'Traditional bonds can’t deliver in this market'

After a landmark year for fixed income, one leading analyst sees a gloomy picture and a need for smart plays in the bond market through 2020.

Phil Mesman, partner and head of fixed income at Picton Mahoney Asset Management, sees a tight bond market rife with risk. Bond prices are high, yields are low, and spreads are razor thin. A small change in government bond yields could have disastrous effects for the value of bonds.

“The return in 2019 all came from government bonds,” Mesman explained. “Investors have been kind of pushed out of government bonds into other assets in fixed income to get more yield. And in doing that, it's made the entire fixed income market riskier and people don't see that yet.”

Mesman sees what he calls “forward-looking volatility” in the bond market. Investment grade bond yields are currently averaging 3%. In a hypothetical, Mesman deducts the 2% government bond yield rate leaving a spread of 1%. He says the bond market has spent the past decade in the “red zone” with some of the tightest spreads in the history of fixed income.

Those low yields have resulted in high bond prices, averaging $108 USD for investment grade. Mesman sees these bonds as tax inefficient and deeply susceptible to risk.

“I don't like saying the whole world is terrible,” Mesman said. “I have an abundance philosophy and believe that there's enough room for everybody and we're just part of the solution. I just want to show everybody what’s happening in fixed income, the good and the bad, and help people make better decisions.

“But fixed income is really scary because traditional bonds can’t deliver in this market.”

Mesman thinks advisors need to take a “quality of return” mindset to deliver fixed income to their clients in 2020. An advisor, in Mesman’s view, should ask everyone they outsource their money to in fixed income for attribution on how they made money in 2019. Mesman’s “true north” benchmark should be inflation plus a spread. Somewhere between 3-4% returns after fees.

Mesman has three rules to apply this mindset. The first is correlation. Advisors should find a few different fixed income strategies with different return drivers. The second is resiliency. Advisors need to empower managers in fixed income to be resilient and stay equipped with the tools to navigate this expensive market. Advisors can do that by letting those managers work unconstrained and find opportunities wherever they sit, though Mesman says they shouldn’t be allowed to run rampant. They can do it, as well, by adopting a long-short strategy. Mesman thinks a manager that doesn’t run a long-short strategy is like a plumber operating with only half a toolkit. The third rule is to build high Sharpe ratio portfolios, built from a combination of diverse drivers and resiliency.

Mesman thinks flocking to investment grade credit might not be prudent. He accepts that it’s a popular subset in fixed income for Canadian investors, but thinks that investment grade credit lacks a margin for safety. With small spreads, the downgrading of some BBB bonds at the bottom of the investment grade market could see a big loss for holders.

“I worry that one day, regular savers and investors are going to wake up and find their investment grade bonds down,” Mesman said.

Mesman doesn’t think that we should run away scared from fixed income. Rather, he’s advocating for better understanding. It’s his view that advisors need to find out where the risks come from in bonds and allocating appropriately.

“Going long-short in this market keeps investors in fixed income, gives them that income, and the protection to stay in the game,” Mesman explained. “[Advisors should find] three to five managers that do different things that have different return drivers and are entrepreneurial and creative and attentive. I think that's how this works.”