Fixed income investors have many things to consider when deciding where and how to allocate their capital. Among the biggest issues facing investors today are the direction of interest rates, rising inflation and tightening credit spreads. David Gregoris, Derek Brown and Sue McNamara, the senior leaders of Beutel Goodman’s fixed income team, recently took part in an open-forum event with clients and media to answer questions from the audience. In addition to the current topics, the team also discussed Beutel Goodman’s investment process, ESG integration and their outlook for fixed income.
This recording took place on June 17, 2021. The following transcript has been edited for clarity (updated July 7, 2021).
Ask Us Anything (About Bonds)
PAUL HAMILTON: Welcome, everybody, and thank you for taking the time out of your busy schedules to join us today. This is an interactive, open-ended forum event that we’ve dubbed Ask Us Anything (About Bonds). As a reminder this event is being recorded. However, participants will remain anonymous and they have the option to remain so when asking a question through the Zoom Q&A function. We encourage anyone with a question to use the Q&A function at their convenience. It’s open for submissions now and will be throughout the event.
First, I’d like to introduce David Gregoris, Managing Director of the Fixed Income team here at Beutel Goodman. David, thanks for being here.
DAVID GREGORIS: Thank you, Paul. For those of you [who] are not familiar with the Beutel Goodman Fixed Income team, we are discretionary portfolio managers for pension funds, endowments, foundations, [and] high-net-worth clients across North America and internationally. We also provide access to these bond strategies through separately managed account programs and mutual funds. What makes our fixed income process different is that we use a very active approach, utilizing a top-down macroeconomic assessment together with a disciplined and rigorous fundamental credit research.
Global fixed income markets are a very complex system. We use a three-dimensional approach to determine our macro assessment. We start with growth. We study the economic growth, and more importantly, if this growth is above or below the potential growth rate of the economy. Second, [we look at] valuation. We consider many metrics to assess the right level of interest rates, the shape of the yield curve and the relative value of credit spreads. And last but not least, liquidity.
The amount of liquidity has the potential to move the level of asset prices considerably. Liquidity is usually withdrawn when economic growth is placing inflationary pressure on the economy and it is injected when the economy is floundering. From this market assessment, it determines our portfolio positioning to maximize the value added.
Now I’m here together with my team to take some questions. So, let’s get to it, Paul.
PH: Absolutely, David. Moving on to today’s topic, as many of you can appreciate, the fixed income asset class has become a bit more complex in recent years. This is largely due to the unprecedented amount of stimulus from the central banks and also the persistently low interest rates that have accompanied [the stimulus]. For now, going forward, the Federal Reserve appears to be inching towards some type of normalization, while the Bank of Canada has already begun to taper its own bond-buying programs.
To talk about what all this means for the big picture and for fixed income as an asset class, I’m joined by some members of the Beutel Goodman Fixed Income team. In addition to David, also with us today is our Senior Vice President and Co-Head of Fixed Income, Derek Brown, and Senior Vice President, Sue McNamara. Thanks for joining team.
I’d like to start with a few questions that were submitted by attendees ahead of the event and then we’ll get into any live questions that may come through. As a reminder for the participants, please feel free to type in your question through the Zoom Q&A function on your control panel at any time. But do keep in mind that we’re restricted against giving individual investment advice. But we’d be happy to discuss bigger picture topics, macro themes or the fixed income process.
OK, so to kick things off, let’s tackle a topic that’s getting a lot of attention right now, and that’s inflation. And I’ll pose this question to you, Derek.
“How concerned should investors be about inflation right now? Is this ultimately the effect of all the stimulus and are we heading for a repeat of the 1970s?”
DEREK BROWN: So, no, we’re not heading for a repeat of the 1970s and it’s a timely question, Paul. Actually, our May fixed income monthly [article] addresses this topic head on. For someone [looking for] a little bit more of a deeper dive, I invite you to go to the website and check out our insights page, which goes into specifically how we view inflation. To paraphrase that document, we are seeing high inflation numbers right now.
CPI in the U.S. in April was 4.25% annually in May. Canada’s inflation in May was 3.6% annually. So obviously, these are very big numbers. The central banks prefer when it’s around 2%. So, we’re double those numbers almost. But this really has to do a lot with what’s called base effects.
