Fixed-income roundtable: Part 1

 Brian Miron, portfolio manager in the fixed-income division of Fidelity Management & Research Co., the investment arm of Fidelity Investments. Based in Merrimack, N.H., Miron's wide-ranging mandates include Fidelity Canadian Bond, Fidelity Corporate Bond and Fidelity Tactical Fixed Income. He is co-manager of the fixed-income component of asset allocation and short-term bond funds. In all, Miron is directly responsible for assets of $16 billion.

 Steve Locke, team lead of the Mackenzie Sentinel funds at Mackenzie Investments, currently manages more than $14 billion in fixed-income mandates for four Mackenzie fund families -- Sentinel, Saxon, Maxxum and Universal. His funds include Mackenzie Sentinel Bond   and the fixed-income components of Mackenzie Sentinel Income   and Mackenzie Sentinel Strategic Income  .

They spoke with Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday Sept. 19 and concludes on Friday Sept. 21.

Q: Why have Canadian bond yields reached historic lows in 2012?

McHugh: It's a reflection of a flow of money to relatively higher-quality safe-haven states from less stable sovereign states. There's a global lack of confidence in allocating capital to some parts of the world. There's an emphasis on return on capital, protection of capital. The real yield, the nominal interest rate adjusted for the inflation rate, on Government of Canada 10-year bonds is effectively zero. There's a negative real rate of interest on the shorter end of the curve. This reflects some material dislocations within global capital markets.

Brian Miron and Michael McHugh

Miron: Interest rates tend to have a strong relationship to economic growth and the rate of inflation. Over the past 10 to 15 years, economic growth has been propped up by leverage. It has essentially been built up on a house of cards. We are now in a global deleveraging mode. This is curtailing real economic growth. To Michael's point, there is a lot of uncertainty out there.

There is a spill-over effect of this deleveraging process. It has hurt consumers. Several countries around the world are facing a banking crisis. It has also spilled over into a sovereign debt crisis in many parts of the world.

Other governments that are not facing a crisis per se have seen their leverage go up sharply. The United States is a case in point.

Canada has been a huge beneficiary of the flow of funds seeking safe havens. Over the past five years, there has been something like $300 billion flowing into the Canadian bond market. The federal government has issued a lot of new debt and so have provincial governments and corporations. It has been readily absorbed by domestic investors and by foreign investors.

The federal government has a credible plan to eliminate its deficit in the next year or so. Five provincial governments are talking about balanced budgets next year.

McHugh: We are now in a deleveraging environment, but it's a long-term undertaking. Yields are a lot lower now than they were in 2008. The central banks have tried to orchestrate this.

Locke: There have been multiple rounds of quantitative easing (injection of liquidity into the system) by central banks around the world, most notably the U.S. Federal Reserve Board. This central-bank easing has been a contributor to the low-yield environment globally. After the global financial crisis, the Federal Reserve's first round of quantitative easing was large scale, followed by a program about half as large. This process expanded the assets of the Federal Reserve significantly to about US$3 trillion.

Steve Locke

To promote the low interest-rate environment, the U.S. Federal Reserve has had a heavy hand in keeping control of the yield curve and keeping yields down. If the market dealt with rates on its own, it's likely that yields would move a little higher. When there's a threat that this accommodative monetary policy will change, there's an immediate action in the bond market with yields moving up by 50 to 75 basis points.

The deleveraging process is in its infancy. Household debt in the United States has come down, the financial system has been stricter in granting loans and is deleveraging, but governments and the public sector in general have been leveraging up. The total debt has not moved significantly.

McHugh: Five years into the deleveraging process, aggregate debt levels are still rising.

Locke: One of the reasons for this is that the market has not exercised any discipline against the public sector in the United States. This is because there has been this flight to quality that we've talked about.

McHugh: The United States and some other countries have been given a free pass. If you extrapolate U.S. fiscal deficits indefinitely, there will be a point of investor hesitation. We're not there yet. But the need to reduce fiscal deficits causes a contraction of government spending and contributes to slower economic growth. Looking out five, 10 years, maybe even 20 years, the industrialized countries are likely to have relatively low nominal economic growth.

Miron: Real economic growth at 1% to 2% per annum?

McHugh: Yes in industrialized countries. There will be low inflation levels with the possible risk of deflation.

Michael McHugh

Miron: Numerous central banks are committed to avoiding this. Part of the reason that you have quantitative easing is to thwart the low-inflation environment turning into deflation.

The Bank of Canada's mandate is to have inflation in the 1% to 3% range, centred around 2%. The U.S. Fed doesn't have an explicit inflation mandate. The market has taken it to be about 2% inflation. Europe also has an inflation target of about 2%.

Locke: On the fiscal side, there is a need to reduce deficits and debt burdens at the public sector level in the developed markets. It's a five- to 10-year process to be sure. There will be less entitlement spending by governments on their citizens. In turn, individual savings rates will be higher as people will need to provide for their own future. As a result, interest rates are likely to remain low, as there will be savings available to keep rates low for some time.

Shorter term, as discussed, the flight to quality has had its impact on Canadian rates. In July 2011, Government of Canada 10-year yields were 3% and we're now at 1.75%.

Miron: There are 10 or 11 countries with even lower rates of interest.

Locke: The German 10-year bond hit 1.2% this summer. That was when the U.S. government 10-year bond was around 1.4%. Germany has been receiving capital inflows as a safe haven within Europe.

McHugh: These low interest rates, while positive for borrowers, are punitive to savers, who at the same time are facing the possibility of lower government benefits. Most people have under-saved.

Q: The bottom line?

Locke: Interest rates are likely to stay in the very low range that we have experienced over the past few years, well into the foreseeable future. When we look out five or 10 years, we should expect to see a low set of government yields. If some of the shorter-term concerns abate, such as those surrounding Europe's problems, there could be a slightly higher range of interest rates in North America. There would be a reversal of this capital inflow. But this will be a gradual process.

Photos: paullawrencephotography.com