It is likely that the worst is over in fixed income markets, says Tom O'Gorman, senior vice-president and director of fixed income at Calgary-based Franklin Bissett Investment Management. And while investors have experienced weak or negative returns for the last year, they should also take a longer-term view and bear in mind that fixed income plays a critical role in one's portfolio because it is negatively correlated with equities.
"By evidence that the worst may be over you can look at the U.S. 10-year bond yield. It peaked at 3.1% in mid-May and has been trading between 2.8% and 3% since. In Canada, the 10-year bond peaked at 2.5% and has been trading between 2.1% and 2.4% since then," says O'Gorman, lead manager of the 5-star $1.8-billion Franklin Bissett Core Plus Bond.
"But the bigger issue to us is that inflation is rising, but the expectations for inflation are still pretty muted," says O'Gorman, a 30-year industry veteran who joined Franklin Bissett in June 2010. "We are not seeing a lot of the 'pass-through' from inflation to broader cost pressures in the economy where workers demand wage increases and companies have to pass on the costs."
There is no doubt, however, that sentiment in the bond market is about "as negative as it can be," says O'Gorman, a native of Verona, NJ who earned an MBA from Rutgers University in 1994 and currently oversees about $6 billion in fixed income assets. "We have been at a record level of short positions on the U.S. 10-year bond. If you combine that fact with the impact of demographics and technological change, and the U.S. tax cuts which are about as bullish as can be, it seems that the worst [in the bond market] is likely over."
O'Gorman does concede he could be wrong as far as inflation is concerned if the market believes that central banks are behind the curve, rather than in front of it. "We believe they are ahead of the curve," he says, adding that the Federal Reserve has stated it is not finished with tightening measures, even into 2019.
"Every recession in the past in the U.S. has been caused by the Fed going too far. The yield curve is likely to continue its flattening trend, which sets up the likelihood that the curve will invert," says O'Gorman, referring to the phenomenon where interest rates at the short end are higher than those at the long end. "Yes, the front end will have pain, because the Fed will raise rates. But further out on the curve we don't see longer rates moving much higher for any sustained period. Every time the Fed has done this, they have broken something, and you get the risk-off mentality. Eventually the Fed has to reverse course and provide stimulus at the front end and the market rallies. It plays out like this every time."
O'Gorman argues that the Bank of Canada is unlikely to match the Fed's moves because we face a slew of head-winds in the form of uncertainty about the re-negotiated North American Free Trade Agreement, escalating trade wars with the U.S., a strong domestic housing market and over-leveraged consumers.
Despite the upward move in rates, O'Gorman maintains that fixed income remains attractive, although his preference is for corporate bonds, or credit, as it's also known. "We don't like government bonds per se, because they have the least cushion in terms of yield and we are still at pretty low yields. We do like corporate credits because they are decent value," says O'Gorman. "When we look at credits, we think about the fundamentals, the valuations and the technical supply and demand back-drop. Spreads have moved wider, but not wide enough to say they are pound-the-table-cheap."
Corporate spreads are about 100 to 120 basis points over comparable-duration government bonds. Yet O'Gorman remains cautious, as reflected by the number of hedges in place to protect the portfolio should volatility suddenly flare up. In terms of duration, O'Gorman is being moderately cautious as the portfolio is about a half-year lower than the benchmark FTSE/TMX Universe Bond Index, which is 7.5 years.
O'Gorman is known for making tactical shifts, and in late 2015 adopted an aggressive posture, loading up the portfolio with beaten-up energy producers impacted by the crude oil collapse. At the same time, government bond yields kept sinking lower and lower. "Credit was super-cheap back then," recalls O'Gorman. "We asked ourselves, 'What percentage of that all-in yield came from the spread versus the underlying benchmark government bond yield?' In June 2016, the spread as a percentage of yield was at its all-time high -- and even cheaper than during the 2008-09 financial crisis."
Since 2016, O'Gorman gradually reduced the energy exposure and in 2017 became more defensive and continued that strategy into 2018. "We took the component allocated to corporate bonds, whether investment-grade or high-yield bonds, and moved up in quality. We had a little less in corporate loans and high-yield and more BBB-rated and A-rated bonds. At the same time, we put on our hedges."
From an asset allocation viewpoint, the fund is currently split roughly into two halves. The first half consists of corporate bonds, which are a mix of Canadian investment-grade bonds, Canadian and U.S. high-yield bonds and bank loans. The second half consists of a mix of Canadian provincial and municipal bonds and a tiny weighting in Government of Canada bonds. On a geographic basis about 20% is in bonds outside the Canadian benchmark, which accounts for the "Plus" in the fund's name. Of this allocation, about 8% of the fund is in U.S. investment-grade bonds, 5% is held in high-yield, and 5% in bank loans.
From a currency perspective, O'Gorman is favouring the US-dollar, and currently about 8% of the US-dollar exposure is unhedged. Highly diversified, the portfolio has over 300 issues from more than 100 corporate and government issuers.
Going forward, O'Gorman counsels patience for investors who are frustrated that bond funds are modestly up or flat. Franklin Bissett Core Plus Bond Fund Series F returned 1.4% for the 12 months ended Aug. 1, compared to the Canadian Fixed Income category which averaged 0.34%.
Taking a longer view is critical, just as it applies to other asset classes. "We view our investment process over rolling four-year periods," says O'Gorman. "Anytime fixed income has had a sharp drawdown, because interest rates have popped higher, the asset class bounces back. If you go back to 1994 or 2001 or 2013, you will always see that a negative period is followed by a very positive one. In 2014, after the so-called taper tantrum, bond funds saw a higher bounce back."
Investors should bear in mind that fixed income will never produce continuous negative periods. "Canadian and U.S. fixed income never lost money on rolling four-year periods," says O'Gorman.
The key is that fixed income is the only true negatively-correlated asset class to equities, O'Gorman notes. "If equities are at all-time highs, and the news is quite good, you may need fixed income now more than ever," O'Gorman argues. "When that volatility finally does return -- as the Fed is doing quantitative tightening -- I would argue that now is not the time to be thinking of getting out of fixed income. It is a true hedge against the volatility of other risk asset classes."
