Higher yields are bringing investors back to fixed income

Following a forgettable year in 2022, most asset classes began 2023 on a very strong footing as investors rightly took the view that the bulk of the rate hikes needed to combat decades-high inflation were in the rear-view mirror.

Bonds in particular have seen a strong turnaround. While last year’s rate hikes wreaked havoc on asset valuations, the associated increase in bond yields generally meant new-issue coupons at levels last seen before the 2008 crisis. Depending on term to maturity, Government of Canada bonds and U.S. Treasurys are currently yielding 2.5–4% and 3.5–4.5%, respectively. Investors will get an additional 100+ basis points for corporates, which means coupons of about 6% on some investment grade issuers.

And since the yield curve is inverted, investors are in the unusual position of receiving higher yields as they shorten their term to maturity. These tall yields have many investors scrambling to add more fixed-income exposure, with FOMO – fear of missing out – becoming the rallying cry to get ahead of an eventual central bank pivot that will bring yields back down (more on that later).

The key question becomes, how do we best position ourselves to benefit from the fundamental changes that transpired in the global bond market last year, especially in the event that higher yields prove temporary?

In this paper, we examine a few different ways of tapping into today’s relatively stronger yields, and identify the strengths and weaknesses of each approach. In the Appendix we explain a number of key concepts for readers who are new to fixed income or could use a refresher.

Yields bounce back from historic lows

The past decade was quite challenging for fixed income. The post-2008 central bank focus on furnishing liquidity to keep the global financial system humming along and the world economy on life support meant a prolonged period of zero or near-zero interest rates. In Europe, rates actually fell into negative territory.

Disconcertingly, every time the central banks tried to pull some liquidity out of the system – both to give themselves room should monetary policy stimulus be needed in the future and to try to keep inflation at bay – the markets recoiled, triggering the so-called Fed put. Central banks even went so far as to buy their own sovereign bonds as well as the bonds of domestic corporate issuers to keep yields low, in what was termed quantitative easing.

Central banks’ focus on cheap money meant bond investors were left with much of the burden of keeping the financial system afloat. Granted, inflation was next to non-existent in the decade leading up to the global pandemic, but this was small comfort to retirees and business owners whose livelihoods relied on steady payments from their fixed-income holdings. In the worst case, investors were paying bond issuers to simply hold their money and in return were getting back less than what they started with. Some investors opted to increase credit or maturity risk so they could access yields or coupons that were more in line with their needs. But with sovereign yields now above 3%, the options available to fixed-income investors are more appealing.

GICs

Interest rates on GICs above 4% or 5% may appear as a long-awaited gift after years of barely getting more money back than what you put in. GIC investments entail minimal risk, no fees if held to maturity, and no variability in rates during the holding period, provided you purchase a fixed-rate product.

But GICs have some important drawbacks. To begin with, the return on a fixed-rate GIC is limited to its coupon level and therefore cannot account for changes in inflation or variations in yields in the fixed-income market. Moreover, given the relatively low risk profile of GICs, the initial yield is less appealing than what you can get from provincial or corporate bonds.

There is also reinvestment risk, which refers to the possibility that interest rates may be lower when the GIC matures, a problem that becomes particularly pronounced if the bulk of your money is tied up in a limited number of products that mature around the same time.

Finally, GIC ownership can be a real problem if you need your money prior to maturity, as the issuing institution will likely charge a steep fee to buy it back (the fee will be determined in part by interest rates at the time of sale).

Buying bonds directly

As mentioned, provincial, municipal and corporate bonds typically offer higher yields than GICs, but nothing comes for free. Several factors must be considered when purchasing bonds directly, such as commissions and the need to maintain a brokerage account.

Most retail bond orders are a fraction of the size of orders placed by pension funds and other institutional investors. As a result, trading commissions will take a bigger chunk out of the individual investor’s overall return.

Furthermore, once you leave the relative safety of GICs, credit risk becomes an issue. Obviously, a country like Canada, with its AAA rating, presents little credit risk to buyers, but its yields are lower as a result and buying these bonds will entail some of the same risks associated with GICs (reinvestment risk, inflation risk, and interest rate risk).

Investing in provincial, municipal and corporate bonds will generally mean higher yields, but credit risk will become more of an issue. Anything rated BBB or above is considered investment grade, but ratings change over time and are influenced by factors such as issuer-specific, industry, economic, and business risk. As a result, just as with buying equities, direct bond investing requires a very high level of sophistication as well as continuous monitoring of conditions related to specific issuers.

Once we move below bonds rated BBB, we enter what is termed non-investment grade, high yield or junk bond territory, which introduces a wide array of very complex risks. Selecting individual securities in this part of the market requires professional-level expertise and should not be attempted by non-specialists.

Exchange-traded funds (ETFs)

Bond ETFs are usually well diversified since they are typically based on a broad index or benchmark that has exposure to a wide range of issuers. In addition, commissions are more straightforward and similar to equities, while liquidity is usually not a problem (although pricing can be an issue in times of market stress).

