“Only when the tide goes out do you discover who's been swimming naked.”
– Warren Buffet
Experienced investors may remember times when 5‒7% of investment income was achievable simply through government bonds or even guaranteed investment certificates (GICs). Those days are indeed long past, with government bond yields having significantly decreased over the past decades; today, finding yields like that with reasonable risk is no easy feat. However, it’s not impossible, and we believe that by combining thorough credit research with sound risk management, investors can still construct a diversified strategy that minimizes interest-rate risk and can deliver appealing income generation despite the current low-rate environment.
As we can see in the table below, there exist traditional asset classes that are attractive from a yield standpoint. However, it’s critical to keep in mind the capital preservation flipside to the hunt for yield — i.e., taking money from your left pocket and putting it into your right pocket won’t make you any richer, positive total returns will. More specifically, there are three crucial elements to assess in helping to preserve capital when moving higher in the risk spectrum:
- credit sentiment
- an issue’s risk/reward profile
- interest rate direction.
Examples of current traditional asset class yields
Source: Manulife Investment Management, Bloomberg, as of April 30, 2021. For illustrative purposes only.
As a general rule, the riskier the asset class, the higher the beta, which is a Greek way to say that riskier assets tend to underperform/outperform during market drawdowns/rallies. Therefore, one of our top priorities is to continuously evaluate whether the underlying economic conditions are favourable for risk assets, and tactically adjust our portfolios’ asset mix and credit risk accordingly. Our base-case scenario over the next 12 to 18 months is that overall risk sentiment will remain positive thanks to the unprecedented support from governments and central banks that’s helping bridge the current crisis, as well as successful vaccination programs and the subsequent reopening of economies worldwide.
The main programs put in place by central banks and governments, which have been critical for tackling the COVID-19 pandemic so far, will keep supporting consumers and businesses, at least for the medium-term time horizon. In the U.S., the Biden administration recently signed a US$1.9 trillion stimulus package into law, which includes direct payments to most Americans, and is working on a multi-trillion dollar infrastructure package while the Canadian government extended its income benefit programs into the summer. Meanwhile, the Bank of Canada and the U.S. Federal Reserve have both pledged to continue buying bonds until the economic recovery is well underway. Vaccinations have accelerated in developed countries, and after more than a year of lockdowns or partial lockdowns, we’re finally seeing light at the end of the tunnel.
Moreover, the massive response from governments, combined with the fact that populations have been restricted for quite some time, has resulted in consumers saving more than ever before. The chart below highlights an important aspect of this recession that differs from the global financial crisis of 2008: consumers are financially healthier and have a greater ability to spend. Thus, as the economies reopen and consumer confidence returns, this pent-up demand could help fuel and extend the current economic recovery and provide additional support to risk assets as a whole.
Saving rates at record highs as consumer confidence is shaking off its steep plunge
Source: Manulife Investment Management, FRED, as of March 2021; U.S consumers.
However, we do believe that asset valuations have become somewhat stretched, notwithstanding the positive recovery narrative. Thus, while we believe the current economic backdrop warrants continued exposure to riskier assets, investors shouldn’t be overly aggressive with their allocations at this time and should keep some cash and cash equivalents available to take advantage of any short-term market corrections. In short, we remain optimistically cautious on credit sentiment and nimble in our portfolio positioning.
Issues’ risk/reward profiles
Although the current macro-environment is supportive for risk assets, it goes without saying that not all investments are good investments. Only one year after one of the worst market collapses in history, financial markets have sharply rebounded, and most equity and credit products are well above their pre-pandemic levels. With so much good news — e.g., vaccine rollouts and accommodative central banks — being priced in by the markets, even industries hard hit by the pandemic have rallied significantly, and from a market perspective, it’s almost like COVID-19 never happened.
Airlines, for example, have arguably suffered the most during this crisis amid worldwide travel restrictions, yet despite massive debt still piling up on their balance sheets, inability to pay their employees without government help, and fragile cash positions, high-yield bond spreads of the air transportation subsector were at 340 basis points by the end of April 2021, similar to the year-end spreads of 2017 and 2018, and only 40 basis points above the overall U.S. high-yield index. While people are slowly returning to flying, with the load factor (a key metric that measures the percentage of seats taken) for U.S. air carriers trending higher, we’re quite far from healthy air passenger volumes, and we question whether the sector’s fundamentals justify the valuation of its bonds at the moment.
