David Lafferty, chief market strategist at Natixis Global Asset Management, says tighter monetary policies have not affected the performance of investors' bond portfolios -- but they have made the ride rougher.
"The U.S. Federal Reserve has actually done very little" in terms of interest rates, says Lafferty, who joined Natixis in 2004 after covering fixed-income and asset allocation products for State Street Research. "They've only moved a quarter of a point. They appear to be on hold, at least for the next three to six months. We don't expect another tightening until at least June, maybe even September. But all the discussion about when and how quickly they're going to move has created a ton of volatility in the interest rate market."
The bear market of early 2016 has pushed central banks worldwide to lower interest rates further in the hopes of creating economic stimulus. The Bank of Japan (BOJ) and the European Central Bank (ECB) made headlines by entering negative territory; however, Lafferty believes that's only the beginning.
"I would put the BOJ and the ECB as likely to do more stimulus," Lafferty says. "It isn't clear that they'll get more out of it, but they're still putting downward pressure on rates. The U.S. is in a different situation: Rates are going to remain low for a while, but the bias is upward. We're already at a level that would imply tighter monetary policy, if you just look at the employment side. We're waiting for the inflation side of that equation to come in."
In contrast, the Bank of Canada is focusing more on commodity prices before determining its next move, says Lafferty. "One of the things that the Bank of Canada will be looking to do is take the lead from where the price of oil goes and where that drives the economy," he says. "If oil starts to stabilize and even go back up, it might be that the Bank of Canada doesn't need to ease anymore."
In the thick of volatility created by questions over what central banks will do next, Lafferty says fixed-income investors have a big choice of their own to make: Should they take on more credit risk, or more interest rate risk? In the United States, Natixis has offered bond funds with varying degrees of both types of risk since 1995. Their approach became available to Canadian investors in September 2015 with the launch of Loomis Sayles Strategic Monthly Income.
"The delineation between interest rate risk and credit risk is almost as wide as it's ever been," says Lafferty, who graduated from Suffolk University with a master's degree in finance. "By lowering interest rates, and because spreads have widened, central banks have made that decision all the more stark. It's not just whether you're in bonds, or how much you're in bonds, but which side of the bond market you're going to emphasize."
Lafferty and his team find more value on the credit side of the market, which includes investment-grade credit, high-yield bonds, bank loans and convertibles.
"What we own in high-quality paper, we mostly hold for its liquidity," he says. "The bond market is not all that liquid anymore. Because you want to maintain some liquidity in the portfolio, you do need some ballast. But we're trying to minimize the exposure there. In the long run, you get paid for credit risk. Credit portfolios, almost by definition, will outperform higher-quality portfolios, simply because of the yield."
Lafferty says low interest rates are pushing retail fixed-income investors toward credit risk, especially those looking for reliable retirement income.
"If you use the standard 4% rule of thumb,” he says, referring to a commonly accepted retirement withdrawal rate, “it's almost impossible to get 4% in the sovereign bond market today. Almost US$7 trillion of the global sovereign bond market has a negative yield at this point, and most of the rest is yielding less than 2%. If you need anywhere from 3.5% to 5.5% to make your retirement goals, you've almost been forced into the credit side of the market."
Another important factor for the individual investor is the role of fixed-income products in their overall portfolio, Lafferty says.
"If you think of fixed income as a diversifier to your equity exposure, then you need to be higher quality. Your fixed income then becomes the so-called ballast in your portfolio, and you'll want to de-emphasize credit risk a little bit. If you think about your bond portfolio as having to drive total return in a low interest rate environment, if you're a 60/40 investor, you can't just let 40% of your portfolio do nothing. Sometimes the credit side makes more sense."
