The pain administered to fixed income markets by central banks has been severe. Yet Derek Amery, a member of the team at Toronto-based 1832 Asset Management LP that oversees about $55 billion in fixed income assets, argues that the rate hiking cycle is approaching the end. Indeed, Amery maintains that prospects look far better in 2023.
“The simple answer is yes, we are nearing the end,” says Amery, vice-president and senior portfolio manager, who oversees the 4-star silver-rated $167.2 million Dynamic Advantage Bond Series F. “After the most aggressive period of monetary tightening since the early 1980s during the Volcker era, we are likely to see from this point forward, cumulative rate hikes of 450 basis points. Clearly, we are getting closer to the end as policy rates are nearing levels that central banks have given guidance to what the terminal rate of policy rates will likely be. So: ‘Yes, we are approaching the end of the rate hiking cycle and we are getting to the point where we will see a winding down of additional hikes from this point forward.’ You have already seen that here in Canada,” says Amery, adding that we will see the same at the Federal Reserve’s meeting this week [week of Dec 12].
A Percent of Pain Likely Remains
Despite the optimism, Amery cautions that we are not quite at the end of the tightening. “My expectations are that the Fed will raise rates by 50 basis points at their December meeting and then an additional 50-to-75 basis points at subsequent meetings. This would take the terminal rate to around 5%,” says Amery, a 28-year industry veteran who joined 1832 Asset Management in 2019, after lengthy stints at HSBC Asset Management and TAL Global Asset Management. “Similarly, we are likely to see another 50 to 75 basis point hike from the Bank of Canada, which would take the overnight rate to around 4.5%. While most of the heavy lifting has been done, I’d say that we are nearing the end of the tightening cycle. The question is, how long will central banks keep their policy rates at these high levels? That’s a key question for market direction going forward.”
Amery notes that over the summer the fixed income market got ahead of itself and rallied as it priced in an optimistic scenario of the rate hikes ending soon. “People asked, when will we see a pivot in rate policy, going from rate hikes to rate cuts? We’ve seen some occasions when the market got ahead of where central banks were guiding. But central banks have repeatedly pushed back against what markets have started to discount,” says Amery, who earned an MA in economics from Dalhousie University in 1992, and a BA in economics from Queen’s University in 1991.
Market Expects Relief Mid-Next Year
“If you look at what the market is expecting from the Federal Reserve it is saying the terminal rate will be 5%. I’d agree with that. Where the market is getting ahead of itself is the potential for interest rate cuts in the second half of next year. At the moment, the market is looking for about 50 basis points in rate cuts in the latter part of 2023 and early 2024. It could happen. But it’s a little aggressive compared to what the Fed has said,” observes Amery, who works alongside Dominic Bellissimo, vice president and portfolio manager. “When the Fed meets in mid-December, they will provide us with guidance as to what their expectations are for how they see policy rates will evolve over the next few years.”
While Amery is reluctant to make any forecasts on where interest rates will be in 2023, he does admit that he is more constructive on investment opportunities and the Dynamic Advantage Bond Series F is more or less fully-invested. “My level of confidence in the bond market is a lot higher than it was in that June-July period. We had less interest-rate risk in the fund for the first six to seven months of the year. Over the last couple of months, we have been systematically adding interest rate risk back to the portfolio as we have seen market valuation re-price to something that is more in line with a fair value concept.”
To put it another way, the market was expecting the Fed funds rate to reach 3.5%, but his team did not believe there was a lot of value at that level and the market’s expectations were overly optimistic. “As yields moved higher over the fall, expectations for the terminal rate in the U.S. reached 5% and bellwether 10-year US treasury yields reached closer to 4%, that was the catalyst for our team to be more constructive on the market. “We are going through a period where the market is going from being concerned about how high policy rates will get, to being more constructive about the fact we are getting closer to peak policy rates. That’s been the driver in rates that we have seen over the last six to eight weeks. That enthusiasm that we are getting closer to the end of the rate hikes could be a tailwind for the bond market. But as we move through 2023, we are likely to see if not an outright recession then a notable slow-down in economic activity. That should also be constructive for the bond market. Those are the two drivers for what should be better performance in the fixed income space in 2023.”
Year-to-date (Dec. 8) Dynamic Advantage Bond Series F has returned -8.90%, versus -8.84% for the Canadian Fixed Income category. However, over longer periods the fund has outperformed. Over the last five and 10 years, the fund returned an annualized 1.0% and 1.59%, while the category returned an annualized 0.39% and 1.39% respectively.
Better Risk-Reward in Diversified Income
The fund is a somewhat different species from other Canadian fixed income funds as it uses a diversified approach to asset allocation. “Being able to complement that core Canadian fixed income foundation of the fund with a broader set of fixed income exposures provides a more diversified portfolio and a better risk-reward profile,” says Amery, noting the fund’s benchmark is a blend of 65% Canadian bonds, 20% U.S. high yield bonds, and 15% inflation-linked real return bonds. “Historically, that has been proven out with how our blended benchmark has performed versus the more generic Canadian universe bond index that is the benchmark for most funds in this category.”
From a structural perspective, Amery seeks to diversify further by accessing different parts of the market than many conventional bond funds. For example, it also holds prime Canadian residential mortgages, as well as U.S. floating rate asset-backed securities. “We try to broaden the opportunity set in the portfolio to provide unit-holders with a broader set of exposures than what you get in a typical investment-grade type of mandate.”
The fund uses a fund-of-fund approach since about 27% of the portfolio is invested in 1832 AM Investment Grade Canadian Corporate Bond Pool Series I, plus 15% in Dynamic High Yield Bond Series O. There are smaller holdings in Scotia Mortgage Income Fund Series I as well as individual bonds such as Government of Canada 1.5% maturing in Dec. 2044 Real Return Bond and U.S. Treasury 2% maturing in August 2051. “We are at the lower end of the ranges for investment grade and high yield bonds,” says Amery. “The benchmark weighting for high yield is 20%. We are at 15%, so we are a little more defensively positioned with our credit quality in the portfolio and running the fund on a tactical basis at the moment. The 27% held in investment-grade corporate bonds would be at the lower end of the range. We’re still a little bit cautious on the credit front. If we don’t see an outright recession, then we are likely to see deterioration in the macroeconomic environment next year. Based on that fundamental backdrop, it’s prudent to be somewhat cautious on your corporate weights.”
From a currency perspective, about 75% of the fund is in Canadian dollar investments, plus 20% in U.S. dollar investments, and 5% in non-North American currencies. However, the foreign exposure is 100% hedged back to the Canadian dollar. The fund’s duration is slightly under eight years and in line with the blended benchmark. The fund has a running yield of 4.3% before fees.
Bonds Will Be Back
Valuations reflect the weakening economy, Amery adds, and investors are compensated for a less constructive economic backdrop. “We are a little cautious on the outlook for the credit segment of the fixed income market. But we are certainly more constructive on the bond market as a whole than we have been for some time.” Indeed, he points to tailwinds in the form of peaking inflation, a peak in policy rates and weakening economies that, when combined, spell for a more positive investment environment compared to the last 12 months. “The outlook is much more positive as we look towards 2023. Yields are much more attractive--when you look at them in a historical context. Income is back in fixed income.”
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