Last year proved to be a strong one for fixed income funds as central banks cut interest rates as a way to promote global growth. But the COVID-19 pandemic has unexpectedly created a tailwind for fixed income markets as rates have fallen once again. Going forward, conditions are in place for solid performance.
“It [the tailwind] was decidedly unexpected,” says Dagmara Fijalkowski, head, global fixed income and currencies, at Toronto-based RBC Global Asset Management Inc. “At the turn of the year, expectations were generally for growth to improve in 2020 for most economies. Given that central bank support was already offered we were setting up for the likely scenario of coupon-like 2-3% returns for the entire year.”
Yet Fijalkowski and her team of 42 portfolio managers and analysts, located in Toronto, London and Minneapolis, were also contemplating a scenario of lower rates and higher credit spreads, should a recession be triggered by some unknown risk. “Our process involves scenario analysis with some scenarios expecting the unexpected,” says Fijalkowski, lead manager of the 5-star rated $21.3 billion RBC Bond Fund D, the largest fixed income fund in the country. In aggregate, the team oversees over $100 billion in fixed income assets “The unknown risk is known now, and it has the name, COVID-19. Analyzing these types of scenarios that some unexpected risk would bring about a recession helped us manage our portfolio in a way that limited exposure to credit, for example.”
It was not a call expecting a pandemic, Fijalkowski hastens to add. Rather it was an evaluation of the market and whether it offered some additional compensation for unknown risks. “In that case, we believed that markets didn’t do that. One could say the markets were priced for perfection, especially credit markets,” says Fijalkowski, a native of Lodz, Poland who is a 26-year industry veteran and holds a Master’s degree in economics from the University of Lodz, and a MBA from the Richard Ivey School of Business.
In 2019, RBC Bond Fund D returned 7.13%, versus 6.02% for the median fund in the Canadian Fixed Income category. Year-to-date the fund has returned 4.55% (as of May 19), compared to 4.03% for the median fund.
The fixed income landscape has seen some material shifts. For a brief period in March, Fijalkowski notes that government of Canada bonds were up 4.6% year-to-date, while Canadian corporate bonds fell 3% and high-yield bonds dropped 20%. “Only government of Canada bonds were unscathed, and even among those there was a strong preference for benchmark bonds. Other bonds, including provincials, and investment-grade bonds were in the red [in March] and non-investment-grade deeply so,” says Fijalkowski, who conducted a telephone interview from her home office.
Yet there was a turning point on March 15, when the Federal Reserve cut interest rates by 100 basis points (bps), followed by the Fed’s intention, announced on March 23, to buy corporate bonds. “Things turned around quite quickly. Spreads peaked in U.S. investment-grade bonds on March 23, European investment-grade bonds on March 24 and Canadian bonds on March 27. Risk appetite has returned cautiously since then. Corporate spreads have been narrowing and the returns in the last month, since spreads peaked, have been extremely impressive.”
Fijalkowski cautions that markets and risk appetite are ahead of the economy, which has not shown any real signs of a recovery. Even the Bank of Canada is avoiding any specific forecasts. “Our assumption is that the economy does not return to pre-COVID-19 trajectory until the end of 2021. But that does not translate into the market’s trajectory,” says Fijalkowski. “Markets have been looking through the uncertainty and are relying on the support of monetary and fiscal policies that will help companies return to normalized earnings. There is a lot of faith there.”
In making forecasts RBC does not rely on one specific scenario. “The odds of getting such a scenario wrong are too high. That could cause very adverse consequences for long-term performance,” says Fijalkowski. “Our objective is to construct a portfolio that will have a degree of resiliency in adverse scenarios and will enable us to take advantage of that adversity. Even though the Bank of Canada suggested that interest rates are at the lower bounds, we cannot take it as a given. But the normalization of interest rates by the Bank of Canada does not necessarily translate into higher yields on long-maturity bonds. A lot of assumptions have to be built into our scenarios.” The RBC team constructs a range of possible scenarios, which encompasses even low probability scenarios.
From a strategic viewpoint, at the end of February RBC Bond Fund D series was tilted to government bonds, which accounted for 55% of the portfolio. There was also 37% in corporate bonds, 3% emerging markets and 5% cash-like securities. As of April 28, corporate bonds accounted for 49% of the portfolio, plus 42% in government bonds, 7% emerging markets, and 1% cash. Non-investment grade, or high-yield corporate bonds, account for 6% of the fund, compared to less than 1.25% in late February.
Because of the fund’s large size, and the team’s interest in less-followed securities, the fund has over 900 bond holdings from 370 issuers. “In diversification, there is stability, safety and alpha,” says Fijalkowski. “If we limited the fund to a fixed number of issues, we wouldn’t be able to access some of the smaller issues that were potentially better opportunities.”
Among the top investment-grade positions are several bonds across a range of maturities issued by BCE Inc. “We view the telecommunications sector as stable, strategically important to business and to consumers.” One example is an Oct. 2022-dated bond with a 3% coupon that was yielding 1.55% (at the time of the interview). There are also deposit notes issued by leading Canadian banks such as Toronto-Dominion Bank and Royal Bank of Canada.
As for duration, the fund is currently at 8.1 years, or similar to the benchmark FTSE Canada Universe Bond Index. “At times like this, when there is so much uncertainty, especially given that we have increased our allocation to credit, we prefer to keep our duration fairly neutral. In fact, as spreads widened during March the duration did provide insurance. For this reason we are keeping duration quite close to the benchmark.”
Going forward, Fijalkowski and her team have examined various scenarios including one which shows stronger economic growth than expected. “That could be caused by massive fiscal and monetary stimulus or faster development of a COVID-19 vaccine or a broader immunity to the virus than markets appreciate now, or something completely unexpected to cause stronger growth,” says Fijalkowski. “But these would be good things to worry about. While government bond yields might go up a little bit higher, to reflect the stronger growth, we would expect that central bank bond-purchasing programs will continue and that would give growth a boost, but also keep yields fairly low.”
One of the negative scenarios includes a second wave of infections which might result in credit spreads widening out again. Yet another scenario sees all the physical distancing measures failing and the economy once again in lock-down, for far longer than before. “We assign lower probability to this last scenario,” says Fijalkowski. “These adverse scenarios are about one-third of the total outcomes, with the other two-thirds more positive and lead to tighter spreads to a smaller or larger degree over the next six to 12 months. The odds favor holding larger credit exposures at this point.”
