VGSH - The Bond Market Has Been Battered But Are There Opportunities Emerging?
Summary
- Where opportunities might be emerging in the battered bond market.
- Why the bond market may face even more volatility.
- Bond market volatility. Is the bottom in sight?
Global bond markets have suffered their worst selloff in decades, as central banks aggressively hike interest rates. Greg Bonnell speaks with Anna Castro, Senior Portfolio Manager at TD Asset Management, about the outlook for fixed income and possible opportunities for investors.
Greg Bonnell: Maybe the worst bond market in a century has even the most conservative investors wondering where they can find opportunity. Well, our feature guest today says fixed income is becoming increasingly interesting after a volatile year. For more on this, we're joined by Anna Castro, Senior Portfolio Manager at TD Asset Management. Anna, welcome to the program.
Anna Castro: Hi there, Greg. Thanks for having me.
Greg Bonnell: So let's talk about -- perhaps a lot of -- a lot investors watching this show, trying to wonder, where could there be opportunity in this market? Because it has been very tough. And as we said, even for the most conservative investor, there's not been a lot of places to hide.
Anna Castro: You make a good point because most conservative investors appreciate the stable income from fixed income, and they have more of that. And yes, it is the worst bond market in the century, in history, practically. So this year, the bond market has been down. An index of Canadian bonds has been down 15%. And the worst prior to this year is down -- low, single digits, maybe, mid-single digits, I mean, down 7%. And even high-quality debt from the US government, US treasuries at a 20-year term is down 30%. So that's the landscape that bond investors have faced, the sell-off. And the other thing that has been challenging is that there has been no diversification, and what does that mean? So in the past, when it was a growth type of shock that people were worried about when equities fall, fixed income would be positive, especially government bonds. In this case, because the focus has been inflation -- and to your point, what has driven this sell-off is, in March, when the US Federal Reserve started hiking rates, inflation was already 7%. So that's the highest since 1988 when they started the last six hiking cycles. And then from 0% interest rate, practically easy money, six months later, we're up 3% in terms of interest rate. And because of that, that's what pushed fixed income down, and also equities, US equities are down 20%. Canadian equities have fared basically better, mainly because they have a higher rate in energy equities, and energy prices have benefited from this inflationary environment.
Greg Bonnell: What is it going to take -- and it's been a painful year -- for the pain to start to subside and perhaps some opportunity to start presenting itself?
Anna Castro: So first of all, in the near term, we expect bond volatility to remain because this tug of war from the growth outlook as well as inflation will continue. And so a good thing, the positive things -- you asked for opportunities. The positive thing is that the hiking cycle, the Federal Reserve, central banks around the world has started increasing rates. So we're maybe 2/3 past that, and we're not talking about where they might pause next year. And so we've also started to see some economic indicators that their effort to tone down inflation or have it in control is working. So we've had slowdown in the manufacturing activity as well as we've seen commodity prices come down. But what has been sticky has been wage increases and the strength in the labor market. And what it would take is that they need to see inflation back to the level that they're more comfortable with, so the 2% target, and know that it will stay there. And so that's the tricky part because before we're so used to one institution, the central bank, doing something to ease an economic challenge or a market condition. But here we have millions of people, companies, et cetera needing to address -- to let the higher interest rates flow into the system for employment market, the labor market to slow down, for wages to calm down, and rent prices to go down. And so once you have that, you would have some stability in how the Federal Reserve and central bank will approach inflation. And so when you asked about what would take -- in this time, for equity investor, what you'd need to see is earnings revisions go lower, earnings growth estimates to show that slower economic growth or even negative economic growth is reflected there. And on the fixed-income side, it's an interesting setup because this bond volatility impacts prices. So where are we right now? Yields have increased, and so a fixed-income investor can now get higher income from higher interest rate.
Greg Bonnell: This should make bonds more attractive, right?
Anna Castro: Exactly, exactly. So going back -- let's go back to the basics. Like what -- a fixed income investor, what does it mean? They literally have a contract. And then you have a borrower, a contract, a lender-borrower, and this borrower has to pay an interest rate and then eventually pay back the principal. So now that interest rates are higher, as an investor, you are getting a higher income, and there could be bond volatility prices on the market or on paper. But you're getting that income, and if you do your due diligence, you're going to get your money back at that point in the future.
Greg Bonnell: OK, the due diligence in terms of getting your money back in the future. When we talk about bonds, now we can talk about government bonds, and there's corporate bonds, and there's high-yield bonds. When we talk about the opportunity in the space, does something look more attractive than anything else, or is it a matter of doing your homework?
Anna Castro: So, well, first of all, we have to do our homework across, whether it's government or corporate bonds, whoever the borrower would be. In this case, what we're doing -- I'll share with you what we're doing in our portfolios. And we have a great -- aside from our asset allocation team, We have a lot of people in our fixed income team helping us with our due diligence. We're seeing opportunities in two categories, two buckets. So with what happened to interest rates, yields picking up on a two-year basis, on the two-year bonds, both on government, the government of Canada. In the US, you see 4% yields, yields that you haven't seen before. And you can see corporate bonds. So high-quality debt from high-quality issuers at the 5% to 6% level. And this is debt that you can get the principal back in two years. So we have a team that's doing due diligence to make sure that there's quality business models and cash flows behind it to make sure that, whatever happens, you have economic slowdown, et cetera, you're going to get paid that interest as well as that principal back in two years. That's one bucket of the opportunity in the short term. The other bucket of opportunity that you've seen is there's been an increase in yields as well on the long end. So US and Canadian long-dated bonds are at 3.5%, 4% levels, again, levels you haven't seen before. And so the value of this setup is that while you're waiting you get that higher income, but the interesting with longer -- with long-dated bonds is that they're sensitive to long-term expectations, and growth, and inflation. So if we believe that central banks are very aggressive in reducing rates, and they will eventually slow down the economy to tame inflation, then you have growth come down and inflation come down. So going back to bond math -- so when yields come down, bond prices go up. So these long-dated government bonds will provide a recession insurance as well during the time, as well as opportunity to get paid 3% or 4% while you wait. So those two combinations I wanted to give as an example of how we're using active management. And we're being very selective to make sure that we preserve capital. And you also have flexibility, because you can sell this if you --
Greg Bonnell: They can sell your position, right?
Anna Castro: You can sell out of a bond. Yes, exactly. You can sell out of it. For example, you're seeing indicators showing that earnings revisions have come down and the recovery is about to start in the -- and investors are forward-looking, so you can actually sell these bonds -- these are liquid instruments -- in position to buy into quality equities that have also sold off as well as high-yield credit.
Greg Bonnell: What's the biggest risk here in terms of saying -- OK, things are setting up, from what I hear you're saying. That could be quite advantageous for fixed-income investors, opportunities in the bond market. What is the biggest risk? Is it waiting for the right conditions?
Anna Castro: So the biggest risk -- I would highlight two of them. So I started off saying that we probably are 2/3 there. So the biggest risk -- if you have another shock in the system that causes inflation to spike up. And it'll be stickier again and harder to push down. And then you have central banks needing to be more aggressive from where we think they would be to raising rates. That's one. The second part is the explanation I gave on those long bonds, US and Canadian bonds -- if you don't have an economic slowdown soon, you might be waiting for a bit. We believe that the recession is just a matter of when, not an if. So that would be the risk for that. You would be waiting until you have more negative news, more bad news for it to be good or better for that trade.
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The Bond Market Has Been Battered, But Are There Opportunities Emerging?