Gifts from the Bond Market with Mark Wisniewski

Michael Hainsworth:
Bonds are getting a lot of attention recently. TD Bank recently raised a red flag over the corporate bond market, and the Financial Post calls it a technical tidal wave coming for the biggest slice of the 10 trillion US dollar corporate bond market. So the Alt Thinking Podcast turned to Ninepoint Partners senior portfolio manager overseeing the firm’s fixed income team and investment strategies. I asked Mark Wisniewski for his 2023 strategy – and what he thinks of the headlines.

Mark Wisniewski:
I didn't necessarily agree. So I'll explain. I think that the interesting thing about what's going on with these smaller banks is that they're creating a lot of volatility in the market, because the expectation is that there's a big knock-on effect, right? A lot of these small, regional banks are going to go down. And as they go down, there becomes a big liquidity problem. Everybody panics and thinks that this is the end, because credit completely dries up.

So the ironic thing about this is that this big dry up in credit... Because these little regional banks are big lenders to real estate, and they're big lenders to small businesses. So as the liquidity gets taken out... And by the way, this whole liquidity thing probably really shouldn't be a surprise to anybody, because the central banks loaded the whole economy with liquidity, and stuffed the banks with liquidity during the pandemic, because obviously, they wanted to smooth things out. And now, they're taking that liquidity back out.

And then the other thing, that should be of no surprise to anybody, is interest rates in the short end are so high now. I mean, look at what you get if you leave your money in the bank account. You don't really get a lot, but if you move it into a GIC or a money market account or something like that, you get a lot bigger return. So consequently, there's a liquidity problem. And then the other problem, obviously, is there's a lending problem when rates go up, and you have a whole bunch of assets on the balance sheet. They impact them. So what we're having here, obviously, is these smaller banks are becoming constrained. And actually, in a bizarre way, it's basically creating the situation that the central banks wanted. They want credit conditions, because they want a recession. So mission accomplished, there.

Now as far as the rest of the market is concerned, I think there is some concern about this, but I don't think there's enough concern to create an '08 scenario, where you get a real financial crisis. You have a bunch of small, regional banks that have gotten into trouble. I don't think it's going to be a widespread problem, but consequently, all of a sudden, everybody says we're going to get more volatility. Well, last time I checked, the equity markets seem to be doing okay. And if the equity markets are doing okay, so why should this be a complete tidal wave for fixed income?

Having said that, there's a lot of financials, as you know... If you look at financials in any market, especially in the bond market, they're over 40% of the issuance. They're only 40% of the float. So as you get a little bit more volatility in financials, obviously these things get under stress. And certainly when the situation with Credit Suisse happened, a lot of the financials came under a lot of stress. But regular corporate paper, the stuff that Enbridge issues, et cetera, et cetera, wasn't really that materially impacted.

It was more on the financials. And if we go full circle, most of that stuff has almost come back to where it was pre-Credit Suisse. A lot of it's recovered. It's still a little bit wider than what it was, but it's recovered, which tells me the mod market isn't really expecting a big problem here. And quite frankly, I'll tell you, we've had numerous new issues come to the market since then, and the attendance, the amount of appetite for credit has been immense. The amount of activity in the US market this week has been incredible. Apple did a massive deal the other day and the appetite has been unbelievable.

Michael Hainsworth:
You pointed out though, that the bond market is basically pricing in a recession in 2023, but the equity markets don't seem to agree. That is a pretty common disconnect though, isn't it?

Mark Wisniewski:
Yeah, well we often see this, I mean, let's face it, equity guys are always a lot more optimistic. Bond guys are perpetual glass is half empty, right? So you're right. But the thing is that the earnings that have been coming out have actually haven't been that bad. So consequently, I think people are feeling a little bit more about the situation, but if I really look at it closely, equities really aren't pricing in much of a recession. If anything, it's kind of a modest, modest, maybe slowdown. Fixed income is more so, like we've seen a pretty dramatic drop in 10 year interest rates. That's a pretty good proxy for what the market thinks about a slowdown. So I mean, you were up north of 4% and you're down three point a half in the US and you're close to 3% in Canada.

So we've had a move that says the market expects recession. The thing that we look at is the shape, shape of the yield curve, and we look at three months versus 10 years, the same thing the Fed and the Bank of Canada look at, and that basically our model translates into an 80% chance of recession. So yield curve, awesome predictor of recession. Timing terrible. So some people say common wisdom is a recession within 10 months. Some people say could be less, could be longer. All I say is that if I look at past history, I look at the shape of the yield curve, I would say that probably the end of this year or early next year, I accept recessions on the horizon. So you're right, fixed income is already starting to price that in, not to the same extent that the equity... Or sorry, the equity markets much less so.

Michael Hainsworth:
If earnings really aren't all that bad, I suppose the collapses of Silicon Valley Bank, Credit Suisse, First Republic are playing an outsized role in the sentiment that you're seeing on the street for investment grade corporate bonds.

