What a billion-dollar portfolio manager thinks about fixed income

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Written by Sandy Liang

It was great to be a bond manager in the 1980s, the period that inspired Michael Lewis’s Liars’ Poker and Tom Wolfe’s The Bonfire of the Vanities. Interest rates peaked with inflation in 1980 and 1981, with the benchmark 10-year Treasury yield halving by the early 1990s (bond yields move inversely to price).

It was also fascinating to be a bond manager in the years following the global financial crisis in 2008. Led by the US Federal Reserve, global central banks pioneered the widespread use of quantitative easing, effectively “printing” money to essentially buy government bonds from investors and issuers to push interest rates down and stimulate economic activity.

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But all good market cycles come to an end.

Inflation has come roaring back in the wake of the global pandemic after a 40-year benign period, ending central banks’ money printing to buy bonds, because when too much money is chasing too few goods, printing more money from quantitative easing risks accelerating the inflationary spiral.

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In the post-pandemic years, it’s been no fun being a bond manager, at least for those traditionalists who invest primarily in government bonds and investment-grade corporate debt. The bond market has a high degree of correlation globally.

Over the five years ending May 31, 2024, the iShares Core Canadian Bond Index ETF, a broad portfolio reflecting the universe of Canadian bonds, generated negative cumulative returns for investors even though 2020 was a banner year for traditional bonds. Five years of investment and nothing shows.

Now the traditional bond market has reached a crossroads. The rules that markets have followed in recent years are that as the economy slows in North America, and the Federal Reserve comes close to cutting short-term interest rates (similar to the Bank of Canada), interest rates are at the long end of the yield curve – generally 10-year bonds. years or more – must decline, which is in favor of bond prices.

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This will include the benchmark 10-year US Treasury bond, which is yielding 4.3%, and the 10-year Canadian government bond, which today is yielding 3.3%. The inflation rate in the United States and the world has exceeded its peak after the pandemic, which is also in favor of bonds.

But is the bond market really at a turning point? What is different about this economic cycle compared to previous cycles and what does this mean for bond market returns?

What’s different this time is the massive budget deficit. There has been a shift in the supply and demand for Treasuries: from the pre-pandemic surge in demand due to quantitative easing to the current state of oversupply caused by the massive budget deficits in the United States and other major economies.

Government budget deficits are financed by borrowing, which is done in the bond market. More borrowing means more supply of bonds, which causes prices to fall and bond yields, or the interest rates governments pay, to rise, all else being equal.

United State Congressional Budget Office The Congressional Budget Office projects that the US budget deficit will reach $2 trillion in 2024, then increase steadily to $2.8 trillion in 2034, up from just under $1 trillion in 2018 and 2019 and a post-financial crisis low of $400 billion in 2015. .

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The fair value of Treasury bond yields includes an inflation component because investors should receive compensation for the loss of spending ability over time. In the entire post-financial crisis period until the global pandemic, bond prices were above fair value and bond yields were below fair value.

There is a strong possibility that bond prices will be below fair value and bond yields will be above fair value for most of the next bond cycle, which has already started with weak yields. This cycle may continue for ten years unless the United States changes its course on deficit spending, as the Congressional Budget Office expects.

Compared to the post-financial crisis period, when bonds were trading higher, this time is different. The Fed can’t print money to cover the deficit. And the supply of bonds coming from the massive budget deficit is expanding even as a number of other traditionally large buyers of U.S. Treasuries — including the Fed as well as China and Japan — are reducing their holdings.

We strongly believe that it is now important to have a healthy portfolio with a good weight in alternative fixed-income funds managed by skilled active managers whose investment returns are not dependent on a decline in long-term interest rates over time.

The huge budget deficit that characterizes the current economic expansion will put downward pressure on government bond prices and increase yields relative to their fair value. If there is an economic slowdown, the supply of bonds will increase even more as the budget deficit grows.

Sandy Liang, CFA, Portfolio Manager and Head of Fixed Income at Purpose Investments Inc. Purpose of Credit Opportunity FundAramex will celebrate a decade of strong revenues next July.

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