Justwealth’s Chief Investment Officer, James Gauthier, was a fixed income panelist recently at the Markets Group Private Wealth Canada Forum. Following is a transcript in which he shares his views on a few different topics through Q&A with a moderator.
Moderator: IG and high yield bonds have been strong performers YTD. Credit Spreads on corporate and HY bonds are below long-term averages, albeit not reaching all time lows yet. Additionally, defaults continue to be at all time lows. What is your view of credit at this part of the cycle? Does it offer a compelling alternative to government bonds for fixed-income exposure?
James Gauthier: Well, we are in a low interest rate environment across the board – government, investment grade and non-investment grade, they’re all low based on historical levels.
On a relative basis, spreads are also pretty low compared to historical norms, high yield is a bit closer to an all-time low compared to investment grade spreads.
The single biggest factor that impacts credit spreads is the health of the economy – everything else is secondary. So, the bottom line is if you think we are headed for a recession, defaults will rise, corporate bonds will get punished and spreads will widen. High yield bonds, being the riskier grade will likely get hurt worse than investment grade.
There’s been a fair bit of coverage in the media that investors are “reaching for yield” in this low yield environment and that may be putting abnormally high pressure on spreads – so they are tighter than they might otherwise be. There is probably some truth to that – a retired couple living comfortably off the interest from their government bond portfolio would have taken a pretty big pay cut over the years. To make up for lost income, all they have to do is shift 30% (for example) of their government bonds to lower credits and they can bump their income back up and maintain their lifestyle. But rest assured, if there is a recession and corporate profits suffer, investment grade and high yield bonds will get hit regardless of whether investors are “reaching for yield” or not.
If you’re in the camp that a recession is not going to happen in the near term, or you don’t really want to speculate on that, it is fair to ask, “What value do corporate bonds have based on current valuations”? The way I would look at it is this: government bond yields are extremely low, below inflation in most cases – meaning that if you bought and held these bonds until maturity you would guarantee that you have less purchasing power in the future! To add another 2 or more percent [in corporate yield pick up] on top of a very low number is thus a very compelling argument – if government yields were 4 or 5%, adding another 2 or even 3% might not be required or worth the extra default risk. I don’t think that this has been fully appreciated yet, so that there is considerably more room for spreads to tighten to all-time lows, leaving plenty of upside for corporate issues.
I think the argument is comparatively better for investment grade, compared to high yield. But ultimately, if you are predicting recession, do not load up on credit.
Moderator: Achieving fixed-income exposure through passive ETFs continues to be a popular strategy. With yields so low, passive fixed-income ETFs with their very low fees, look even more attractive than their active counterparts. Do you believe that passive fixed-income ETFs are the ideal way to gain exposure to fixed-income markets, and what role if any are fees compression playing into this?
James Gauthier: There’s a perception, particularly among HNW investors, that it is better to own individual securities rather than “pooled” products – for both equities and bonds. While it might be interesting to see specific issues in your account, there is no guarantee that it will improve your performance or have any other meaningful benefit.
Prior to the widespread emergence of low-cost ETFs, the alternative to a portfolio of segregated bonds was a mutual fund or a private pooled fund – probably with high fees and mediocre performance. Not a compelling alternative.
Well, ETFs are here now, and I think they do present a compelling alternative for all fixed income asset classes. They are not sexy, they are mostly passive and very well-diversified, but they are very low cost – quite often, lower than the costs associated with the dealer bid-ask spreads for buying and selling individual bonds. You can own broad-based bond exposure to the FTSE TMX Canadian Bond Universe for as low as 10 bps. Furthermore, you can target pretty much any subsector of the market to create a portfolio of just about any combination of sectors, maturity and credit quality that you want.
Competition amongst the ETF providers is continually driving prices lower which only strengthens the argument to adopt.
Moderator: Emerging market debt, which represents 25% of global debt securities, offers an alternative to negative yielding developed market government debt. China’s bonds are being integrated into the Bloomberg Barclays Global Agg Index and will represent 6% by mid 2020. Are there other alternative fixed-income strategies that you like right now, such as hedge funds or other specialty plays?
James Gauthier: When you are looking at making a “trade” within the fixed income component of the portfolio, you can’t approach it naively. Some people will be holding bonds for the income that they produce, others may be holding it as a diversifier or a way to lower volatility. Whatever you are looking to substitute, you have to try and manipulate the trade so that you are somehow better positioned to satisfy your investment objective from an overall portfolio perspective.
For those who are looking for income from their fixed income investments, particularly non-registered accounts, I like preferred equity right now. Although it is technically considered equity, preferred equity has some fixed income attributes, and it has a huge tax advantage compared to bonds. The downside of preferred shares is that they are more closely correlated with equities and more volatile than bonds, so swapping bonds for preferred equity directly results in a pretty big increase in portfolio risk. So, I would suggest in addition to this trade, you complement it with an additional trade within the context of an overall portfolio to reduce risk at the same time – for example, sell some longer maturity bonds for shorter maturity.
Another good “trade” or asset class that I like is put-write strategies (non-leveraged). We would consider this to be an alternative asset class. These strategies are actively-managed and derivative-based, and we don’t have too many active strategies in our portfolios. We like this strategy because it is very low volatility (lower than many bond ETFs) and they have high yields. And key for us, there are ETFs available in this space, which tend to be expensive coming in around 70 bps, but that is still significantly cheaper than conservative hedge funds. The combination of low volatility, low correlation and high yield more than justifies the higher cost.