Rising interest rates have inflicted much pain on the bond market this year. But as the rate hike cycle moves closer to the end, could a generational opportunity in fixed income be emerging? Kim Parlee speaks with Anna Castro, Senior Portfolio Manager, who leads the Multi-Asset Portfolio Management at TD Asset Management.
I want to first start about-- just take a look at the chart that you've brought in, taking a look at Canada's overnight lending rate. And can we understand maybe why bonds have taken such a huge hit? Tell me what we're looking at here.
So we've had an aggressive increase in Bank of Canada's rates, mainly because the central banks have been very focused on fighting inflation, which they've seen as very sticky. And with that rapid increases we've had in the past 10 months, we have generally Canadian bonds, north US bonds down 10% this year. But we're heading into towards the end of the hiking cycle, so we don't expect this rapid increase will occur again next year.
Right. So there is a bit of light at the end of the tunnel right now in terms of the rate increases. The bright side to this story is that-- and again, you're seeing it, again-- I'll use this word-- generational opportunity right now for fixed income.
And again, we brought another chart to tell us what you're seeing. So let's bring that up. Tell me why, just a little bit, in terms-- because what basically the damage that happened, now we're going to undo it on the other side. Right?
So after a sell-off, now we look forward to a recovery or a stabilization of where rates could be. So what we have here is the long-term capital market assumptions, the long-term expected returns. So the interesting thing here, Kim, is that, at the end of 2021, the long-term expected returns from fixed income were about less than 2%.
And now, towards the end of 2022, looking out to 2023, because of what we've had in the sell-off in fixed income, we're seeing this like about 4% to 5%. And the more interesting part is on what you see on the far right-hand side, in the column, is that the increase on the higher yields has led to higher income opportunities. So you have, for a fixed income investor coming in right now, an opportunity to lock in that additional income of 2%. And this type of higher yield opportunity is not something we've seen in the last 15 years. That's why we find fixed income quite attractive at an entry point right now.
15 years is a long time to not see something like that. Right?
What about-- the one thing, the challenging thing, I think, for a lot of people is that you like the opportunity in, as we're saying, US bonds and global bonds, but not all US bonds and not all global bonds. You have to be very selective.
Yes, because we're at the beginning of an economic slowdown, and it's still uncertain how long the slowdown would be and how deep.
And that's another thing. So how do you discover what credit is safer than others, and how do you make that determination?
So at the beginning of an economic slowdown, it's very important for us to focus on quality. So our fixed income team is very much looking at the different types of business models corporations would have, and how they would do in various types of economic cycles. And the key thing is they have to have resilient sources of cash flows that they can weather an economic slowdown, no matter how deep or long, as well as be able to pay off higher interest rates. So that's the type of resilience you're looking at.
The other component is that we're looking at government debt. So they've also become more attractive in their income opportunity. But when you have an economic slowdown, there's going to be a flight to quality. And so high quality government debt from Canada and the US, because people don't think they will default. They're very strong.
And then you would have even a capital appreciation, or a capital gain, because of, when yields go down, as economic growth expectations fall, as well as inflation expectation falls, then you have here additional income in the capital gain opportunity. And I would say Canadian and US government bonds would be your recession trade. The bad news becomes good for them.
Right. Right, and that's the generational piece. It's not just the coupon, but it's the capital appreciation that goes with it.
Let's bring that chart up again, because I think it's notable. And I want it-- because there's a couple of things I want to highlight here too is that the right-hand column we have in the yellow, this is not just showing fixed income. We are talking about fixed income, but what's also notable is the equity side, Canadian equities and global equities. And the difference for them on the long-term expected return versus the '23, it's quite notable there. So this is why you are leaning a little more towards fixed income.
Yes. So we still like equities. So there's nothing wrong with them on a long-term expected return. But it's just that fixed income right now, because of the sell-off that's happening, where we are in the economic cycle, it's more interesting at this point.
With equities, well, they could be still OK longer term. Their earnings expectations has not been adjusted lower to account for a recession, and the recession could be a mild one to a longer or deeper one. And so when earnings expectations fall further, then equities could still fall in the next year. So that's why we're waiting. It's a whole different conversation on those earnings forecasts and how long they take to come down to match actually what's going on. That's a different conversation. I get asked constantly about buying GICs, constantly.
So let me ask you, is that an equivalent right now to bonds? What people are saying, why can't I just buy a GIC? So first of all, no, but however, it always depends on your own risk appetite and your own investment objective. But overall, as I've explained, fixed income right now, you have a higher coupon, more than the 4%, 5%, even for the highest quality fixed income compared to GIC. And then here, you have an opportunity wherein, if you have yields go down, prices can go up, and you can have double digit type of returns in fixed income, in the next two years, which you wouldn't have in GICs.
In GICs, you're also locked up, and you wouldn't have the flexibility to move into to sell your fixed income and move into equities, after an equity sell-off, when a recession is better priced in, in those earnings expectations. And lastly, since we haven't had an opportunity before to buy fixed income below par, right now, there's also tax efficiency in the future returns of fixed income because from capital gains, and then GICs, you wouldn't have that.
Right. That's a whole lot of good reasons right now, which talks to that generational opportunity. Doing what you do is not simple. I was just going to say, it requires active management, and this is what you do full time for people too. What do you need to effectively include bonds in your portfolio?
So first of all, in fixed income, there are so many different things. We talked about quality. There could be duration, currencies, et cetera, but that's only one component of your asset, one asset class in the portfolio.
We have a fixed income team. We have an equity team, alternatives team, and their asset allocation team's focus is really approaching-- this is almost like each asset class is a ball that you're trying to juggle, and our goal is to juggle this as you have different market conditions, risk, and opportunities. But the eye on the prize is making sure that these are all working towards a long-term goal.