Mark Wisniewski:
So there's two factors here. Anytime you're going into recession, of course you get more volatility in equity markets, and you're right, credit reacts because let's face it, if you're going into recession, default rates go up. So two things about that, default rates are more pronounced in high yield because it's a riskier credit. So I think if we break it down, high yield credit is expensive and much like equities, I don't think it's pricing in much of recession. So I think there's a lot of risk in high yield right now.

If I look at investment grade, I would say the movement in credit spreads and investment grade are such that it's already pricing in a mild recession. If we talk about... One of the indexes that we look at is the Bloomberg Barclays all corporate index. When things were really good, that spread was about a hundred over, it got out to 160 over. I mean, could it go to 200? It could. But all I'm saying is that a lot of bad news is already priced in to investment grade credit. It's not price into high yield to the same extent, I don't really think it's priced in to equities yet either.

Michael Hainsworth:
You speak of fixed income sector diversification. I take it then you are looking at diversification through a different lens than an equity manager would.

Mark Wisniewski:
Well, it's interesting thing as a bond manager that invests in a lot of credit. I mean literally what we're doing is we're really... We're buying the same thing an equity manager buys, but we're buying higher up the capital structure safer. But also if you think about it, if I go and buy... I buy a TD Bank stock or a Royal Bank stock, one of the major fives, there's one stock and maybe some preferred to buy, but a fixed income, there's numerous securities because banks issue several securities every year. So there's a plethora of Royal Banks, TDs and so on and so forth, Enbridges, all the big corporations issue on such a regular frequency every year that there's all sorts of things to choose. So for us, it starts with basically is the economy growing? Is it slowing? Are interest rates going up? Are interest rates going down?

Where do we want to be? So what sectors do we want to be in? What sectors don't want we want to be in? And then from that drills down into the kind of companies that we want. And then again, if we think that interest rates are going up, we probably want lower duration. So we take the companies that we like and we buy the lower duration, the shorter term bonds. Then the exact opposite is true. When the economy's doing great, things are humming along, we want to take a little bit more risk. So we'll buy the longer dated, longer duration bonds of different sectors, we'll buy more high yield, et cetera, et cetera. You want to take more risk. So right now with our expectation of recession, there's three things that we're doing to the portfolio. We're slowly adding duration because obviously if we get recession, 10 year rates, 30 year rates, longer rates will drop down.

We're also taking our credit, and transforming that into higher quality. So where we had a triple B, we'll try and buy an A, so on and so forth. As I said, we don't particularly like high yield, so we're divesting most of the high yield that we owned. And the other thing that we're doing is because the shape of the yield curve is so inverse, we're selling some longer dated credit and buying shorter dated credit at almost the same yield. So as a bond guy, anytime you can less lend for somebody over a shorter period of time and get paid the same, that's kind of a no-brainer to us. So where we had 12 year and 10 year credit, we've sort of sold that down and bought five year and four year credit where we'll be a little bit less volatile because there's less duration than a longer bond.

So shorter data credit, higher quality credit, and then get in defensive sectors. So no surprise, we're basically down weighting things like real estate, consumer facing companies, things that we think will get a little bit more vulnerable and a little bit of energy as well. And not because we have anything against energy, it's just that energy's done incredibly well. I mean, we can now sell some of the energy bonds that we bought and turn in and buy Canadian bank financials and basically give up almost no yield. So we say sell [inaudible 00:09:42]... That would've never happened five years ago. So just creating a more defensive posture in our portfolio.

Michael Hainsworth:
In light of all of this recession talk over the last 10 minutes or so, do you think rates are continuing to go up?

Mark Wisniewski:
We're going to go full circle here. You asked me about our equities. So equities don't seem to think there's a chance of a hard landing. If I look at, they keep saying, "Well, employment is fairly good." Basically an amount of people that are out there working. I mean, we haven't seen a considerable move move up in unemployment. That's good. As you pointed out, and we were both talking about earnings have been pretty good. So corporations are doing quite well. There's lots of people working, and the only way you're going to get a recession obviously is that if a bunch of people get put out of work and companies basically get in... Things get a little bit choppy from there. And so far that hasn't happened. So I would say that the equity markets think that there's probably a high probability of a very, very soft landing here where the fixed income, I think thinks that we're probably going to have a mild recession.

So it's a little bit more pessimistic. So at this point, it's really tough to handicap because what we're talking about is where do we think inflation is going to be between now and the end of the year. Now, the only thing that would make interest rates go substantially higher would mean that even though the Bank of Canada is pausing, the Fed kind of sounds like they're pausing. If they now had to raise rates another 50, 75, a hundred basis points because inflation is too high, i.e. goes from where it is right now and it starts moving back up again. That would create an environment where they'd have to start raising rates again. I don't think that's the case, although I don't think we're going to get the two or three... The Fed and the Bank of Canada's target of two this percent this year.

I don't even think we're going to get the three, but I think what you're going to find is we're going to have a slow transition down, which means rates this year are going to be higher for longer. So are they going to go higher than where they are? I don't think so. I think they're going to be here for longer, then I think the market pricing in two rate cuts in the US one rate cut is probably a bit optimistic. I think, as I said, the bond market seems to think that we're going to have recession be somewhere in the second half of the year. I mean, again, that's a hard one to handicap. I just don't think inflation is going to be low enough by the end of the year. Consequently, I don't really think in the short end you're going to see a lot happen with rates and then long end has already kind of adjusted. 10 years have already adjusted because it's already expecting recession.