The numbers were very, very low last year and we’re just kind of catching up, reverting to the mean. Overall, we’re not overly concerned about inflation. We do think it’ll be stickier than it has been in the past.
We spent most of 2008 to 2018 trying to generate inflation. The scars we had from the great financial crisis and the European debt crisis really pushed inflation lower, especially inflation expectations. So, we do think that this will change over time. The fiscal stimulus we’ve seen, the easy monetary policy we’ve seen, they will definitely push inflation a little bit higher. But we’re talking about moving to 2% to 2.25%, maybe 2.5% over the long term, but most likely 2% to 2.25%.
So, we’re not overly concerned about it. We are not inflationistas, as you’d say. There’s just too many structural issues. There’s demographic issues. We’ve put on a pile of debt [during] the pandemic. It’s just hard for the economy to sustain significantly higher inflation and [the] significantly higher interest rates that would have to come to combat that inflation.
It’s highly unlikely we see anything close to 1970s. And just to remember to put the 1970s in context, we went through about a decade, almost, of easy money from both the mid-60s into the mid-70s before we hit an oil crisis, which then popped inflation dramatically higher into the 1980s or late-70s and 80s. If we’re still at [0% interest rates] five, six, seven years from now, then I think maybe we should start worrying. But I think that’s unlikely to be the case.
PH: OK, thank you. I think that makes sense, but a quick follow up question to that, Derek.
“For those who still might be a little bit concerned about the inflation ‘boogeyman,’ or if inflation does become higher than expected, what are some of the ways that you can protect against that in a portfolio?”
DB: Yes, so if we’re wrong and in six years from now, rates are still zero, inflation’s consistently above 3%, what would you do to combat that? Ultimately, it depends who you are, what your time frame is, and there are very different answers for different people. This gets back into that [restriction against] individual advice you were talking about. I’ll try to break it down very simply.
For an institution or a pension plan who kind of has long term liabilities that are indexed to inflation, they need to do something. So, you have options such as real-return bonds, real estate, infrastructure. There’s a variety of different asset classes that they can pursue.
For a retail investor or high-net-worth individual, I would recommend against going after these types of securities; specifically, real-return bonds. The bid-ask spread in these are very high. The duration is very high. The transaction costs alone will cost you 1%-2% when the yield on them is 1%-2%.
It’s very, very difficult to get in and out of these markets and try to time that from a retail-investor perspective. I’d suggest they own a little bit more of an expensive house, buy a condo, things like that, from a real estate perspective. That’s a great inflation hedge.
There are also options such as commodities. That gets a little bit trickier depending [on] which commodity [you consider]. But there’s ways to do it through an equity portfolio or through personal real estate holdings that are much better options than moving down to real-return bonds, from a retail perspective.
PH: Understood. Another major theme that we’re seeing in the questions is around interest rates. Derek explained [that] we’re not overly concerned about inflation. But David, I wanted to ask you, [this question].
“What does this mean for the Bank of Canada and what is your outlook for interest rates in Canada?”
DG: Thanks, Paul. Yeah, the Bank of Canada. Let’s start with some basics. The Bank of Canada is an inflation-targeting central bank, like many other central banks. Their target is 2%. They employ models to achieve that 2% goal and that model is based on something called an output gap. And that is looking at what the economy’s potential is, how it’s performing versus its potential over a period of time.
Now, with that in mind, we know that last year the Canadian economy was way under [potential] and looking at the inflation rates that Derek mentioned, we know that we’re growing a lot quicker. And as the vaccination programs roll out and the pandemic fears fade and reopening occurs, that the economy will continue to grow above potential. And in doing that, you’ve already mentioned that they’ve slowed down and are tapering purchases. That’s one part of slowing things down.
And the next is they’re going to increase interest rates. When does that occur? Central banks have been very vocal about this. They’re waiting for the unemployment rates to recover back to pre-pandemic levels. Our timeframe right now is 18 to 24 months before we expect to see the first rate hike from the Bank of Canada. And in that, we would also expect it to be very well disclosed when they’re going to start increasing interest rates. So, they’ll be very transparent on that.
PH: David, just a quick follow up to that question.
“If interest rates do rise, how might you respond strategy-wise?”
DG: Yeah, as the expectation builds for those rate [hikes] to occur, we want to be less exposed to duration in our portfolio. That would mean that growth is very strong, so we want to be fully exposed to risk assets. But we’re also very conscious that as rates rise, financial conditions tighten.
