The Bond Market in 2023 with Mark Wisniewski

December 2022

After back-to-back negative years for fixed income, we learn why Ninepoint's bond fund manager Mark Wisniewski believes 2023 will be a turn-around year for the sector.

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

Michael Hainsworth:

Bond investors have never seen a market environment like this. For the first time since the 1970s, we're in double digit losses. We haven't had back-to-back negative years, and before 2022, the worst year ever was a 3.3% decline. And that was when Ace of Base's I Saw the Sign was the top song of 1994. What signs are we seeing going into 2023 that will help fix income investors and their managers? For perspective, we turn to Mark Wisniewski, overseeing the firm's fixed income team and investment strategies as partner and senior portfolio manager at Ninepoint Partners. Mark, hello.

Mark Wisniewski:

How are you doing?

Michael Hainsworth:

Well, maybe I should be asking you that question. Have you ever seen a year as bad as 2022 for bonds?

Mark Wisniewski:

No. What we keep saying to clients, it's been a perfect storm.

Michael Hainsworth:

A perfect storm is described as three things coming together at once. What are those three things to you?

Mark Wisniewski:

I think we got to go back in history to basically understand where we are today. And coming out of the financial crisis, as you know, we had very low growth and we had very low inflation. So we had a long period of time where interest rates were really, really low, because of that. And then low and behold, the pandemic showed up and created a situation where there was a lot of fiscal stimulus, so people were given a lot of money. There was a lot of monetary stimulus, obviously, so rates were driven down incredibly low to juice the economy. And then you had a lot of people sitting at home spending money and a lot of people not working. So consequently, it had excess demand for a lot of products, but not a lot of products available, because people weren't making them. So massive amount of inflation and a significant response now by central banks to sort of counter that.

So really what happened, obviously, is interest rates went way, way higher than people ever expected them. And in addition to that, people started building in a real risk of recession, which means anytime people think of a recession, obviously, equity markets go down, high yield markets go down. And in addition to that, credit spreads widen, because people want to get paid more because of the risk of default. So it's really when interest rates obviously go up, everything goes down, as we say. And then the last thing, and this is very interesting, that because we are in an environment of interest rates being so low, the coupon on all the bonds that were issued throughout that period are very, very low. So what happens when interest rates move? There's no real income to support. So consequently, bond prices move down significantly. So a lot of things came together to really, really, really create an awful environment for fixed income. Well, for all assets for that matter, because there aren't really many things that are up this year.

Michael Hainsworth:

So these are the 2008 chickens coming home to roost.

Mark Wisniewski:

Yeah, you got it.

Michael Hainsworth:

So what has it meant for fixed income strategies?

Mark Wisniewski:

In fixed income right now, I think that the old sort way of managing money, which was in fixed income and which was prevalent for yields, were really what we call index funds. So they're passive funds that replicated index and they used to work. And the problem nowadays is because we went from an environment we had interest rates that were so low, and now we have so much volatility, they don't really have any ability to change the characteristics of the portfolio. So perfect example, a typical index bond fund is stocked somewhere between six and eight years of duration. Well, when interest rates go up 4% this year like they do, that's a recipe for disaster. So more active managers that are calling themselves alternatives are really just basically saying that they're active, and that means they're changing the characteristics, all the characteristics of their portfolio, whether it's duration, credit quality, security mix, et cetera, et cetera, they're actively changing all the risk components of the portfolio to put them in a defensive or an opportunistic mode.

Michael Hainsworth:

Was that little shade you were throwing on the passive bond managers becoming active?

Mark Wisniewski:

More fixed income managers are now launching alternative products. So the old type of product is still there. But what they're also doing is they're adding what we call alternatives. And again, alternatives just allow a manager to be more active, but they also allow you to use leverage, right? Which is, well, leverage in fixed income isn't leverage like leverage and equities, but that's one of the things, obviously, that people can use as part of their strategy.

Michael Hainsworth:

So income is always that first line of defense in a fixed income portfolio.

Mark Wisniewski:

100%.

Michael Hainsworth:

You wrote in a Globe and Mail piece recently that the income is back in fixed income. Investors are no longer relying on interest rates being low to make a return.

Mark Wisniewski:

Exactly. Well, I also said the glass is half full. And believe it or not, for a bond guy, that's massively optimistic. So this is the way we're thinking about it. Two year interest rates in Canada were 15 basis points just over a year and a half ago. 15 basis points. And they're now four and a quarter, right? That's a massive move. I mean, and 4% doesn't sound like a lot, but in fixed income world, that's a massive move. And central banks have raised rates a lot this year. The trajectory is incredibly, incredibly steep. So after the U.S. gets done with 50 basis points this year, and Canada gets done with probably another 25, we'll be at 4% in Canada. It will be 4¼ in the U.S. I don't know how much farther they can go, right, because a few things. First of all, it takes a year for all these rate increases to hit the economy.