Divergence between air carriers’ valuation and their load factor
Source: Manulife Investment Management; Air Carriers' spreads, Bloomberg, as of April 30, 2021; Load factor, Macrobond, using most recently available data, as of May 20, 2021
Moreover, support from government and lenders — including wage subsidies, loan deferrals, and extensions — has helped prevent the worst for corporations, including airlines, but that support won’t last forever. Meanwhile, corporate debt issuance has surged to record levels, as companies borrowed money to either save their business or, in some instances, take advantage of the low rates to expand them. In this environment, diligent and in-depth fundamental analysis has become more important than ever before to properly differentiate good from bad debt and to assess each bond issuer’s ability to meet their payment obligations under different scenarios. As mentioned, the crux of a successful income strategy is to avoid capital losses that would offset investors’ income-generation efforts, and there’s nothing more threatening to capital preservation than a company losing control over its balance sheet. Thus, we believe that active solutions with the expertise to identify opportunities that compensate investors for the risk taken, and avoid situations where significant capital loss could occur, should be favoured over passive management.
Corporate debt jumped to new all-time highs during the COVID-19 pandemic
Source: Manulife Investment Management, FRED, using most recently available data, as of May 20, 2021; U.S. non-financial corporations
Interest rate direction
With the yield curve typically upward sloping, another option to achieve higher yield is to buy longer-term bonds. However, this strategy also increases the portfolio’s duration (that is, its sensitivity to changes in interest rates), which could be hazardous in the current low-rate environment. In fact, government yields have sharply risen since the beginning of the year, to the detriment of longer duration strategies — with Canada’s 10-year and 30-year bond yields both gaining 87 bps over the first four months of 2021.
Canada’s yield curve has significantly steepened so far in 2021
Source: Manulife Investment Management, Bloomberg.
While long-term rates have indeed become more appealing over the past few months, we believe the path of least resistance is for rates to rise somewhat from current levels and that shorter-duration strategies should still prevail over the short-term. One of the main drivers for rates is inflation (and inflation expectations), and we believe that inflation will remain above the 2% mark given the base effects, increased economic outlook, and the continued accommodative monetary and fiscal policies. However, we believe these pressures on inflation will be transitory in nature and will settle down to pre-pandemic levels as markets stabilize further.
Of note, there are income-generating asset classes that have historically outperformed long-term bonds during similar market regimes as the one we’re currently experiencing, allowing investors to boost total returns with capital gains. For example, the S&P/TSX Composite Index returned 11.6% on average during the past six rising rate periods, while the S&P/TSX Preferred Share Index also performed well, with an average total return of 6.4%.1 Although we’ve already seen a significant surge in equity and credit products from a year ago, we believe that such asset classes should hold their value, thanks mainly to the aforementioned positive economic backdrop — but again, rigorous security selection is key.
Bottom line: research, react, repeat
The low-yield environment has forced income-oriented investors to get out of their comfort zone, as a passive allocation to universe bonds may not be enough to generate sufficient income in the current market context — and may even lead to further disappointment should rates keep rising. Enhancing income can be achieved through different approaches, but the key to success is to stay nimble and avoid any unwanted risks to help preserve capital. Underlying economic conditions and market regimes can change quickly, and based on thorough credit and macroeconomic analysis, we believe you need to tactically adjust your income strategy and constantly seek out investment opportunities with appealing risk/reward characteristics.
While we acknowledge the positive economic backdrop and credit sentiment, we remain cautious — as we’re seeing economic data and financial markets return or even surpass their pre-pandemic levels — favouring thorough issuer due diligence, nimble sector allocation, and prudent duration management. We’ve indeed positioned and adapted our strategies to suit our views, but more importantly, we’re ready to react quickly to changing economic conditions as they unfold.
1 Manulife Investment Management, Bloomberg. The past six rising rate periods: Sep 2010 to Mar 2011, Jul 2012 to Dec 2013, Jan 2015 to Jun 2015, Aug 2016 to Jan 2017, Sep 2017 to Oct 2018, and Jul 2020 to Apr 2021. Monthly returns.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
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