We’re halfway through 2021 and fixed-income investors are in an interesting position. Central banks are keeping short-term interest rates low, yet inflation expectations are increasing, eroding any real yield (nominal yield minus inflation). With a diminished outlook for core fixed-income asset classes, let’s explore the benefits of including structured product strategies in your portfolios.
A challenging environment for fixed income
Two primary challenges core fixed-income investors face today are:
- Increased inflation, which reduces real yields; and
- Increased duration (relative to historical market levels), which increases the magnitude of losses if rates rise.
1. Increasing inflation
The reopening of Canadian and U.S. economies should act as a tailwind to economic activity and GDP growth as large pent-up demand is released. Furthermore, continued government COVID-19-related benefits are bridging income gaps for those impacted by the virus, supporting consumer spending and confidence.
This shift in consumer behaviour has raised prices in larger ticket items like lumber, housing and cars, while supply-chain bottlenecks have caused shipment delays in a myriad of products, including microchips, furniture, pet food and bicycles. With increasing consumer demand and decreasing supply for select items, many expect that inflation in 2021 will be considerably higher than previously experienced (see Figure 1).
Whether current inflation is transitory or continues at these high levels remains to be seen. However, one certainty is that increased inflation is negative for fixed-income investors.
Figure 1: Real GDP and Inflation Figures: Canada and U.S.
As of July 23, 2021
Please refer to the bottom of this blog for all sources and indexes used within all charts.
2. Increasing market duration
Duration measures the sensitivity of bond prices to changes in interest rates. Generally, bond prices are inversely related to interest rates, meaning that if interest rates increase, bond prices will decrease. As a simple example, if a bond’s duration is 7.0 and rates rise by 1.0%, the bond’s price would decline by 7.0%. If a bond portfolio increases its duration, the portfolio is now more sensitive to increases (and decreases) in interest rates.
Following the global financial crisis of 2008-09, the Bank of Canada (BoC) and U.S. Federal Reserve (“Fed”) maintained accommodative monetary policies, with neither raising rates above 1.0% until 2017-18. These easy financial conditions allowed governments and corporations to issue relatively cheap debt to fund budget deficits (for governments), and operations, market expansion or acquisitions (for corporations). This led to increased bond issuance, with a preference from issuers to extend the maturity to delay repayment (see Figure 2).
For example, since 2010, the Canadian Aggregate Bond Index has increased in market value by 167%, while the U.S. Aggregate Bond Index has increased 91%, indicating more bonds have been issued. Although increased debt levels are accommodated by low interest rates (for now), and higher corporate profits and government revenue, increased duration levels within the broader bond market could result in more risk and potentially negative consequences if rates rise.
Figure 2: Historical duration levels of Canadian & U.S. bond markets
As of June 30, 2021
Diminished outlook for traditional fixed-income
Although we believe Guaranteed Investment Certificates (GICs), government bonds and investment-grade corporate bonds remain a viable part of an investment portfolio, they currently have some temporary drawbacks.
The appeal of a generic GIC is a guaranteed and insured return in exchange for locking up your deposit for a specific term. With both the BoC and Fed holding interest rates at 0.25%, GIC rates have subsequently declined, providing very little nominal returns and negative real returns (see Figure 3). Furthermore, GICs lock up your investable money, costing you for potentially missing an investment opportunity.
Figure 3: Median Non-Redeemable GIC Rates
The multi-decade rally in government bonds may have reached its peak in August 2020 when the U.S. Treasury 10-Year yield fell to 0.51%, the lowest in history. Since then, positive vaccine developments and expectations of a stronger economy have increased confidence. Broadly, government bonds have sold-off on this sentiment, pushing yields to 1.52% (as of July 23, see Figure 4), while many market participants expect yields to increase as economies reopen and central banks become more hawkish. This longer-duration profile along with expectations of increasing yields and interest rates may lead to negative returns for government bonds.
Figure 4: 2021 Year to Date: U.S. 10-Year Yield vs. U.S. Government Bond Returns. As of July 23, 2021
Benefits of structured products
Better potential performance in rising-rate environments
Structured products, such as agency mortgage-backed securities (MBS), non-agency MBS and asset-backed securities (ABS), contain a pre-payment factor that lowers their duration profile. Although the negative convexity of these asset classes leads to increasing duration as yields increase, overall, the asset class has outperformed during rising rate environments (see Figure 5). If interest rates rise in the future, the lower duration profile could lead to positive outperformance vs. government bonds and investment-grade corporate bonds, all else equal.
