Imagine going back to the end of 2020, the first full year of the COVID-19 pandemic. At that time, the virus was running rampant. Pfizer's first vaccine had just become available, but it would still take months before the death rate peaked in many parts of the world. Lockdowns were common, and the economy was in a recession, with unemployment reaching 9.5% in Canada. The economic environment was bleak. In times such as these, it pays to be safe and conservative with your investments.
Or does it?
The above pyramid provides a simple visual representation of the relative risk vs. reward for certain asset classes. Among the safest asset classes are government bonds. However, if you had chosen them for safety in December 2020, at the height of the pandemic, you would now find yourself (almost 3 years later) with a cumulative loss of more than -15%.
This article aims to:
- Explain what happened.
- Address why these outcomes occurred.
- Describe how we were able to avoid these losses with different fixed income approaches.
While it's difficult to compare to the dramatic market movements of 2022, 2023 has proven, thus far, to bring its own share of excitement. With North American central banks raising their short rates by roughly 5% over a 2-year period, we've seen bond markets suffering significantly. The Canadian Universe Bond Market is in the midst of its third consecutive negative year of total return; these are market moves that many investors will have never experienced in their lifetimes.
In fact, when we look historically at the significance of this move, since 1990, the total return of the Canadian bond market has never seen three consecutive years of negative returns. In fact, three consecutive years of rising yields are just as rare. It's only when we look back to the high inflation periods of the late 1970s and early 1980s that we come across three or more consecutive years of rising rates.
(Source: Bloomberg)
Since the Great Financial Crisis, fixed income investors in Canada have faced a challenging return environment with policy rates at historical lows and disappointing total returns. All of this changed in 2021 as the Bank of Canada began signalling that rates would rise to fight inflationary pressure.
Rising interest rates, without the cushion of meaningful yields, unfortunately led many fixed income investors to suffer with negative returns from what they considered to be a normally safe and reliable part of their portfolio.
Thankfully, the experience for Nicola Wealth clients, in all four of the fixed income pools, has been much more palatable. The Fixed Income Team focused on protecting client assets in the face of rising yields. They employed various strategies that, at their core, relied on building high-quality portfolios with low sensitivity to changes in interest rates. Short duration and floating rate exposures allowed for continued capital growth in the face of a historical interest rate move higher.
On a cumulative basis, the fixed income pools have outperformed the broad market by between 20.1% and 40.1%.
As we’ve moved through this year, higher policy rates have impacted inflation, slowing us from the dramatically high levels seen over the past few years. Inflation has seemingly begun its path back to more reasonable levels.
(Source: Bloomberg)
Through much of the year, the interest rate markets, and many other market participants, began to focus on a future easing (reduction) of rates, likely driven by the onset of an economic downturn or recession. The market expectations of these interest rate cuts was aggressive and had rates beginning to fall within this calendar year. Just as inflation was initially viewed as transitory, these rate increases were also viewed by many in a similar manner, and this is not what has played out in reality to this point.
In more recent days, the markets have found themselves in a state of reckoning. The U.S. Dollar has reasserted dominance globally, causing our currency (CAD) to weaken to nearly $1.37 (0.73 USD). Commodity prices are descending from their lofty levels, with oil prices now below $90. Despite the level of rates, Canada has experienced persistently high inflation, and the United States has maintained a surprisingly resilient economy. The realization that interest rates could remain higher for a longer period has started to take hold. Since the beginning of September, 10-year Government of Canada Bond yields have continued their upward trend, rising by a further 60 basis points, with the longer end of the yield curve bearing the brunt of this movement. We believe that this further increase in interest rates has caught many people by surprise.
(Source: Bloomberg)
The questions we at Nicola Wealth ask ourselves are: What will the real impact be on other risk assets if rates remain higher for longer? How long will it take for the impact of these rates to be truly felt? At what point is it prudent to increase duration and exposure to changes in interest rates?
Within the fixed income world, it has been notable how well the high-yield market has performed compared to the investment-grade market. In the face of rising default rates, this has seemed surprising to us and possibly a sign of complacency. Is this starting to change?
Equities have performed reasonably well. However, the internal dynamics of certain markets have led to a significant dispersion of returns. Only in recent days have we seen indices such as the NYSE Composite Index or S&P/TSX Composite Index dip into negative territory for the year. A small group of technology stocks, colloquially known as the Magnificent Seven (including Apple, Microsoft, and Nvidia), holds outsized weights within the S&P 500 Composite Index, with a total return of over 80% this year. This small group has had a substantial impact on the return of that index. When re-weighted equally among all firms, the total return is over 10% lower and negative for the year.
(Source: Bloomberg)
What we’re faced with currently is weakness in our equity portfolios, weakness in our bond portfolios, and a decision on how to react.
At Nicola Wealth, our portfolios have been defensively positioned throughout this year. Fixed income portfolios have maintained substantial cash positions, modest durations, and credit portfolios focused on high-quality investment-grade credit. Both our public and private fixed income portfolios are structured to navigate this uncertainty and capitalize on emerging opportunities. Equity portfolios have built up cash reserves to allow for opportunistic risk-taking when the time is right.
In recent years, cash has often been seen as a drag on portfolios due to its inability to keep pace with inflation. However, currently, it offers an attractive allocation for patiently waiting as market uncertainties surface and as we prepare for the possibility of a future recession. Our defensive posture now positions us for greater opportunities in the days to come.
Historically, fixed income has played a significant role as a portfolio diversifier, although the past decade of low yields has altered this dynamic to some extent. As yields begin to rise, our portfolios will extend their duration and enhance their sensitivity to interest rates wherever possible.
By the end of 2022, the Core Portfolio Model was 32% invested in fixed income. As of today, this allocation has increased to 37.5%, marking a significant shift. This adjustment lays the foundation for sustained, robust risk-adjusted returns in the future.
The next one to two years are fraught with uncertainty, and a recession is a very real possibility, although the timing remains unclear. Nicola Wealth's investment model has consistently delivered strong performance in challenging environments. We will continue to make prudent decisions regarding client portfolios and are confident that our current positioning positions us to outperform.
These moves in interest rates are testing the markets and cracks are starting to appear. When they truly do, we feel like we’re well positioned to take advantage of them.
Only time will reveal whether "Bondageddon" will resurface. Prolonged higher interest rates and inflation will carry significant consequences for the broader economy, affecting both markets and households. It's likely that we have not yet reached the end of this scenario, and the possibility exists that the worst is still ahead of us.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
Past performance is not indicative of future results. All investments contain risk and may gain or lose value. Returns are net of fund expenses charged to date. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. This is not a sales solicitation. This investment is intended for tax residents of Canada who are accredited investors. Residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.
