Finding Opportunity in Fixed Income

Welcome to Advisor ToGo, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Aaron Young, vice president, global fixed income, CIBC Asset Management. 

With the repricing and fixed income that we’ve experienced and with the backup of yields that we’ve seen over the last two years, we actually think fixed income can step back into the role of being a ballast in an investor’s portfolio and actually help hedge the risks that they have in other asset classes. 

This is less possible in an environment where we were near zero interest rates, we had 18 trillion in essentially negative yielding bonds. There was really no buffer built into that market. Rates could really go one way and bond prices could really only go down. 

Now that we’ve replaced and yields have come up, we actually see the opportunity for bonds to replay the role of hedging risks because they have that buffer built in, in terms of yields can go back down. You earn income while you wait. It’s actually an opportune time to rethink about fixed income as playing a greater role in hedging other risks in the portfolio and avoiding that kind of high correlation between drawdowns in your fixed income portfolio and drawdowns in other asset classes that we experienced in 2022. 

We see lots of opportunity in fixed income, but we really think the opportunity lies in lower risk, low volatility assets, and that’s the beauty of the fixed income market that we’re sitting in right now. 

So right now, when we look at how we position our overall portfolios, whether it be core portfolios where we own government bonds and investment grade credit, whether it be in our dedicated corporate bond mandates, we don’t have to take a lot of risk to earn an attractive yield and return for our investors. And this is the nature of short-term yields, have really come off of their lows during the pandemic, and we can now own both government and corporate bonds that yield north of 4% with very little duration risk. They’re lower volatility assets because they’re closer to maturity, they are high credit quality, and we can build a kind of core portfolio that yields above, say, 4.5% quite easily with the bonds that have repriced in the short end. 

Other areas where we see opportunity is within the corporate bond space. Active investing is really key there. We think that area of the market is highly inefficient and our active approach allows us to take advantage of relative value and go where the value is in the market. But again, with the underlying idea that there is income to be generated from that portfolio as well. 

We are more cautious on some of the riskier parts of the market, not that we think the quality is really bad and that they’re going to face dire straits in the near term, but more because we think you don’t need to own those parts of the market to hit an attractive risk adjusted return for investors. Given the volatility we’ve seen in interest rate markets, that’s actually an interesting opportunity now to add value through active management. That has not been the case over the past couple decades where all interest rates across the globe were essentially compressed down to the lowest levels we’ve ever seen. 

So right now, we’re actually finding interesting opportunities to own, say U.S. treasuries over government and Canada bonds, arguably same if not better risk profile, but with a pickup in yield. We’ve even looked at U.S. Agency MBS that has an implied guarantee from the U.S. federal government, much larger market in just U.S. Agency MBS versus all of Canada’s bonds outstanding, so highly liquid and again offering a yield pickup versus government of Canada’s. And even more recently looking at the United Kingdom government bonds known as gilts. Again, in the longer end there, great opportunity to earn almost 1% or more yield pickup versus an equivalent government in Canada, those types of relative value opportunities did not exist in prior markets. 

We do think duration risk is more attractive right now. We do think the balance of probabilities is towards rates going down, not up from here. And that’s really been starting to play out a bit over the last couple months of 2023 and into the new year in 2024. But we caution investors against trying to do what we would call a pure play, long duration position, because especially in the long end of the yield curve, prices’ yields are driven by a lot of non-economic factors. And you got to think about who are the natural buyers in that space. Those are pension plans, life insurance companies. These market participants are what we call non-economic or not price sensitive buyers. They always need to have duration exposure because they have liabilities they need to match, and they’re willing to buy that exposure at almost any cost. 

So although logic would tell you if interest rates are coming back down, the best way to play that is going extra-long duration bonds, we would caution against that. 

A real time example of this to prove is look at the Canadian 30-year bond. It’s one of the most expensive among developed markets, the G7. You would expect that bond price to come higher as rates fall down. But given the amount of demand in the long end, those rates have not moved the way anyone would expect or the way logic would predict. So again, we caution against trying to make a singular positioning play on super long bonds. 

In our opinion, you can tilt your portfolio and this is what we do in all of our active funds, towards the long end or the short end, but you always remain well diversified across the curve. And for us right now, as an example, in our core, core plus strategies, we actually prefer to position for steeper, so looking for the yield curve to steepen as opposed to going for long duration positioning. We think that’s a more efficient way to play a possible backup in rates. 

And just one final note, I’ll leave with everyone. Durations very important, the kind of headline number, but also the composition of that duration is just important. So if you have a 10-year duration, that’s good to know, but you also want to know from your underlying managers, how do they get to that 10 years. Are they concentrated on the short end or the long end? The composition is just as important as the final number. 

From a core bond allocation, we think high yield right now, it’s not the most attractive we’ve ever seen it. If we look at 2024, the average read on the high yield index has been around 315 basis points. That’s trading towards some of the lower levels we’ve seen over the past couple decades. So high yield is priced almost to perfection, and we’re reflecting that in our core, core plus portfolios, by having a lower exposure to high yield overall, because we actually think there’ll be better reentry points in the near term, as spreads move wider and as those valuations become more attractive. 

My only caveat to that is if we look at high yields from an equity point of view, high yield can play a different role even at these valuations, if you view it as kind of a equity light style of investment. So it has more volatility than your core bonds, but still less risky versus an equity allocation. 

And in that case, high yield bonds right now are paying a decent yield to investors versus say, the dividend yield in the equity markets. And they do have a role to play in the sense of if you’re looking to de-risk some of your equity exposure, high yield can act as kind of a hybrid asset class between the low risk of core fixed income and the higher risk of equities, so we do think it has a role to play there. 

The last thing I’ll just mention quickly about the high yield market, we often talk about high yield as a singular entity, but what we need to remember about the high yield market is its very bifurcated. And depending on which section of market you’re looking at, you’re looking at a very different risk return profile. 

So if we go into the weeds a bit more, we think Single B and Triple C rated bonds are highly expensive. We don’t have exposure to them. We think they should be repricing. And at that point we may look at say, Single B bonds as an attractive entry point, but right now, they are relatively priced to perfection. 

We would delineate between that section of the market and the Double B section of the market or the crossover space, where the quality of that underlying market has really changed post Great Financial Crisis and post Covid, where you see a lot of former investment grade Triple B or higher rated issuers, who got downgraded into that space, but offer a lot of quality for the yield that they have there. And I’ll give you an example. Ford is a great example of issuer that was downgraded to Double B and has since been upgraded back to Triple B in October 2023. 

That’s a position we held in our fixed income portfolios because we saw it as an upgrade candidate. So if you can be very selective there, there are pockets of opportunity in the high yield market and the high quality space.