And as that happens, you start becoming more cautious about your risk assets, at that point in time. We’re nowhere near that yet, but we will start monitoring that as we go forward. So, that’s when you want to be very careful with your credit allocation.
PH: Right, understood. Well, you mentioned that you like certain risk assets, so maybe that’s something that we should delve into a little bit more. And I think this is a question best posed to Sue.
“What is your outlook for credit generally and what are the sectors and the specific issuers that you’re finding attractive today?”
SUE MCNAMARA: Thanks, Paul. I think right now we’re kind of heading into a little bit of a difficult credit environment, and what I mean by that is credit spreads have tightened significantly. We have pretty much erased all the credit-spread widening that happened last year with the fears of a pandemic and with the decline in commodity prices and that collapse [that occurred alongside them]. Now we’re kind of sitting with spreads almost as tight as they were there when we started last year. And that is pretty much through our long-term averages, which will tend to give a credit analyst warning signs.
But then, you look on the flip side on what your backdrop is. The backdrop is positive. Economics are strong. We’re expecting a very strong recovery, as Derek and David have spoken about, as we come out of this lockdown and we unleash the consumer. There’s going to be consumer spending. It’s going to lead to growth. And you’re starting to see that come through in quarterly earnings.
I think Q1 was a lot stronger than we even expected. And it’s kind of also setting the stage for a strong Q2 and Q3, as many companies have recovered. So, your backdrop remains strong. It’s also kind of getting into to what I guess we call a credit picker’s market, where you really do have to be careful because as credit spreads are this tight, some sort of risks are starting to bubbling around on the surface.
We’re seeing two major risks right now. One is on the M&A side. You’ve seen a tremendous amount of mergers and acquisitions so far this year. On the credit side, it really depends on which side of the M&A you are, whether it’s good or bad or how the acquisition is being structured.
If you are invested in a lower-rated entity that is being taken over by a stronger-rated entity, that’s actually a credit positive. But [on the] flip side, if you’re invested in the acquirer and they’re increasing their debt and levering up to make the acquisition, that usually brings about a credit-rating action and could be negative.
So, we’re watching the [emerging M&A risk] very carefully. And the other side is [that] a lot of companies had levered up a lot prior to the pandemic. And even during the pandemic, there was a tremendous amount of debt issuance, which you would argue was absolutely what they should have done.
When you’re heading into a period of uncertainty and you could issue debt and interest rates were low as the central banks brought them there, companies did exactly what they should do. They issued debt, they provided liquidity, they had cash on their balance sheet to weather the storm.
But we’re through that storm now. Now the question is, how are you going to use that cash? A lot of companies also have started to de-lever and show discipline. Are you going to keep that discipline? Are you going to run back into growth and lever up the balance sheet again? Or are you going to start doing buybacks and dividends, which are great for equities, but not necessarily always great for fixed income?
You know, fixed income people are usually the guys in the room with a cloud over our heads. We’re not really optimistic. It’s great for equities on dividends and share buybacks. If you’re using debt to do that, that’s not so great for the debt holders. We’re always trying to maybe look for the difficulties [or] the holes in strategies and how things can go wrong for us.
So, I’d say we’re cautious on credit, but we do see the chance for some credits to continue to tighten. It’s not an exit and risk-off type [of mentality]. It’s just to say more [that we’re] starting to get defensive, starting to look [at] safe haven [assets].
You asked, “what sectors do we like?” I think there’s still some room in energy, but maybe not necessarily in your pure oil and gas companies. We like playing energy mostly through the midstream companies. These are the companies that actually provide the pipeline and the fractionation facilities, all the services that enable the oil and gas producers. You’ve got exposure to the commodity through the producer, but you don’t necessarily have that 100% commodity risk because these are contracted businesses.
We still like financials. The banks and the insurance companies have come through strongly from the recession and the pandemic. And I think what’s attractive within financials is the different parts of the capital structure that you can play in, whether it’s deposit notes or NVCCs [non-viable contingent capital] or the new AT1s, you have exposure to the bank, but through different types of instruments.
We still do have a little bit of an overweight in telcos. I think telecommunication companies during the pandemic became the new utilities. We all needed Wi-Fi. It was a must-have service and they performed very strongly. And we are looking very closely at how this 5G auction is going to come later this year. But still like the telcos.
