With interest rates near zero, earning yield in fixed income has become a greater challenge for advisors
While interest rates have been low for a few years, the COVID-19 pandemic forced central banks to bring them even lower, to provide relief to the economy. Yet as a result, it has made the challenge of finding yield in fixed income portfolios even greater. As advisors look to tackle the issue, Jonathan Hartman, head of advisor channel sales, RBC Global Asset Management, has some options.
Hartman says that right now the major factor is the impact of COVID-19 and says that impact will continue to affect government bond yields well into 2021. “If you think about everything the government is doing, they are in a stimulus position with low short-term rates. Central banks around the world have committed to purchases of financial assets – government and corporate debt. So, you can expect rates to remain low longer.
“When I look at where we were in 2018, the Canadian high point was 2.6% on the 10-year. Last year, it dropped in Canada and the high point was 2%. It has fallen off dramatically this year. The Canadian 10-year is now around 70 basis points. The shorter terms are 15-25 basis points, so we have been low but, in this current period, we have never been lower,” he added.
What that means for Hartman is the challenges that already existed in managing fixed income portfolios will remain amplified, leading advisors to question how they want to handle that part of their portfolios.
However, for Hartman, it is not all doom and gloom. He says it might be time for advisors to look at options other than traditional government debt. “One (option) is to allocate away from Canada, go global. The ability to diversify across yield curves, historically, has shown you can get equal or higher returns with lower volatility because of diversification. It has been top of mind for equities for a long time, but the same thing applies to bonds.
“The second would be diversify by credit. Sovereign debt is at historically low levels and expected to remain there. We are close to long-term historical averages for spreads on investment grade credit, which are in the neighborhood of 140 basis points over Canadian government bonds. There is a premium for taking on credit risk, whether investment grade, high yield or emerging markets.”
While Hartman presents those options, he does add that they do require their own considerations. “Credit risk needs to be managed, monitored and time varied as spreads evolve. You also need to manage currency risk. When you diversify geographically, you take on currency exposure and that currency exposure, if not managed, can amplify the risk you face in investing in bonds and overwhelm the return you get. Our default position for bonds is to hedge currency exposure back to Canada and take tactical opportunities.”
Hartman also adds that it is important for advisors to limit their bet on interest rates. Trying to forecast changes historically has not equaled success. Additionally, Hartman says it is important for advisors to consider the cost of execution when it comes to fixed income in a low-rate environment.
For RBC GAM, diversifying fixed income options has been something they have worked on for more than 15 years and now offer a variety of strategies to help advisors and investors. “Looking for alternative sources of returns is important, but you need to understand what you are investing in and what the tradeoffs are. Private debt, for example; we offer a private Canadian commercial real estate strategy, a partnership with the British Columbia Investment Management Corp. We fully believe that you need to diversify fixed income into alternative sources of return. With private debt, you give up liquidity, so it is an approach that gives you different exposure, but shouldn’t make up the bulk of your allocation, rather an additional component.”
In addition, RBC recently launched a global alternative bond fund, managed by BlueBay, the London arm of their investment shop. “It is an investment grade bond strategy that actively manages duration, credit and currency. It will take long and short positions and is different in the sense that the return target is 30-day Canadian T-bills plus 300 basis points. It is an example of adding a differentiated approach into fixed income beyond simply Canadian government debt.”
Yet even with the individual options, Hartman says the most interesting offering RBC GAM may have are the RBC Fixed Income Pools. “What we try to do is change the dynamic. Many core bond offerings in the Canadian market sit around the benchmark and have the same return and duration tradeoff. Our bond pools, given the diversification we have been able to build in, lower the duration and risk of portfolios while increasing the yield. The risk-return dynamic is quite interesting, it has been a popular solution for advisors in an environment where people want to take duration down. These strategies have done that without giving up yield and have actually provided a bump.”
Hartman believes government yields will remain low, so looking at those other options is something he believes is important. “In the investment grade corporate space, we view the premium for risk that people are getting paid as compelling. While high yield valuations are near their long-term averages, we think they offer an attractive yield pickup relative to treasuries. Within emerging markets as sentiment improves and market conditions improve it will be supportive and attractive for the EM debt space.”