Agency MBS vs. U.S. Treasuries
Agency MBS are investments issued by government-owned Ginnie Mae, and government-sponsored entities Fannie Mae and Freddie Mac. Broadly, these agencies pool together mortgages, wrap the loans with a credit guarantee (for a fee) and securitize the net cashflows, which are sold to investors. Agency MBS historically trade at a positive yield spread relative to U.S. Treasuries, while its lower duration profile makes it less volatile. Given the explicit and implicit U.S. government guarantees of agency MBS, they represent a unique opportunity for exposure to a government-like issuer that provides higher yields and lower volatility than a traditional government bond. As of June 30, agency MBS yields were 1.77% vs. 0.95% for U.S. Treasuries, while the duration of agency MBS is 4.16 vs. 7.01 for U.S. Treasuries. Furthermore, agency MBS are negatively correlated to equity markets (-0.16 to the S&P 500 Index over the past 10 years), acting as a portfolio stabilizer in times of market stress.
Figure 5: Fixed Income Sector Performance in Rising Yield Periods
A core asset class in U.S. fixed-income markets
Agency MBS have a long history in the U.S. of being a core fixed-income portfolio holding. This is due to their unique characteristics (which attract U.S. and global investors) and how, as a function of U.S. government policy, they generally make mortgages more affordable to the U.S. public. At US$7.1 trillion, agency MBS make up approximately one-quarter of the Bloomberg Barclays U.S. Aggregate Bond Index, have a larger market than U.S. investment-grade corporate bonds and is considered one of the most liquid asset classes available.
Figure 6: Bloomberg Barclays U.S. Aggregate Bond Index: Breakdown by fixed income sector (in US$ trillions)
Diversifying fixed income with structured products
Although agency MBS and structured products are considered a core part of U.S. markets, they’re not common among Canadian investors who miss out on their benefits. CI Global Asset Management has partnered with DoubleLine Capital – one of the world’s largest and most experienced managers in structured products with over US$135 billion in total assets under management – to bring three of their flagship strategies to Canada.
CI DoubleLine Total Return Bond US$ Fund is a structured product mandate that primarily invests in agency MBS and structured credit (non-agency MBS, ABS and collateralized loan obligation). Its high-quality, lower-duration profile and focus on structured products has resulted in lower volatility and higher yield than its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, and made it a strategy not easily replicated.
General sources used: Bloomberg Finance LP. Sources for all graphs are Bloomberg Finance L.P. and Morningstar Research Inc.
For Figure 1, 2021 GDP growth and inflation expectations are based on a survey of private firms and individuals surveyed by Bloomberg. For Figure 2, duration is monthly option-adjusted duration (OAD); Canada Aggregate Bond Index = Bloomberg Barclays Canada Aggregate Bond Index; U.S. Aggregate Bond Index = Bloomberg Barclays U.S. Aggregate Bond Index. For Figure 3, median GIC rates represent the median non-redeemable or non-cashable GIC rate as offered by RBC, TD, BMO Scotia Bank and CIBC as of June 22, 2021. Rates represents GIC that compound annually. The inflation rate used is the 5-year average CPI. Source: websites of RBC, TD, BMO, Scotia Bank and CIBC. For Figure 4, U.S. Treasury Index = Bloomberg Barclays U.S. Treasury Index. For Figures 5 & 6, Canadian IG Corporates = ICE BofA Canada Corporate Index; U.S. IG Corporates = ICE BofA US Corporate Index. For Figure 7, Agency MBS = Bloomberg Barclays U.S. MBS Index; U.S. Treasuries = Bloomberg Barclays U.S. Treasury Index; U.S. Investment Grade Corporates = Bloomberg Barclays U.S. Corporate Index.
Glossary of Terms
Duration: A measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. Duration is expressed in number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).
Credit risk rating: An assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. Credit risk is the risk of default on a debt that may arise from a borrower failing to make required payment.
Volatility: Measures how much the price of a security, derivative, or index fluctuates. The most commonly used measure of volatility when it comes to investment funds is standard deviation.
Yield curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve indicates that short-term rates are higher than long-term rates.