And then another thing that we’re watching, too, is on the high-yield side in terms of rising stars. I think the rating agencies did maybe what they were supposed to do, but it’s looking a little premature. And what I’m referring to is they did downgrade a significant amount of companies during the pandemic. They didn’t know how long the pandemic was going to last and how long demand was going to stay depressed. They were very, very quick with their trigger. And I think this was because they were very, very late with their trigger during the great financial crisis.
This has created a lot of formerly investment-grade companies that were downgraded to high yield, but now have come very strongly through the pandemic and are looking like they have metrics that are investment grade. So, we have a handful of names that we’re watching and investing in that we think will be probably upgraded back to investment grade, if not this year, next year or even into 2023. But these are the [companies] we call rising stars.
I don’t want to take up too much time because I love credit and could talk about it forever. But back to you, Paul.
PH: Very interesting. Thank you very much, Sue. OK, well, let’s get to some live audience questions. And remember, you can ask questions at any time through the Q&A function on your Zoom control panel. However, again, we’re restricted against providing individual investment advice.
OK, so we’ve got a question here. It’s on responsible investing, and I think, Sue, you’re probably the person I wanted to direct this towards.
“How do you integrate ESG into fixed income?”
SM: Sure. So, you know, I think it’s an interesting thing, and I think you could say that maybe the credit market has lagged a little bit [compared to] the equity market on the ESG front. But I think there’s a tremendous amount of similarities, especially with equities.
If you look at what the Beutel Goodman philosophy is towards ESG, [it] is that we believe that you are more powerful to engage with the issuer and discuss ESG issues, to have that seat at the table, rather than not investing in a company. So, we want to effect change by direct, active engagement with companies, and we do so on our own on the fixed income team and where there’s cross ownership of equities and bonds, we do it together with our equity portfolio managers. So, I think that first and foremost is how we approach ESG is from an engagement side.
We see ESG as both a risk and an opportunity. In essence, what you’re doing with analyzing ESG is examining a company through an ESG lens to see what sort of risks you could see
If it’s a mining company, are they investing in developing [or] emerging markets? Could there be issues there on the regulation front? How is their safety? How [are] their mines? Could there be a tailings pond leak or that type of reputational damage? For oil and gas companies, it’s very topical right now to talk about energy transition. If we somehow are able to get to net-zero GHG emissions by 2050, are we going to be consuming as much oil? Most likely not.
So how do you, as an oil and gas company, transition for this future? By using carbon sequestration and storage, by using hydrogen. And so, we have a lot of conversations with management teams about how they’re going to prepare for this coming transition.
You know, we engage with companies on diversity. It is proven that having representation on the board of 30 percent or more female is actually very beneficial for a company. So, we keep them to their diversity targets. And then inclusion is also becoming even more broad, not just into discussing about females, but other minority groups and having diverse interests on boards.
And, you know, I think where it becomes unique to fixed income is what we can do. We can invest directly in what they call green bonds or sustainability-linked bonds. And this is what you can’t do on the equity side.
So, companies will issue bonds where the specific use of the proceeds are to fund a project like renewable power, wind turbines, solar, a green LEED building. We can actually fund green types of projects and with sustainability-linked [bonds], we can actually fund projects that [are] going to make the company, or help [them], achieve their net-zero emission targets. It’s kind of unique on the fixed income side in that we can directly participate in the ESG transition.
PH: Terrific, thank you Sue. The next question that has come in here pertains to the value of active management. And David, I’m going to present this question to you.
The submission asks, “I have a passive bond fund, but is now the time to go active? Can you make the case for active management in fixed income?”
DG: I forgot I was on mute! Yes, first, the fee differential. If you find an active, low-fee fund, the fee differential is not that much. In addition to that, the excess return that you get from an active manager is shown, over time, to be significantly over that extra risk that you’re [taking] or the extra money that you’re paying for through your expense ratio.
You’ve got to remember: index managers are simply trying to replicate bond indices. They’re Canadian bonds issued by Canadian issuers in Canadian dollars and they’re weighted by the amount outstanding. So, it’s a quite a simple task.[With] active management, what we try to do is we try to weight the bonds, the best performing ones, by the ones that are going to perform better than that of the index. In addition to that, there’s a class of active bond funds that have actually way outperformed most broad-index funds, and that is the core plus funds.