Michael Hainsworth:
So then walk us through how you've been adjusting the nine point fixed income strategies as a result of the Bank of Canada's existing interest rate increases.

Mark Wisniewski:
We think that recession is going to happen within the next 10 months. So I think it could be the end of the year. I mean, I'm only trying to be directionally accurate. I don't have a crystal ball, right? So I think recession happens somewhere in the end of the year. So what we are doing is we're adding duration to our bond portfolios. We do that by two things. We buy a little bit of government bonds to add duration to the portfolio because we want high quality. We also use options to give ourselves the benefit of governments, and we would use something like TLT, which is the long duration ETF. We can buy calls on that to give us a little bit more duration kick. And the nice thing about that is we don't have to sell out a bunch of our high yielding credit to buy government bonds and give up a bunch of yields.
So we've use a little bit of options on TLT to do that. And credit, as I said, we're getting rid of as much high yield as we can. We're buying higher quality investment grade, we're picking more defensive sectors. And in addition to that, we're also doing hedges on our credit as well. So we would use something like the junk index, HYG, and have puts on that as some insurance against what we own in our portfolio. So more duration, higher credit quality, and basically hedges. And I think the last thing that I would add is we like cash in the portfolio. So it's a big penalty now when you can get... We were buying Enbridge paper last week at five and a half percent for two months. So it's a big penalty to actually sit in cash right now.

So what we do is we buy a lot of short-term commercial paper. We buy short data securities. So about I would say depending on what portfolio, over 20% of our portfolio of all our portfolios matures in the next year. So that means when recession comes, we're going to have two months securities, one month security. That stuff is real easy to sell when the volatility happens. And we'll take all that liquidity and then hopefully at that point the market has been down, it's been kicked around a little bit because of recession, and we'll be able to take that liquidity and buy higher yielding securities and drive more yield into the portfolio and more opportunities.

Michael Hainsworth:
So what's the greater priority for you right now for your investors, shielding them from volatility or increasing returns because you pull one lever and the other one goes down the other way?

Mark Wisniewski:
For sure. For sure. So depending on what portfolio you buy our yield now is anywhere from seven to 11%, believe it or not, which is absolutely uncharacteristic. And in a bond fund, obviously your first line in the defense is the amount of income you have. So we have a lot of income. But what I would say to you is, you're right, we probably have too much income, which means over time that income is going to shrink because as you become more defensive, you're selling things that yield more to buy, things that yield less. So the expectation would be the yield of our portfolio would come down a little bit as we continue to get a little bit more defensive and that will happen. And the other thing I should add is that in liquid alternatives, in offering memorandum funds, you're allowed to use leverage.

And leverage in fixed income is not leverage in equities. Think about it this way, as a bond manager, I don't have a lot of levers to pull to add more yield to the portfolio. As you point out, I could buy more high yield, I could buy risky securities, I could add a bunch of duration to provide more income, I could invest in more esoteric securities like structures, preferreds, all sorts of things to drive. But all of those add risks to the portfolio. Duration obviously gives you more interest rate sensitivity. Lower quality of credit means you're taking on more risk and more structured things or less liquid, so you don't have the same liquidity. The last thing I could do is I could use leverage and leverage again in fixed income is not like leverage in equities. I can basically take money, borrow money against the portfolio and buy more TD Bank, buy more Enbridge, buy more Royal, buy more TELUS, buy more PC, things like that.

So borrow money to buy more high quality credit so that that's something that we do to add more income to the portfolio. But what we would do in an environment where we are expecting recession is to take that leverage down. And in our alternative portfolios, we've been reducing leverage as well because again, we want to be in a position when the volatility happens and things start getting on sale that we have leverage, we have cash, we have things that we can do to take advantage of the situation. I never want to be in a situation where I can't act. And so a lot of what we're doing is making sure that we're in a position to act when things get really, really cheap. The last thing that we haven't talked about that I would like to mention and we should mention is that the bond market has actually given you a gift right now. Well, it's given you two gifts.

First of all, we've got the most yield that we've seen in bonds in over 10 years, maybe even 14 years. So you've got a lot of yield, a lot of income that you didn't have for the last 10, 14 years. The other thing is we haven't had an environment where rates have been so low and then they've gone up so much. So consequently, a lot of the bonds in the corporate universe and the government universe now are trading at deep discounts. Very, very deep discounts. So what that means is that as we go through time and these bonds start moving back up in price, more of your return in a bond fund could, if you structure properly, could come in the form of capital gains as opposed to income. So you get tax efficiency. So what we've been doing with our portfolios is if we own an Enbridge that's at par, a hundred dollars, been trying to find an Enbridge that's at $85 or $90, so to add more discounts into our funds so it becomes more tax efficient.

Michael Hainsworth:
Sounds like you're living in interesting times.

Mark Wisniewski:
That's great. (Laughs)