By Guest Blogger Ryan Lewenza
.
With the pandemic-induced global recession, interest rates around the world have plumbed to new all-time lows, putting even more stress on investors who need the income to fund their spending and retirement. Sure it’s great for millennials who can borrow money hand over fist at stupid low interest rates, but on the flip side, it hurts investors who depend on the interest income from these investments. As I sometimes (crassly) say to clients, “central banks are screwing retirees with these record low rates!” So today I review the fixed income landscape and discuss how we’re structuring client portfolios in this low rate environment.
With the Federal Reserve (Fed) and the Bank of Canada (BoC) cutting interest rates in response to the global recession, the Fed funds rate and the BoC Overnight Rate currently sit at just 0.25%. This matches the all-time lows hit back in 2008/09.
As central banks slashed their benchmark rates, this has brought down interest rates across all bond types and GICs. Currently, 10-year government bond yields – the most important bond yield to focus on – are below 1% in Canada and the US. Looking at the broader FTSE Canadian All Government Bond Index, which includes all the different maturities, yields just 2.07%. The similar FTSE Canadian All Corporate Bond Index yields 2.76%.
I reviewed our firm’s GIC list and GICs with a 3-year maturity range from 0.6% from most banks to 1.3% from the higher risk trust companies. And you’re locked in with GICs so I see little reason to invest in them right now.
If we look at higher risk bonds, Canadian and US high-yield bond indices yield 4.53% and 4.98%, respectively. While this looks attractive on the surface, it’s important to stress that these high-yield bonds can fall hard during recessions, which is exactly what happened in March. Thankfully we got out of these early last year.
So from high-quality fixed income investments, you’re looking at roughly 0.5% to 2.7% depending on the maturity and quality of the issuer. For further context, I used to trade bonds and fixed income some years back and I could easily find high-quality bonds yielding 4-5%. Boy how things have changed!
Current Yields on Various Investments
Source: Bloomberg, Turner Investments
So how do we position portfolios in this low rate environment?
First, we have a low government bond weight given their puny yields and in fact, we’ve lowered our exposure to these bonds in recent months.
Second, we prefer high-quality corporate bonds or ‘investment-grade’ corps. We prefer investment-grade corporate bonds as we get a decent yield ‘pick up’ and I see them outperforming government bonds next year.
I capture this in the chart below, which measures ‘credit spreads’ for US corporate bonds. A ‘credit spread’ is simply the additional yield of corporate bonds over government bonds of a similar maturity. Currently, credit spreads for US corporate bonds (BAAs) is 225 basis points (bps), which means the average corporate bond yields 2.25% higher than the US 10-year government bond yield. With a historical spread average of 200 bps, this suggests there is some value in US corporate bonds, which is a key reason why we prefer this area. Keep it simple. We prefer corporate bonds yielding around 2.5-2.75% to government bonds, many of which yield below 2%.
US Credit Spreads
Source: Bloomberg, Turner Investments
Third, in the downturn we changed our tune and added back some high-yield bonds, after selling them last year. Specifically, we’ve been adding bank loans to client portfolios, which are loans made from banks to small and medium-sized companies. We decided to add these to client portfolios since: 1) bank loans yield an attractive 5-6%; 2) bank loans are, on average, trading at 90 cents on the dollar, so as the economy recovers these bank loans should increase in value back to par; and 3) bank loans are floating rate loans so when central banks reverse course and start hiking rates, we’ll get paid more interest on these investments. We’re already up nicely on this investment and I see more gains coming in 2021.
Lastly, we continue to recommend preferred shares to our clients and see them continuing to recover in the coming year. As seen in the table above, the Canadian preferred share index currently yields 4.9%, which is well above government bonds yielding below 2%. And these pay dividends so on an interest-equivalent basis, this is closer to 7%. But it’s not just the yield that we like.
I see two key positives for the Canadian preferred share market over the next few years. First, I see government bond yields slowly moving higher as the economy recovers and inflation picks up. The key government bond yield for the Canadian pref market is the Government of Canada (GoC) 5-year bond yield and that currently sits at just 0.5%. As illustrated below, the Canadian pref market is highly correlated with the GoC 5-year yield, so when this starts to rise over the next 1-2 years (and it will), the pref market should rise along with it.
Second, some of the Canadian banks have started to issue a new type of debt instrument called a ‘limited recourse capital note’ or LCRN, to shore up their balance sheets. For example, Royal Bank issued $1.75 billion of these notes during the summer. With these new proceeds the banks are then turning around and redeeming some of their outstanding preferred shares, as preferred share dividends are more expensive than bond interest for the banks. So as the banks redeem more and more of their outstanding preferred shares it reduces supply and in Econ 101 we learned that less supply generally means higher prices. The combination of more pref redemptions and higher government bond yields in the coming years, should boost preferred share prices.
Canadian Prefs and the GoC 5-Year Yield
Source: Bloomberg, Turner Investments
So there you have it. In this low interest rate environment there are still opportunities out there, you just need to know where to look. We’ve positioned our client’s fixed income portfolios with more investment-grade corporate bonds, bank loans, and preferred shares. The corporate bonds provide stable income and help protect against deflation, while the bank loans and the preferred shares provide higher yields and a hedge to rising inflation and interest rates. There’s that balance again!
Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.