These are the mutual funds that have priced in Canadian dollars. There are a lot of them out there. And what they do is they have much broader mandates. They can buy a significant portion of their portfolio in bonds that may perform better than those that are within the index. They could be global bonds in some ways, could be by different issuers, issuers that may exclusively issue in the U.S. They may be more diversified in terms of credit rating. That will provide you a lot more return. They’re just priced more attractively.
So, when you ask an active bond manager to whether it’s time to go active, I would say yes, for the primary reason that we discussed here at length: that there’s a possibility of interest rates continuing to rise over the next year or so.
The active manager can take steps to protect you against that, can take steps to expose you to different credits that are outside that index and add extra value that way, all for a marginal extra fee that that usually is exceeded. And looking back over the last five years, index funds have drastically underperformed the active manager set.
PH: That makes sense. Thanks, David. So we’ve all, as consumers, benefited from an environment for quite a while of low interest rates. Maybe not so much for savers, that’s been difficult; but as consumers, it’s been good.
The next question that’s come in is, “can the consumer survive an interest-rate environment that’s between 2% and 5%? What are your thoughts there?”
DB: Yeah, not an easy answer. I will say 5% is a high number. I don’t think our expectation is for rates to get that high. You know, 2% is roughly where the Bank of Canada got in their last hiking cycle. So, I don’t think 2% is overly concerning. I think that’s essentially the Bank of Canada’s target. Now, that’s the Bank of Canada rate [and] that would obviously mean mortgage rates and other types of lending, consumer lending rates would be higher.
So, 5% would be a high rate, depending [on] if we’re talking Bank of Canada or a mortgage rate. Most mortgage rates are stress tested now at about 5%. A 5% mortgage rate would definitely slow the economy down. Mortgage rates above 5%, without question, would slow down the economy.
But that’s kind of self-reinforcing, right? Like you can only hike rates so far as the economy can bear. And over time, central banks have proven to be exceptionally adept at eventually hiking too much and breaking the economy. We expect they’ll do it again. They continually do it. At some point, yeah, the Bank of Canada will hike too much. If they go over 2%, I think that would be hiking too much.
From a Bank of Canada perspective, [if] you’re trying to translate that into a mortgage, that would be somewhere in the 4% range. I’m ballparking there. There’s a lot of bank funding costs that goes into that math. But anything above 4% would start causing some serious problems on the consumer level.
We can’t take as high rates today as we could a decade ago or 20 years ago. There’s so much more debt on the consumer side that every incremental 25 basis points of hikes is — it’s much more meaningful from a total payments from a monthly perspective.
To just answer the question, no, I don’t think we could survive 5%. It’s unlikely. It’s going to depend on what we’re talking about. I mean, credit card rates are obviously much higher than 5%. The main part of consumer lending is mortgages. So, I think a mortgage rate above 4% would be difficult. Now, again, that’s part of the reason why the stress testing above that. But again, their stress test isn’t perfect. Right? Let’s just say there’s a lot of ways around the stress test and we’ll move forward.
I think the Bank of Canada will be very slow. I don’t think they hike much more past 1.50% to 2%. And it’s going to be very slow, very steady and [they will be] warning people. I think you already see [Bank of Canada Governor] Tiff Macklem telling everyone rates are extraordinarily low, they’re not going to stay here. So, get your five-year fixed rate mortgage or something like that.
PH: Understood, thank you. Our next question is a longer question, so bear with me here. Stay tuned. Here it is.
“How do you think about the balance of spread duration versus interest duration, given the tight credit spreads and likely rising interest rate environment that we’re in? Does it make sense to have lower interest duration and higher credit duration, or do you think that having a higher credit duration today is too risky given how tight spreads are?”
DG: I’ll start and then invite Sue in to finish. OK, that’s a somewhat complicated question. And yes, what we’ve been doing in the portfolio has been reducing the average duration of our credit spreads. I guess the attendee is very knowledgeable [as] credit spreads are very tight. So, we don’t think that they’re going to narrow very much, but we also don’t think they’re going to widen very much.