ETFs are generally intended for more sophisticated investors as daily price moves are influenced by underlying market conditions. Consequently, bond ETF investors should have a solid grasp of the economy, the rates markets, geopolitical events, and so forth. Investors should also be cognizant that ETFs trade on price, not yield. The value of your investment goes up and down like stocks and is marked to market, even though the underlying constituents are bonds. In addition, since an ETF is purchased as a pre-built portfolio, there is no way for the investor to modify its holdings.

While passive ETF fees are generally much lower than active mutual funds, ETFs may include securities that most investors would rather not have exposure to, which in the long run may end up costing more than the fee savings. These problems are typically more pronounced with corporate bond or high-yield ETFs.

Mutual funds

Bond mutual funds (including segregated funds) address a number of the concerns cited above, but they have their own risks.

With bond funds, retail investors can access the market as if they were an institutional investor and therefore benefit from the size advantage, which diminishes the negative impact of commissions. Buying in size can also allow bond funds to achieve better pricing beyond commissions, as fund managers may purchase bonds in bulk and then distribute them across various mandates. Because of the size of their portfolios, bond fund managers are typically invited to participate in new-issue transactions, allowing them to benefit from any price concessions that are offered prior to a bond’s inclusion in an index. With bonds in particular, retail investors are generally excluded from direct participation in the new-issue market.

Similar to ETFs, bond funds generally have a level of asset diversification that retail investors cannot replicate on their own due to size constraints and commission costs. There is also a wide variety of fund options available, so investors can tailor their choices to meet their risk, asset or economic exposure criteria. Portfolio positioning can easily be adjusted in response to changing economic conditions or personal circumstances.

What’s more, with the growing quantitative sophistication of institutional investors, bond funds now benefit from processes such as portfolio optimization, giving fund managers the opportunity to outperform an index by zeroing in on bonds with the best performance potential based on historical statistical testing. And benefiting from the expertise of a portfolio manager is really why someone would purchase a bond fund in the first place. Whether it is through quantitative methods, fundamental analysis, technical analysis, or a combination of all three, professional portfolio management offers a more comprehensive approach to asset selection. This process is intended to add value beyond passive or minimally managed investing, which accounts for the higher management fees relative to ETFs.

Bond funds address concerns around reinvestment risk by trading every day and putting coupon and maturity payments back into the market along with new investor inflows. Those constant reinvestments permit portfolio managers to regularly reposition their funds to reflect changing conditions in the credit or rates markets, extending/shortening duration or increasing/decreasing credit risk. What’s more, given their larger size, bond funds can utilize derivative products to enhance performance by temporarily adding risk or creating protection.

As mentioned, bond funds have their own risks. They trade on price, like ETFs, and can go up or down depending on market conditions. We only have to look back to 2022 to see the value-damaging impact a rising-rate environment can have on bond fund valuations.

But bond funds have an advantage when it comes to reinvestment risk exposure. Unlike GICs, bond funds have the benefit of rolling reinvestment exposure to both higher coupons and higher yields, depending on the bond (new issue or secondary market). An added benefit is after-tax returns, which are a mix of coupon income and capital gains/losses. Equally important is that, outside the past couple of years, it is extremely rare for bond indexes to suffer losses two years in a row, so even a bad year offers an opportunity for averaging down and participating in the recovery rally.

The path forward

We believe bond yields in Canada likely peaked late last fall when the 10-year crested above 3.6%. Inflation is clearly on its way down, but we are not out of the woods yet. We do not fully embrace the market’s expectation that the Bank of Canada and Federal Reserve will pivot this year, even though recent troubles with U.S. regional banks and Credit Suisse show rising rates are adversely affecting the financial system. We also see potential for yields to temporarily climb back towards recent highs once the current market turmoil subsides, especially given sticky inflation and strong jobs numbers.

We still expect policy rates in the U.S. to peak above 5% and stay there for the remainder of 2023, or close to it. Inflation is well above the desired 2% level, and central bankers on both sides of the border have emphasized that getting inflation under control is their primary goal.

In this context, we believe bond funds offer the best solution to take advantage of currently higher rates. We do not believe yields will follow a straight path downward, permitting bond fund managers to add yield with their regular cash inflows. In addition, as yields decline – which we believe will be the case over the next couple of years – bond funds will benefit from both the currently higher coupons being issued and the capital gains resulting from the related rise in bond values. We are strong believers in the difficulty of market timing and think that mutual funds are better positioned to mitigate that risk. Moreover, investors can create their own market timing risk protection by enrolling in an automatic mutual fund purchase program.

Bond and GIC yields are higher than what we have seen in a while, but reinvestment risk becomes more pronounced as yields decline. We view the outcome of the current market conundrum as binary – either inflation comes down and central banks begin to ease off on rates, or inflation remains elevated and they keep rates higher for longer, which would induce a recession and compel them to lower rates. Either way, rates are likely heading lower over the next couple of years – barring a geopolitical event that sparks inflation, similar to Covid or Russia’s invasion of Ukraine.

We believe outperformance in fixed income over the coming months will stem in part from curve positioning. With a level of curve inversion not seen in a couple of generations, we believe bond fund managers are best positioned to benefit from trading the curve using steepener or flattener strategies, for example – as compared with individual investors using GICs or direct bond ownership, or even trading bond ETFs that are situated on different parts of the curve. And should we experience slowing economic conditions later this year, the credit appraisal expertise of corporate bond fund managers will become increasingly important.