How to take advantage of bond market dislocation

Thrive amid volatility rather than become a victim of it, industry insider tells advisors

How to take advantage of bond market dislocation

Doom and gloom reporting at the state of the world may not be good for the soul but these uncertain times also represent opportunity.

Adrienne Young, VP and director of Credit Research, Franklin Bisset Investment Management, said portfolio managers’ strategies should be focused on how they can take advantage of volatility rather than become a victim of it.

Calgary-based Young told WP risks abound and advisors should be on top of a number of potential downturn catalysts. Trade policy in the US, China, Europe and Canada is a worry as is the political uncertainty around Brexit and the US election, and subsequent US foreign policy. Geopolitical concerns are also weighing heavy on investors amid elevated situations in Syria and Iran to name just two.

Young said the consequence is CFOs and CEOs are reluctant to make investments, preferring to keep money close to home or give it back to shareholders. In Canada, the consumer is also highly levered, stunting growth and resulting in a slowdown of GDP.

Yet, despite this dire picture, markets are on a tear with record numbers from the S&P 500 and the Dow, and the TSX on Friday just 142 points away from its September record high. It’s a stark contrast that has many scratching their heads.

Young, in Toronto to speak at Franklin Templeton’s fixed-income presentation for advisors, said: “We look at bond prices and they appear to us to be broadly pretty expensive. But why is that? In part, it’s because of a technical issue in the market affecting both the United States and Canada.

“Negative interest rates in most of Europe and a lot of Asia, especially Japan, are sending Asian and European investors to US dollar and Canadian dollar fixed income markets to find product that allows them to make a positive return. That incremental demand is pushing spreads tighter, even in the face of all of that uncertainty.”

Where are the opportunities?

Expensive markets amid political turmoil means you really have to shift through the options to find genuine portfolio opportunities. Young told WP that could mean diversifying aggressively and making sure you have liquidity. Her advice is to put money into the vehicle that has “as many levers to pull as possible” and as many places to go as possible. This may include US and Canadian investment grade and even EM investment grade where there is growth still in their market.

“You don't want to put your money in simply a passive fund that mimics the Canadian index,” she said, adding that she believes the Bank of Canada will likely reduce rates by at least 25 basis points in the near future and by 50 bps by the end of 2020.

“With that in mind, you might want to look at a fund, or an ETF, that has the option of investing more heavily at the short end of the curve, because the long end of the curve really will not move much from a central bank rate cut. The short end will come down and that's where you'll get a bit of extra profit.”

Market dislocation

The question of how long this bull market will run is the great unknown and Young characterizes it as a fight between fundamental and technical market-drivers; the latter being the aforementioned search for yield by foreign investors.

Another potential problem is that, broadly speaking, Canadian, US and European banks are holding less bond inventory than they ever have before. This means that if any of the risks explode further, liquidity is going to be a major problem because the natural buyer for bonds when investors are anxious are the banks.

Young explained: “They may not be willing to be buyers to the extent they were before the Great Financial Crisis of 2008-09. That means you could see some dislocation and some volatility in the bond market, even while you have the longer-term trend driven by demand from foreign investors.

“You may have these periods of dislocation that can be an opportunity if you have liquidity and you buy liquidity. That could mean cash or highly liquid government paper or highly liquid good quality bank paper or utilities, for example.

“But the funds that are constrained and must own X percent of Canadian utilities and Y percent CU Inc.  won't be able to take advantage of those dislocations. It’s the active funds that do not try to mimic that will be able to take advantage.”


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