What we call this period is a carry time period. So, what we do is we sell our longer-dated corporate bonds and move into shorter-dated corporate bonds, trying to preserve that spread or that carry in the portfolio until the point in time where we think that those rates, as Derek was alluding to earlier, start impacting the economy. Now, it’s two-fold. That’s one part of the portfolio sense, and then I’ll have Sue come in and talk about the actual names that we will purchase.
SM: I think in the long end of the curve, there’s only a certain amount of issuers who can issue long. And because you have to think about that if you are actually going to hold the bond to maturity and you’re going to lend somebody money for 30 or 40 years, you actually want to make sure that they have assets that you think are going to stand the test of those 30 or 40 years.
Your traditional issuers in the long end of the curve are utilities, some telcos. We tend not to buy issues in companies where there might be a lot of technological or other sort of change, like in the telecommunication industry. You know, it’s very difficult to know how technology is going to change five years from now, let alone 30 years from now.
For us, there’s a very limited pool of issuers that we even buy in the long end of the curve. And where you look at where utilities are trading right now, they’re trading very tight as they should. They’re the safe haven, defensive, “boring is beautiful” type of bonds that you want in your portfolio.
But with David’s background and what he said on duration, you know, we kind of want to move into that seven [years] and under. That’s where you can take a little bit more risk, say, on the credit side, because your duration is a little bit less. That’s where we’re slotting in those midstream companies, financial AT1s and those types of names that I already spoke about.
PH: Thank you. I’m seeing that we’re getting a few questions here pertaining to currency, and so let me ask a currency question, if I may.
We’re asked, effectively, “what effects or what impact will a change in the Canadian/U.S. exchange rate have on bond yields?” And this particular submission actually notes that the Canadian yield curve is somewhat out of sync with the U.S. curve and the fact that our short rates are higher, but the 10-year rate is lower.
DB: Sure! Some of the strength we’re seeing in the Canadian dollar recently has to do with what you mentioned about our short-term rates being higher in Canada than they are in the U.S. And that’s called interest-rate differential. The big pension plans, global reserve funds, they can essentially borrow and invest in different countries and get the differential.
As David said, it’s carry environment. This is a big carry trade for these large international players. So what they’re doing is coming into Canada and buying our two-year bond and selling U.S. two-year bonds. Obviously, that has an effect on the currency.
There is an energy impact and oil price impact at $70 [per barrel], as well. But a lot of it has to do with the differential between Canadian and U.S. front-end rates. However, we’re seeing that unwind, since yesterday.
For the longest time, we’ve kind of viewed that the Bank of Canada couldn’t really hike six months before the Fed. The market had priced in in about 12 to 18 months. And we’ve seen as of yesterday, post the Fed meeting, the market [is] rethinking that opinion. And you’ve seen the U.S. dollar be very, very strong today. Canadian dollar is weakening a little bit, but U.S. dollar is doing very, very well.
So, that interest rate differential is slightly shrinking. It’s not dramatically shrinking, but it is slightly shrinking. Over time, we do think the Canadian dollar will probably be range bound. We look at it from $1.20 [USD/CAD] perspective, so like $1.20 to $1.25. And I think we would be range bound in that level.
But we’re not currency experts, either. We base it on an oil price forecast and an interest rate differential forecast. We think somewhere in that range [noted above] makes sense. If I was to put that the other way, I think that would be $0.78 [CAD/USD] to $0.83 or something like that. So that’s kind of how we look at it.
On the point of how does that affect our duration perspective? Not much. It tells us that there might be more international buying from the front-end perspective, but it doesn’t really change how we view 10-year bonds and out.
Most of the duration in a bond fund, about two-thirds of it, is in 10-year bonds and longer. That’s really how we’re looking at it. And that really has to do much more with an interest rate forecast on inflation and nominal growth, much more so than the currency. If anything, the currency is the release valve between the economies moving at different speeds. It doesn’t really get played out in the bond market as much as it gets played out in the currency market. And that’s what you’re seeing here.
The U.S. is reopening faster than Canada and the oil price is higher. So, we’re seeing the U.S. dollar now, at this point, with the Fed acknowledging the faster economic growth, the U.S. dollar finally appreciating. It doesn’t affect our duration positioning too much or [decisions on] where to spend our bullets.
If we do buy a U.S. company, so, for instance, a U.S. issuer of some sort in U.S. dollars, we hedge that back because that’s a credit decision. That’s Sue and her team deciding “I like Bank of America.” That has nothing to do with a currency call or a duration call. That’s a credit call on the issuer. And then we’ll hedge back that currency exposure.
