The past year was generally a tough one for fixed income. And the combination of historically low interest rates and inflation that we explored in the first two instalments in this series could point towards even more elevated bond-market volatility in the months and years to come—especially if, as market-watchers expect, central banks rein in their loose monetary policies of the past two years.
You may think of volatility as something bonds were meant to protect your portfolio from. But it can also be thought of as an opportunity for active managers to add value to fixed income holdings.
After expanding early in the pandemic, yield spreads—the range of yields from the shortest to longest terms and safest to riskiest investments—have generally compressed again to the levels similar to those of two years ago. This has resulted in a relative mispricing of different segments of the bond markets, in our view, that a flexible management team like that at Nicola Wealth can take advantage of to generate additional return over time for our clients. With a flexible approach, we can ensure your fixed income allocation continues to aim to provide diversification and incremental income to your overall portfolio.
One strategy we use is to tilt the balance of holdings towards high-quality corporate bonds that offer higher income than government bonds and therefore have more capacity to absorb further interest-rate changes should they occur without major price swings. We consider these bonds a “bend but won’t break” investment, with a less risk of default, whatever may happen in the macroeconomic environment. We share the view expressed by RBC Wealth Management in its recent 2022 outlook that investment-grade corporates will remain a sweet spot in the market in the coming year.
Nicola Wealth’s confidence in this trade is such that we expect to make use of leverage to increase our corporate bond holdings, especially banks, which should enhance returns. (This is where today’s low interest rates can actually come in handy, allowing us to finance further bond purchases at a lower cost.) At the same time, we can hedge some of our duration risk – reducing volatility in the portfolio when interest rates rise.
In general, any increase in interest rates, bond price volatility and a widening of credit spreads will serve to create new opportunities for tactical moves to increase or decrease exposure to assets we consider to be mispriced or set for a shift. In this way we can add returns that yields and index-hugging bond portfolios are generally not providing.
With our active strategy, bonds can still play their role as ballast for your portfolio – aiming to provide stable returns, adding diversification, and allowing for upside opportunities as they arise.
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. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.