In our recent commentaries, we’ve discussed how rare it is for investors to actually forecast the future correctly and thus why it’s important to construct a portfolio that optimizes return from risk in a variety of scenarios. The global pandemic and the subsequent rise of the delta variant are Exhibit A of this phenomenon – as recently as this spring it appeared that a post-Labour-day return to office was in the cards.
At the same time, we also believe it’s important for investors to be able to visualize an alternate future that is not quite the same as the current environment to overcome recency bias and explore possibilities for where future returns will originate from that are not adequately discounted by investors.
Moving Past the Pandemic
For example, a number of our funds produced favourable returns in 2020 and one of our fundamental tenets was thinking about normalization, even when the world was in the worsening stage of the pandemic. The questions the team explored were: what are company earnings in a normal period, and what is valuation on those earnings in a normal period? During the pandemic that was not our reality, but we believed at some point things would be normal once again.
The team conducted this exercise in many industries affected by the pandemic including commercial real estate, autos, and even travel and leisure. And those target valuations, based on normal earnings, were inputs into our risk-reward framework for corporate credit quality and credit pricing.
Now we’re looking at what an alternate reality could be with respect to traditional fixed income securities. Please do not misconstrue our comments: we have limited confidence in our ability to predict with accuracy where bond yields are actually heading. Furthermore, as bottom-up company investors, we don’t generate investor returns over time by making macroeconomic predictions on their own.
However, in our funds we are staying away from bond market duration (i.e., interest rate risk) and even shorting long-duration securities in our liquid alternative product, Purpose Credit Opportunities Fund, as a hedge to our normal course long credit returns. The ability to short securities is a key benefit of liquid alternative prospectus funds. The rationale for our positioning is a risk/reward perspective as opposed to making a prediction.
The return outlook in traditional fixed income is asymmetric because long-term interest rates are extremely low (i.e., the reward) while duration, or interest rate risk, is at historically high levels (i.e., the risk). We seek asymmetric return profiles in our investments.
The bond market situation is extreme in an unfavourable way if the investor has a long position. According to our research, the average traditional bond fund investor can lose more than 10 years of income if the 10-year bond yield moves up only 1%/100 basis points, which is the combination of post-expense internal yield under 1% and eight years of duration in the 20 largest bond funds in Canada collectively.
Why Is There Asymmetric Downside in Traditional Fixed Income?
The Fed and other global central banks have been manipulating the bond market through quantitative easing (QE) ever since the 2008-2009 global financial crisis. According to Deutsche Bank, in the first half of 2021, the Fed bought all the bonds issued by the U.S. Treasury to finance the massive U.S. budget deficit.
There are indications that QE may come to an end by late-2022 through tapering, lessening the degree of bond market manipulation in coming quarters and years. Of course, the economy has to move forward for the Fed to begin tapering, which would be good news for credit quality.
A Look at U.S. Treasury Yields
We think it’s worthwhile to explore fair value for U.S. Treasury Yields without the recency bias of where they are now and picture a “normal” world absent QE. This can be a two-part question because bond yields are influenced by inflation, which is off the charts at the moment and may be transitory.
Chart 1 below shows that for decades the U.S. 10-year bond has resembled nominal GDP growth (inflation plus real GDP)—nominal GDP growth was most recently 17%. Consensus estimates are for 7.2% in 2022 (source: Bloomberg).
Chart 1: What Is Fair Value for the 10-Year U.S. Treasury Yield?
In the past 20 years, the fixed-income market has become more globalized. Consequently, just looking at U.S. 10-year bond yields in isolation ignores the QE actions of the European Central Bank and the Bank of Japan, for example, since the global financial crisis.
Chart 2 shows that in the past three decades a better fit with 10-year bond yields has been the simple average of the aforementioned U.S. nominal GDP growth and the German 10-year bond yield that is still negative even as Eurozone inflation has also been picking up.
Chart 2: What Is Fair Value for the 10-Year U.S. Treasury Yield?
Finally, at risk of over-simplifying, the 10-year bond yield can simply reflect a risk premium or cost of funds over inflation. Chart 3 shows that historically 200 basis points over the Consumer Price Index seems to have been a good fit for 10-year bond yields. The U.S. inflation-protected securities market are currently reflecting 2.3% expected inflation over 10 years while economists are looking for 3.0% in 2022 – add 200 basis points for 10-year yield fair value.
Chart 3: What Is Fair Value for the 10-Year U.S. Treasury Yield?
On the corporate credit side, we continue to view post-lockdown corporate earnings growth and inventory rebuild as the most important fundamental opportunity today. Credit quality continues to improve – corporate debt default rates are declining, and S&P 500 earnings estimates continue to be revised upward, the delta variant notwithstanding. In recent months, we have had a number of long-time portfolio holdings refinance into new debt, which is common for us having covered many of our issuers through multiple new issue/refinance activities.
Overall, we continue to view the environment as constructive for investment risk assets, but we’re less positive for traditional, long-duration fixed income where investors get all the interest rate risk with little reward (yield).
— Sandy Liang, CFA, is the Head of Fixed Income and Partner of Purpose Investment Partners
All data sourced to Bloomberg unless otherwise noted.
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