As portfolio managers adapt to rapid change, new opportunities arise.
By Ed McCarthy
The bond market has been picking up speed lately. For much of the summer and early fall, the Canada 10-year Government Bond remained below 1.25%. That stability disappeared in late September as the rate began to move steadily higher toward the 1.80% range as of mid-November.
Rates on the Move
Paul Marcogliese
Rapid changes in rates grab headlines but a longer-term view can help keep short-term moves in perspective. Paul Marcogliese, CFA, fixed income portfolio manager with CI Global Asset Management in Toronto, notes that when looking more closely at historical levels, the volatility in fixed-income markets remains relatively subdued. He cites the MOVE Index, a measure of interest rate volatility, as evidence. “The MOVE Index remains below its long-term average dating back to 1987,” Marcogliese wrote in an email response. “When looking at the MOVE Index over a more recent history, it is approximately equal to its average over the last 10 years.”
There are some prominent market shifts, however. Grant Connor, JD, MBA, portfolio manager with CI Global Asset Management in Toronto, cites two trends. The first is the yield curve’s aggressive flattening. The yield spread between the Canadian government 2-year and 30-year bond has flattened 100 basis points (bps) in less than 6 months, Connor points out. This spread was as steep as 190 bps in May 2021 and was below 90 bps in October 2021. “This was a very quick flattening of the interest rate curve when normally we don’t see much flattening, if any, this early into the monetary tightening cycle,” Connor explained by email.
Grant Connor
The second trend is the swift compression in the spread between the U.S. government and Canadian government bonds. As recently as April, the U.S. 30-year Treasury yield was 40 bps higher than the Canadian government 30-year bond yield, Connor points out. Early in November, the U.S. 30-year Treasury yield moved to 10 bps below the 30-year Canadian government bond yield. “This 50-bps change in relative yields is a return difference of more than 10% in six months,” says Connor.
Finding Opportunities
These market changes can create opportunities for properly positioned portfolios. Chris Kresic, CFA, head of fixed income and asset allocation and portfolio manager with Jarislowsky Fraser, Limited in Toronto, says that the firm’s focus has been on companies that benefited and will continue to benefit from a return to normalcy in the global economy; he cites airport bonds as an example.
Chris Kresic
Kresic also sees opportunities in the energy sector, even though they have rallied significantly, and adds that infrastructure bonds are also interesting as their spreads remain above their cyclical lows and the fundamentals are improving. “We are avoiding companies that have taken on more leverage mainly through M&A transactions,” Kresic says. “The telecom sector is unattractive as spreads do not reflect their more shareholder-friendly management and increased leverage.”
Jeff Moore, CFA, portfolio manager with Fidelity Investments, believes it is “a great time to be a multi-sector fixed income manager.” Despite tight spreads and low yields, Moore says the multi-sector bond opportunity set has remained investable because sector dispersion has been plentiful.
In the investment-grade universe, U.S. corporates are less attractive because spreads are as tight as they ever have been and offer minimal yield advantage over Treasuries, says Moore. “Instead, global credit is preferred,” he says in an email response. “It provides a positive carry through hedging and additional diversification, and the opportunity for alpha from security selection persists, given the high dispersion of spreads.”
Jeff Moore
Outside of the core sectors, Moore says leveraged loans have been the best-performing asset class through the first 10 months of the year. “Leveraged loans continue to offer attractive yields, protection from rising rates, due to their floating rate structure, and the potential for spread compression, given low expected defaults and strong technical demand,” he says.
Managing Volatility
The uncertain outlook for economic growth and inflation makes it likely that current levels of bond market volatility will continue for the foreseeable future. Kresic says that Jarislowsky Fraser remains “very attuned to risk management in our portfolio” and in general has been reducing credit risk as markets have rallied from their low point in 2020. As the financial repression that has kept rates low winds down, Kresic expects there will be greater differentiation in security pricing and therefore more opportunities to exercise expertise in security selection and sector allocation.
Marcogliese emphasizes the need for an ability to adapt quickly to changing market conditions. In this fixed-income market environment, he is attaching a higher premium to liquidity. “COVID may yet prove to create new issues and certainly the supply chain disruptions it has caused have been more persistent than central banks initially anticipated,” he observes. “The shapes of interest rate curves are changing quickly as are relative returns across geographies and asset classes. We prefer to respond quickly to these changes.”
Ed McCarthy is a longtime financial writer and author of three books, including “Foundations of Computational Finance with MATLAB.”