PH: Thank you very much. We’ve got a few more questions here that have come in and let me ask this one. I think maybe Derek, I’ll pose this question to you.
“Can the economy sustain inflation of 3% to 4% for a period of three to five years? Then it goes on to ask, does the theory that this would erase 10% to 15% of government debt, a.k.a. the amount of borrowed [money] for stimulus, hold any water?”
DB: That theory is probably not wrong; that time frame is probably wrong. Instead of 3% to 4% for three to five years, I would say 2.5% for ten years. I think that’s the more likely scenario. I don’t think you’d see 3% to 4% inflation for multiple years. Again, heading back to the piece we mentioned, if you run the two-year rolling CPI since 2010, we’ve barely been above 2%. We’re not even [there] now.
We’re seeing this year’s print is really high. But when you combine them with last year’s and average things out, we’re just at 2%. In the U.S., they’re only at 1.6%. What that tells you is that the Fed in the U.S. has moved to average-inflation targeting. So, they’re going to be looking at things generally on a two-year horizon, maybe even a three-year horizon.
They’re going to want to average 2%. They’re not going to average 3%. They’re going to have to materially move interest rates to stop that. And again, it’s hard to get to 3% inflation. It’s just really hard with the demographics and the debt levels. Again, debt levels would require, or that type of inflation would require, higher interest rates, which would go back to the consumer rates question, the consumer lending question, you know, that would really hurt the consumer.[If] the consumer spends less, then there’s not as much demand and less demand means price pressures decrease. It’s kind of all intertwined. So, it’s unlikely that we’d see that.
I know we are seeing big price pressures now, but that has to do again with supply chains. Those are going to work themselves out. And the good thing is that price kills price. If prices are too high for too long, then people don’t want those things and the price comes down. There’s not this sustained demand push at this point.
Right now, we’re seeing supply-side issues. It’s going to be very, very hard to see 4% inflation for a meaningful period of time. 2.5% [inflation] I think is definitely possible. [At] 3%, I think the central banks would push back against [it] pretty quickly. And again, it’s just really hard to do with the technological advances that we’re seeing, the debt levels and the demographics that we have.
Don’t forget, a lot of the baby boomers are now moving into a retirement phase. This is not a high-spending time of their life. It’s an accumulation phase. It’s not until they get into their 80s that they can move back to high spenders again through Medicare costs and things like that. But we’re still probably 10 years away from that. So, I just I find it hard to get 4% [inflation].
PH: The next question is [ready].
“What thoughts does the team have on the growing retail demand for structured products and alternative strategies that target floating rates and lower credit than traditional fixed income? What are the risks and rewards? And is there a place in the portfolio?”
DG: Oh, wow, yeah. Structured products and alternatives? Yeah, there has been a big push for these, we have seen thresholds of deals dropping and they’ve been performing relatively well.
Alternatives are such a broad title. There’s actually real assets, there [are] leveraged funds, which are alternative, which you have got to be very careful with. There are so many. The reason why I’m stuck is that I don’t know exactly what alternatives that [the question submitter is] talking about. There’s just so many. Hedge funds are even considered alternatives and, sometimes, they’re appropriate and, sometimes, they’re just not.
So, the structured credit products tend to be short-term leveraged products, which in our current environment that we laid out for you today isn’t so bad. But can they get out quickly enough or de-lever prior to the next one? I don’t know. We don’t offer those lever-type of products.
So, that’s what I would suggest, is really to do a fine tune with what the underlying asset is and figure out if there is a leverage component in that to be cautious about.
PH: The next question that’s come in is [about the Canadian dollar].
“How does the increasing value of the Canadian dollar affect your decisions about buying and duration of Canadian and foreign-denominated bonds?”
DB: I somewhat answered it before, so I’ll quickly answer again. It doesn’t affect most of our view on duration. Again, when we buy foreign bonds, it’s generally for a credit-specific reason. So, we’ll hedge out that interest-rate risk.
If we do have a view in the currency, it’s because we’re Canadian-based investors. We can only essentially go short the Canadian dollar, we go underweight. We would buy U.S. dollars, most likely, at that point. And we view that, most of the time, as a hedge to the portfolio, a hedge to the credit risk in the portfolio. The U.S. dollar tends to appreciate, like we saw in March of 2020. So, we would view that as kind of a risk-off stance and we don’t have that right now.
