After the blood-letting of the past six months, portfolio manager suggests advisors could start to shift along the curve
The long-duration investment grade credit bloodbath has been painful for many. From the early August highs, the ETF tracking the duration-heavy Canadian bond universe has delivered a total loss in excess of 5% and the triple-A rated 30-year Canada bond has delivered a loss of more than 20%.
With such blood already spilled, Geoff Castle, portfolio manager at PenderFund Capital Management, has posed the question: is it finally time to look at longer duration bonds?
He said: “We believe that, after a long period of answering ‘of course not’, we are seeing enough price movement to offer a qualified ‘yes’. We may not be at the point of maximum longer bond yields in this cycle, but we may be close enough to start shifting a bit of weight rightwards along the curve.
“There are, of course, arguments for making the opposite trade. As we ourselves have noted: inflation is rising, yields are still historically low and the Fed has been slowly backing away from its emergency programs designed to hammer down bond yields. All true. But as the U.S. 10-year Treasury yield closes in on 2%, the case for buying quality longer duration credit strengthens.”
The fixed income manager has highlighted a number of reasons why this is the way forward. Firstly, that higher treasury yields, if sustained, may cap some asset values and slow economic activity. The market has shown in the past six weeks that it's not just long bonds that suffer from rising rates – a host of “long duration assets” are vulnerable.
He explained: “For instance, in a world where you can earn back the cost of buying a house from 10 years of rental income, home prices are not particularly sensitive to 10-year interest rates that move from 1% to 2%.
“But when it takes 50 years of rental income to recoup your cost, a move in longer term yields to 2% is big. And 3% rates in that situation are a disaster. So, the knock-on effects of higher rates may be lower prices for some properties and businesses, and that may ultimately limit the scope for yields to rise.”
Castle also argued that sentiment has got pretty lopsided and, in this case, lopsidedly bearish with “almost no bond bulls left”. With such a consensus in place, he said, the market may be primed for a result its participants do not currently expect.
He also pointed out that the term premium has turned positive. After years of negative term premiums, the instantaneous forward term premium 10 years hence, a key measure tracked by the US Federal Reserve, recently hit 0.3%, its highest level since 2018. “In short, investors are getting paid something again for duration risk.”
Many of the deflation drivers that existed before COVID are still in place or have further intensified. Castle acknowledged that there are certain markets that are experiencing cyclically rising prices, particularly in the commodity area but said that other deflation drivers, more secular in nature, are still in place.
He said: “Demographics still favour deflation. Some weaker balance sheets have added debt in the crisis. And many of the creative solutions to the pandemic, like Zoom, presage a future deflation in disrupted industries like office space, retail stores and business travel.”
He added: “We haven’t taken the Fund to an extra-long duration positioning by any means. But, considering the favourable moves in prices, and the shifting fundamentals of the duration trade, there have been a number of situations where we have picked up 1-2% in yield extending into the seven to 10-year tenors in issuers like Canadian Pacific, Fairfax, Gartner and MSCI.”