Fixed income still carries the scars of ’22, but Rose Devli says that providers are adapting to needs, concerns
Each month at WP, we offer a slate of articles and content pieces that go deep on a particular topic. This month, we're focusing on ETFs.
Canadian retail investors are forgoing traditional fixed income exposures for other means of income generation. That’s the recent experience Rose Devli, VP & Portfolio Manager with the Core Fixed Income team at Dynamic, has had when she speaks with advisors and investors. She attributes this reticence around bonds and corporate credit allocations to the experience of 2022, when post-COVID inflation made bond and equity correlations positive and re-introduced inflation risk into the minds of retail investors.
While inflation remains one of many dynamics now keeping bond markets volatile, Devli says she’s more excited about the asset class than ever. She emphasizes how bond volatility driven by a range of factors is actually offering active managers new ways to capture upside. She outlined, too, that mutual fund and ETF issuers like Dynamic are adapting their fixed income offerings to address the concerns that some investors carry about the asset class and create a better means of delivering the income and ballast that make fixed income a textbook portfolio standby.
“Volatility makes active managers very excited. When I was in the depths of COVID and we were in half a percent of 10-year US treasury bonds and we saw volatility of half a basis point a day, you can’t necessarily outperform an index in that environment,” Devli says. “This environment makes me very excited because I can go to a client and say to them, now is the time for active management. Now is the time where you as an investment advisor can focus on your areas of expertise and leave the active fixed income managers to focus on your defense.”
Why fixed income is so volatile now
Devli sees three primary factors influencing volatility and driving yields higher across fixed income markets. The first, and probably most commonly cited, factor is high fiscal deficits in the developed world. A number of developed economy governments are carrying debt loads near or above 100 per cent of their GDP. That includes the United States, as well as Japan and the United Kingdom. Investor concerns about debt levels and the sheer volume of debt on the market has mandated higher rates.
On the credit side, the ongoing AI infrastructure buildout has necessitated huge bond issuances from tech companies that had previously been mostly cash flow positive. All that debt now has to compete with government bonds for investors, driving yields higher.
The final factor lies in geopolitics. The ongoing oil shock driven by conflict in the Middle East is driving inflation expectations higher. Devli says that oil prices are more correlated to bond yields than at any other time in recorded history. When oil prices rise, bond prices fall, almost in lock step.
Those driving forces mean clients are experiencing more volatility in their fixed income allocations. It also means they might be carrying exposure to certain investment themes that they might not expect. The correlation to oil prices is one such factor, as is credit investors’ exposure to the AI cap-ex theme. Investors buying corporate bond index products as a diversifier against equities might be surprised to see that around 3.5 per cent of the US investment grade corporate bond index is now in bonds issued by AI hyperscalers. Even Canadian credit markets are now seeing issuances from Amazon, Google, and other major AI names. The volatility that Devli says investors now see in fixed income has some harkening back to the difficult days of 2022, but Devli says that enough has changed about macro conditions and the nature of fixed income strategies that investors should not feel those echoes.
How fixed income funds are changing, and the case for fixed income now
Speaking for her own team at Dynamic, Devli says that they have worked to launch more ETFs that offer managers greater flexibility in duration. New fixed income funds being launched, she says, will empower active managers to take duration exposure to zero if they feel that markets are headed towards another 2022 scenario of sustained positive correlation between fixed income and equities. Other fixed income products, she says, have been able to go to half of the predominant index duration, a function that was designed in the wake of the financial crisis when index duration was at about half of its current state.
“We are hearing investors loud and clear on products that they want that can protect them from another 2022 event,” Devli says.
With those protections baked in, Devli says there is a serious and growing case for bond allocations. That begins, she says, with the yields that investors can now get from textbook ‘risk-free’ investments. While price volatility in assets like 10-year US treasury bonds is higher than it once was, the 10-year bond remains one of the most important assets in the world, backed by the global reserve currency. That security, with a yield at over five per cent, is something that she believes advisors need to look at seriously.
Devli notes, too, that while inflation carries risk of positive correlation for bonds and equities, growth scares imply a negative correlation. While economic growth in the US has been robust lately, it is somewhat narrowly driven with AI capital expenditure as a significant force behind it. The recent talk of an AI slowdown by some of the most significant leaders in the space, Devli says, could imply a slowdown in the AI infrastructure buildout, which could be a growth shock for the US and global economies, offering upside for bond investors. For advisors, especially those serving retired clients, the combination of yield and growth insurance should be enough to prompt a reconsideration of bonds again.
“For an investment advisor with clients going into retirement, who might not own bonds right now, this is a way to bring down the growth scare probability in the overall portfolio,” Devli says. “And a way to do that while still gaining income.”