The second thing is it takes up to three years for interest rates to really, really impact inflation. So we may have done enough already, but it's one of these things where it's going to take time to play out. So let's just say, let's just say maybe next year that they're going to raise rates, the bank account or the Federal Reserve, maybe two or three times. That's basically 50 or 75 basis points, and then the market actually thinks, close to the end of next year, they'll start cutting rates. So what I'm saying is that rates are just not going to go up to the same trajectory they did last year. And bond funds yield so much more now, you have a massive amount of defense for less rate increases, so there's lots of income available in an environment where I don't think you're going to get, as I said, a lot of rate increases, unless I'm completely wrong on inflation.

Michael Hainsworth:

Okay, so then let's unpack that a little bit, because you suggested that the Bank of Canada only has another 25 basis points to go.

Mark Wisniewski:

This year.

Michael Hainsworth:

This year. And you think another, how many basis points in 2023?

Mark Wisniewski:

Well, the market thinks 25, 50 basis points, we get up to somewhere around 4.5%. And then we start cutting rates potentially at the end of the year.

Michael Hainsworth:

Right.

Mark Wisniewski:

Because we're in recession.

Michael Hainsworth:

Because we're in recession and we really don't know if we've overshot fighting inflation for as much as 18 months to three years down the road.

Mark Wisniewski:

Well, I don't think anybody knows, right? This is an experiment, right?

Michael Hainsworth:

Right.

Mark Wisniewski:

I mean, we've never raised rates at this pace ever, right? And if you think about it, they're just raised rates in the U.S. for 75 basis points four times in a row. It's unprecedented.

Michael Hainsworth:

How does this impact corporate debt? We talk a lot about the housing market and the impact on the consumer, but what about the corporates?

Mark Wisniewski:

Well, it's the same thing, right? So government bonds, as I said, talked to you about two years. Government bonds have gone from 15 basis points to over 4%. Well, it's the same thing with corporate bonds. Basically, a corporate bond is just a government bond with spread, right? And a spread's like insurance, right? When you don't need insurance, the spread is very, very narrow. When you're worried about things or you're in a toxic environment, you need more spread. So as the market thinks you're going into recession, these spreads widen. So if you think generically about the corporate index, the spread is probably very, very close to double where it was a year ago. So the spread in corporate credit is really wide. And I give you a few examples of that. The dividend yield now in a lot of corporates is less than the corporate bond yield, which we haven't had that in 10 years.

Typically, the dividend yield is higher than a corporate bond yield, primarily because a corporate bond is higher up the capital structure. It's safer than equity. But I mean, some Canadian banks, you can buy things like TransCanada Pipeline, Telus, certain REITs and everything that have a yield of 5 to 7%, which is more than what you get in a dividend yield. So it's really, really attractive. And if you want to go into something like what we call these LRCNs notes, TD yields almost 11.5%. So I mean, credit is dirt cheap. Relative to equities, I think, corporate bonds are real cheap. I mean, in high yield, generic high yield is up to 10% now. So corporate credit is building in a lot of bad news.

Michael Hainsworth:

Which brings us full circle back to your point about the income being back in fixed income.

Mark Wisniewski:

Yeah, exactly. So if I was talking to you about a bond fund a year and a half ago, and I'd be saying, you know what, I think I can do you 3%, and in an alternative, I can probably make you 5. Back in that day, people said, well, I can live with it, but boy, I wish we could get just more income. Well, those same bond funds now yield 7% to 10% now. So a lot of questions I get from clients are, well, what about GICs? Well, first thing, a GIC now yields, I don't know, let's just say 5%. But the problem with the GIC, obviously, is if you cash it in before maturity, you lose your income, so you don't have any liquidity. Plus everything you earn in that GIC is income. So at the tax rate that most people are paying, you're giving away a bunch of return and no liquidity.

In a bond, you're in a bond fund, as I said, at 10%, you're almost making double. But here's the thing that's really very interesting that we've been spending a lot of time talking to clients again. Again, remember a lot of the debt that was issued a year, year and a half ago through the pandemic had a really, really low coupon. So when interest rates moved way up, those bonds went way down, because they didn't have a lot of coupon to, we call it convexity. So there wasn't a lot of coupon. So all of these bonds are trading now in the mid 80s, low 90s. So a typical bond fund now has a lot of potential capital gains. So not only are you going to drive it, so if I'm right, and the market does well next year, and these securities start to move back to par, a lot of your return is going to be capital gains as opposed to income. So these funds are actually more tax efficient.

Michael Hainsworth:

So back to your comment about the glass being half full, which is funny, because to your point, what makes it funny is that guys in your line of work generally are the most pessimistic people on the street.

Mark Wisniewski:

Absolutely, yes.

Michael Hainsworth:

So then let's flip that. Your glass is half full, but argue the counterpoint. What's the risk associated with the environment in which you're operating now?