And just a quick follow up to David’s answer on alternatives. I think it comes back to, again, who the investor is. Much like the inflation question, you know, long-term pension plans who have these return targets they need to hit [that are] inflation indexed. It makes sense for them to have some alternatives, specifically real estate and infrastructure.
When it comes to structured notes, and in the retail space, I think the question has to be, “what’s the point of fixed income in your portfolio?” If it’s there as a liquidity sleeve, a cash sleeve, a ballast to your equity risk, then I don’t think those things make sense. If you’re saying you need some sort of income and you want to take on leverage to do that, that’s fine.
But just know that in a moment, like 2020 or [specifically] March, April and May of 2020, they’re not going to behave like bonds. They’re going to behave like equities. You look at a lot of these credit hedge funds that are around in Canada and the U.S., most of them were down 20% to 30% in the month of March, 2020. [That’s] just as bad as the equity market. So, that’s not doing what it’s supposed to do from a fixed income perspective.
Even pure, 100% corporate, non-levered funds were still positive in March, 2020. But the levered funds got into a lot of trouble. So, again, it’s, “what’s the point of fixed income in your portfolio?” And we view it more as a balance-type mandate, as a ballast equity risk, as a cash-sleeve alternative.
You want to have that money to dive back into the equity market in April, 2020, as opposed to being stuck in some sort of illiquid investment and not being able to rebalance. If you’re looking for some sort of income, then just buy dividend stocks that pay you 4% or leveraged loans or high yield bonds. I don’t see the need for leverage and structured notes. I think there’s a lot of fees over the top of that and a lot of complexity that’s misunderstood.
PH: Thanks, Derek.
We’ve got another question that’s come in and they wanted to get the team’s comments regarding private debt versus public debt.
SM: Sure, thanks. I mean, there’s always a place for private debt, but [you need to] completely understand that it’s all about liquidity. Private debt tends to be in smaller hands. It’s not liquid. It doesn’t trade.
So, you really want to make sure that you’ve done your research and that you’re fully prepared to be a stockholder as well as a bondholder, where when you’re dealing with public debt, it’s much more liquid, it’s tradable. And, you know, the thing about liquidity is that you learn very quickly as you go through any crisis is it’s never there when you need it.
I think you would always very much manage the amount of private debt that you have in a portfolio, because it is the antithesis to what Derek was talking [about], as your anti-liquidity sleeve. But there can still be value there.
PH: Thank you, Sue.
Next question: “what is the impact of a slow withdrawal of the high input of liquidity that governments will likely begin? Or, will they?”
DG: Yeah, I mean, for central bankers who put in this much liquidity to counter the effects of the pandemic, this is the real tricky part for them. This is the hand-off of central bank stimulus to the real economy.
What they’re trying to do is they’re trying to exit really slowly because if they exit too quickly and the economy falters, then you’ve wasted all that stimulus. And if you go too late, you can create overheating, causing financial instability or bubbles, if you want to call in more colloquial terms, or inflationary pressure, as we’ve talked about length here.
“Looking at that, I would think that they share our view on inflationary pressures. They’ll go slowly. Meanwhile, what we’re looking for is to make sure that financial instability doesn’t come into the markets. And we’re forever looking for those type of situations and trying to avoid them.
PH: Well, I believe that’s all the questions that we’ve got today and we’re coming up on the time that we’ve allocated for today’s meeting. So, I wanted to say thank you to everyone who attended and especially those individuals who submitted questions. It’s wonderful to see the engagement and the participation on an important topic, such as this. And of course, I’d like to say a big thank you to my colleagues, David, Derek and Sue for lending their expertise to answer your questions.
Now, if there are any other questions that come up or if you want to discuss how our strategies can help you address your concerns and your fixed income portfolios, please do not hesitate to reach out to your Beutel Goodman representative. Thank you again and have a wonderful day.
Related Topics and Links of Interests
- Hello Inflation, my old friend – I’ve come to talk about you again
- How ESG is Evolving in Fixed Income: Fireside Chat with Sue McNamara
- Beutel Goodman Reduces Management Fees on Four Mutual Funds
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