in a cyclical rebound since the summer after more than a year of severe (but non-recessionary) slowdown which took the U.S. and global growth to multi-year lows. Inflation has also been in a cyclical upswing, especially in the United States since the spring as the deflationary effects of lower energy prices fade and the cost of housing continues to rise. This has been behind the gradual rise in interest rates and inflation expectations since mid-year.

The Republican sweep in the U.S. election on November 8 has taken interest rates and inflation expectations to the upper end of the recent trading range inflicting mark-to-market losses on fixed income portfolios. This blog is the first update on our fixed income outlook and performance of our strategies through the recent correction.

A few words on Trumponomics

There is no shortage of political and economic analysis pre-and post-U.S. election results. We consistently warned about higher odds of Trump victory and its implications for “lower for longer” mentality in the asset markets starting with U.S. Treasury bonds [1, 2, 3]. Our positioning, however, was consistent only with a gradual move higher in inflation and interest rates and has not been successful so far given the magnitude and speed of the moves in different markets after the election.

Here is what we can add today:

  1. There are elements of Trumponomics that can help to improve the productivity of the U.S. economy that is currently at multi-decade lows.

  2. The starting point of Trumponomics and Reaganomics are significantly different. Reagan tax cuts occurred at a time when the U.S. and global debt levels were substantially lower than today and interest rates and inflation were actually falling.

  3. Trumponomics in its current form is different from Abenomics. Under Abenomics, fiscal stimulus was paired with aggressive quantitative easing (QE) by the Bank of Japan (BoJ), to keep interest rates and Yen low which drove Japanese equities to multi-year highs. In the U.S. today, the Federal Reserve (the Fed) is in tightening mode and the U.S. dollar is making multi-year highs.

This helps to put the impact of the changes under the new administration on the economy and financial markets into context especially to reject wildly optimistic or pessimistic views.

Fixed income market reaction

Over the 36 hours following the results of the U.S. election, interest rates and inflation expectations in the U.S. and globally have risen inflicting substantial mark-to-market losses on fixed income portfolios while equities have travelled to all-time highs. On short-term metrics, these moves seem stretched as bond yields in the U.S. are now higher than equity yield in some circumstances (Graph 1).

  

Emerging market bond spreads over U.S. Treasuries have increased exacerbating the losses in emerging market portfolios. In general, credit spread performance has been weak and in many ways the behavior of interest rates and credit spreads has the hallmarks of taper tantrum in 2013 where initially interest rates rose and credit spreads widened. One asset class that has helped to offset the blow from higher interest rates has been inflation-linked bonds as they have substantially outperformed duration-matched nominal bonds this quarter (Graph 2).

Update on our performance

Across our main fixed income strategies (Canadian and global), we are more or less keeping up with benchmark performance which is not good in a quarter where broad fixed income indices are down between 3 to 5%. Our defensive positioning was not sized for the magnitude and speed of the correction in fixed income. Having said that, placing large bets ahead of digital political events is not a repeatable value-add process. For example, positioning the portfolio with short duration ahead of the U.S. presidential election could have easily resulted in underperformance had the election results been different or if the market’s initial move to substantially lower yields during Tokyo trading hours were maintained.

 

In Canadian bonds, we are single digit basis points above the benchmark performance for the quarter. In the global bond strategy, we are single digit basis points below benchmark performance. Our underperformance is due to excessive moves in U.S. rates relative to USD/CAD currency pair. Another source is the weakness of credit spreads that have failed to cushion the blow from higher interest rates. One alpha lever that has worked this quarter for the portfolios is inflation-linked bonds and select spreads.

 

Recent changes in our fixed income strategies

 

In recent weeks as interest rates have escaped the top of the fair value range (1.6-2.4%), we have activated our risk management strategy to reduce duration and dampen the effect of rising interest rates on the total return of our portfolio across the board. In global bonds, we have also slashed our exposure to front-end Yen and Euro denominated bonds (Graphs 3-4). This is a pure risk management exercise and these positions will be reversed if volatility of interest rates subsides.

Look forward view on fixed income

The best minds in investment industry are divided on the prospects of the new U.S. administration policies on the U.S. and global economy. There is an excellent argument for dismissing the recent move higher in interest rates as a bump in the road on the path to eventual lower rates similar to the Japanese experience. If government projects and tax cuts were effective in curing our structural ills (debt and demography) Japan would have been out of the low interest rate environment decades ago.

There is also an equally valid argument in which the new administration breaks from post-war economic order in terms of globalization and currency arrangements causing inflation and interest rates to go substantially higher. We keep an open mind on this possibility. Maintaining duration at close to benchmark level (see previous blog) has worked beautifully for us in the last few years as interest rates have made lower highs and lower lows. If the trajectory of interest rates were to reverse structurally, we will be managing the duration of all of our fixed income portfolios more actively but as always within well-establish risk management limits.

It is our current assessment that markets are focused too much on the political changes and not paying enough attention to the underlying cyclical developments. The cyclical prospects for growth and inflation are positive for the time being and that has and should continue to put pressure on fixed income assets for the next quarter. This cyclical view may reverse in 2017 before any impact of fiscal stimulus hits the economy in 2018 benefiting fixed income assets again in the interim.

What to do with fixed income exposures in the portfolio

The experience of taper tantrum is an excellent example of how investors over extrapolate current conditions. In 2013, Canadian interest rates rose 1% inflicting mark-to-market losses on Canadian Universe bonds of about 3.5% at the peak of the pain. Many investors rushed for the exit calling the end of the bond bull market. Fund management companies worldwide responded by offering floating rate and short-term products. As a result, some investors missed out on one of the best fixed income rallies in 2014 where Canadian Universe bonds return in excess of 8% (Graph 5).

Stay balanced, filter out the noise, emphasize independent research and invest with teams that have the ability and track record to navigate different environment.

References
[1] Hazaveh, Kamyar, Marché obligataire : l'élection de Donald Trump, un tournant ? Les Affaires, August 13, 2016
[2] Borean, Paul, Inflation protection in the fixed income markets, Signature blog, August 23, 2016
[3] Hazaveh, Kamyar, Global Fixed Income, Benefits and Pensions Monitor Meetings & Events, October 2016

Sources
Graphs 1, 2 and 5: Bloomberg 
Graphs 3-4: Bloomberg and Signature Global Asset Management

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 commentary 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. Commission, 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 A units of Signature Canadian Bond Fund as of November 30, 2016 are: 1 year 2%; 3 years 3.4%; 5 years 2.7%; 10 years 3.4%; and 5.4% since inception January 20, 1993. The benchmarks for Signature Canadian Bond Fund are the FTSE TMX Canada Universe + Maple Bond Total Return Index and the FTSE TMX Canada Universe Bond Total Return Index. The historical annual compounded total rates of return for Series A units of Signature Global Bond Fund as of November 30, 2016 are: 1 year 2.2%; 3 years 6.0%; 5 years 4.3%; 10 years 4.3%; and 4.1% since inception August 31, 1992. The benchmark for Signature Global Bond Fund is J.P. Morgan Global Government Bond Total Return Index. The indicated rates 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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