Mark Wisniewski:

What happens to inflation? If you think about it, from peak inflation in Canada and the U.S., we were 9 in the US and we were at 8 in Canada. We're down to 8, sorry, we're down from 9 to 8 in the U.S., and we're down from 8 to 6.9 in Canada. So inflation really hasn't moved very much. And if you listen to central banks, they're saying, well, we'd like to get it back to 2%. So I don't think there's going to be a really, really steep trajectory down to that 2% level. I think inflation goes down really, really slowly for a couple reasons. First of all, what we call the whole sort of big chunk of the CPI is rental equivalent, shelter, all sorts of things to do with rent, housing, and all the things that are involved in that. So part of the problem is rents aren't going down quick enough.

Housing prices aren't going down quick enough. And the other problem is your utility bills, your taxes and all that are going up. All this gets factored into this shelter component. But it's going to happen, because housing prices, at some point, based on every time you open up an article, everybody's talking about housing prices are going down. So they're going to go down at some point, and this is going to get reflected in rent, but it takes a long time. And as I said, it's about 30% of CPI. Energy is the same thing. I mean, I can't tell you where energy's going to go, but it doesn't look to me like it's going to nothing anytime soon. Food's been sticky. Wages have been sticky. So I'm not saying that inflation's not going down. I'm saying it's going to go down very, very slowly and the question's going to become, is the Bank of Canada, the Fed okay with that slow trajectory, i.e. are they comfortable with what they've done so far?

Say let's wait and see how this thing trends down. But I mean, I don't think there is any way we're going to get to 2% next year. I don't even think we're getting the 3.5% next year. I mean, I think it would be a win if we got the 4%. So if they think they've done enough in interest rates and they do a couple of rate increases, fine, maybe we get a slow down. I think that's a great outcome. The problem is we don't want a big recession. I mean, that obviously is going to be the worst thing for everyone. But having said that, if we go into a big recession, they're going to cut rates, which will be good for bond funds.

Michael Hainsworth:

So then let's come back to the point about alternative bond managements. What strategies has your team employed this year to handle these challenging markets that are different from a traditional fixed income manager?

Mark Wisniewski:

Most fixed income, and when I say most fixed income, I don't know what that number is anymore. I mean, whether it's 70% or 80% or whatever, but it doesn't matter, is managed on an index basis. That means those fund managers have no ability to change the duration of their fund. What's the number one risk to a bond fund? It's interest rate risk. So what have we been active in? Obviously, the number one thing we've been active in is managing our duration, right? So part of what we did was shorten the duration of our fund, which wasn't exactly a winner, because it didn't matter where you went this year, there was no place to hide. But part of what we did is we flipped our portfolio to floating. So we flipped, at one point in time, about 40% of the portfolio to floating rate by doing a swap.

And what that means is every time the Bank of Canada Federal Reserve raised rates, you get paid more. So you basically have a really nice hedge against rising rates. So we converted part of the portfolio to floating rate, we shorten the duration. And the other thing is we always are moving the sectors, the type of companies we own. Obviously, if we are in a rising rate environment, we want to be in companies that benefit from that. If we think we're going into recession, we want to be out of companies that we're worried about in recession. So it doesn't matter where they're changing sectors, companies, but the number one thing we're mostly active on is duration.

Michael Hainsworth:

So over the next year, where do you see the best opportunity in fixed income?

Mark Wisniewski:

The way it will probably play out is, as I said, we'll probably get a couple more rate hikes, which means rates may drift up a little bit. But then at some point, rates are going to start moving down as the market anticipates a recession. And this is probably the most over anticipated recession ever, because everybody's talking, but it still hasn't happened. I mean, we really haven't seen a massive slow down. Things are slowing down, but employment's been really good. But anyway, let me get back to where I think the opportunity is. So number one, the biggest opportunity is going to be in long bonds in 10 years, because what will happen is as soon as people worry about, market worries about reception, longer data rates are going to start moving down, right? And then the market's going to start building in rate cuts. And then post that, when you start cutting rates, then the market starts rallying and then credit will do really well, i.e. high yield and investment grade.

So basically, it's a tail of two stories. The first one will be the interest rate move, and the second thing will be the rally in credit. But again, to be clear, if you're buying a fund that yields 10% today, you can endure a little bit more of an increase in interest rates and you can endure a little bit of an increase in credit spreads, because you've got a big first line of defense, right? You got all that income now. It's not like it was if this was happening like it did a year ago, when your portfolio 3%, you got no protection. When you have two negative years, one as bad as this, it's the same thing as when people look at equities, they go, how bad it can it get? It's gone down so much, it's an opportunity to look at it. But in fixed income, it's not like you're looking at the price and you're saying, wow, I need it to... The income is there, right? So to me, it's completely in incomes. It's a great income story right now. It hasn't been like that in years.

Michael Hainsworth:

So you're optimistic, surprisingly.

Mark Wisniewski:

Yeah. No, like I said, I think that this is the most optimistic I think we've been in months. And when I say months, it could be 12 months, 18 months. It's been a while.

 

 

 

Listen on Google Podcasts
Listen on Google Podcasts
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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

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