Robert Pemberton, managing director and head of fixed income at TD Asset Management, says that the unexpected result of the United Kingdom's referendum on its membership in the European Union has triggered a flight to quality in the global bond market.
"The June 23 vote by Britain (known as Brexit) to leave the European Union," says Pemberton, "has substantially increased the already high percentage of sovereign bonds in the developed world that have negative nominal yields, indicating the extent of the flow of funds into this market."
Before this vote, US$8.2 trillion in developed-world sovereign bonds, representing 32% of this total market, had negative nominal yields, Pemberton says. "Over the first two days following the Brexit vote, that number swelled to US$9.4 trillion, or 38% of the global sovereign-debt market."
In all, yields across the developed sovereign-bond market, which consists of some 16 countries, have declined substantially in the aftermath of the UK vote, "as investors globally have been seeking safe-haven securities."
At a recent reading, for example, the yield on 10-year UK gilts had declined to 95 basis points from 137 basis points before the Leave vote. (100 basis points equals 1%.) The 10-year German Bund declined to minus 10 basis points, from a positive nine basis points prior to Brexit. France's 10-year bond yield declined to 28 basis points from 45 basis points.
In the U.S., 10-year Treasury yields fell to 144 basis points from 175 basis points, and 10-year Government of Canada bonds were 110 basis points versus 128 points before the UK vote. "These declines are significant given the enormous size of this sovereign-bond market," says Pemberton.
The uncertainty surrounding the fallout of Brexit, coupled with persistently slow global economic growth, means that central banks worldwide, including the Bank of Canada, are likely to continue to have accommodative monetary policies, Pemberton says. The U.S. Federal Reserve Board, which is attempting to raise its policy rate, is being hampered in this "by threats to already weak global economic growth." Last December, the Fed raised its target range for the federal funds rate from 0.25% to 0.50%. "It is difficult to argue that this move, the first since before the global financial crisis, changed the Fed's accommodative stance," says Pemberton. "In my opinion, this will be the loosest Fed tightening cycle in history."
In the light of this, he says, interest rates are likely to remain lower for longer than many investors anticipate.
Looking ahead, Pemberton cautions that the equity-like returns that sovereign fixed-income securities have provided investors over the past 35 years, with significantly less volatility than equities, "are less likely to persist."
He notes that interest rates are at historic lows, and any further significant decline in them, necessary to generate strong capital gains, would reflect a serious deterioration in the global economy combined with significant deflation. "While the new norm for global economic growth, at 2% per annum, is far from robust and below potential, it is still in positive territory."
At TDAM, Pemberton and his fixed-income team are responsible for both active and passive fixed-income portfolios, as well as managing money-market portfolios. Fixed- income assets under management are $161.3 billion.
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The team's disciplined approach includes a thorough assessment of the macro economy and the bond-market outlook. Its comprehensive process includes an analysis of the yield curve for different issuers as well as "in-depth, independent fundamental research" into the credit health of individual corporate and sovereign borrowers. "This helps us to identify and take advantage of dislocations in the pricing of different issuers along the maturity spectrum," says Pemberton. "Our goal is to enhance income and protect capital."
The Brexit vote's impact on the financial markets is providing some investment opportunities, he says. "The outcome was a surprise to the markets and they have overreacted, as is their tendency." The TDAM fixed-income team is investigating a number of prospects that have emerged in areas such as the investment-grade corporate and high-yield markets. "This is the benefit of having a team of more than 60 fixed-income professionals and in-depth research."
Included in Pemberton's wide-ranging fixed-income mandates are two flagship Canadian funds: TD Canadian Bond with assets of $15.2 billion and TD Canadian Core Plus Bond with $12.3 billion. Both funds are benchmarked against the FTSE Canada Universe Bond Index, which covers investment-grade debt, defined as securities with a BBB credit rating or higher.
TD Canadian Bond focuses on Canadian investment-grade securities, whereas TD Canadian Core Plus has a broader opportunity set, says Pemberton. Up to 30% of the Core Plus portfolio can be invested in foreign securities with up to 25% in high-yield securities, defined as those that are below investment grade or are unrated.
The overall duration of both TD funds is "market neutral" at around 7.5 years, meaning that it is similar to the overall duration of the index. (Duration, expressed as a number of years, is a measure of the sensitivity of the price of a fixed-income security to a change in interest rates.)
But the portfolios' positioning along the yield curve differs from the benchmark, says Pemberton. "This reflects the better relative compensation at different maturities along the curve in respect of the different issuers."
In the case of corporate issuers, the portfolios are overweight in bonds with maturities of seven years and under. With federal and provincial government issuers, the overweight is at the long end of the curve, with the emphasis on securities with maturities of more than 20 years. "In general, currently, corporate-bond maturities are at the shorter end of the yield curve, while provincial and government bond maturities are at the longer end of the curve."
There are also significant differences in issuer weightings in both funds versus their weightings in the benchmark index. The two funds are overweight in corporate debt and underweight in both federal and provincial government fixed-income securities. "This corporate overweight enhances the income of the portfolios."
At present, TD Canadian Bond holds 59% in corporate securities, a considerable overweight relative to the benchmark's 28%. The fund has 20% in provincial securities, which are roughly one-third of the index, and 19% in federal government securities (some 36% of the index). Cash represents around 2%. (There is a small weighting in municipal issuers in the benchmark.)
Pemberton notes that within the corporate weighting, the fund is overweight in the financial services sector, the biggest single corporate weighting in the index. "The balance sheets of Canadian financial institutions have improved markedly since the global financial crisis, and the compensation for investing in these high-quality debt securities is appropriate." The portfolio is "modestly" overweight in energy issuers, for the most part pipelines and energy-infrastructure companies.
TD Canadian Core Plus is managed on a "holistic" basis. "This provides a fully integrated portfolio for investors, allowing for the opportunity to take advantage of an expanded investment set," says Pemberton.
The Core Plus portfolio has 60% in corporate bonds, with 9% of the portfolio in U.S. high-yield securities. The total foreign content is currently 14%. This weighting in high-yield securities is the lowest it has been for some time. "We are concentrating on those securities in the single-B and double-B area; this is the sweet spot," says Pemberton. "They are higher-quality within this category, and offer appropriate liquidity and attractive yield pick-up."
In summary, he says that fixed-income securities should remain a significant portion of many investors' portfolios. "The portfolio diversification and capital preservation benefits offered by bonds, along with the liquidity and volatility reduction they can provide, make them a key to those investors' long-term investment goals."
