The outlook for bonds has rarely looked better

Manulife Investment Management’s Roshan Thiru says inflation, interest rates and the economy are perfectly positioned for investors in fixed income

The outlook for bonds has rarely looked better

Sitting down to discuss the bond market with Wealth Professional, Roshan Thiru wastes no time getting to the point.

“We are extremely bullish. From a bond investor's point of view, the next few years are going to be great.”

Thiru, who heads Canadian Fixed Income at Manulife Investment Management, then proceeds to list the reasons for his optimism. Inflation has peaked, bond yields are at a decade high, and elevated interest rates will work their way through the economy for the next 12-24 months, which he believes will drag on stocks and benefit fixed income.

After almost 15 years at Manulife Investment Management – and another 10 years covering energy, utilities, and credit risk earlier in his career – Thiru believes the opportunity for bond investors today only comes around a few times a decade.

Thiru, who also helps oversee the Manulife Yield Opportunities Fund, expanded on this unique opportunity for bonds while touching on his outlook for inflation, the banking system, equities and GICs.

The return of bonds

Bonds have had a rough ride over the last decade. After a long historical trend in which they generally outperformed equities, the traditional value proposition flipped upside down as investors rushed into stocks.

The key reasons for investing in bonds faltered, Thiru says. Investors didn’t get income generation, they didn’t get capital preservation, and at times they even failed to see the negative correlation to equities when stocks declined. Last year, for example, when the Nasdaq was down 35%, long term US treasuries were down 36%.

But that has all changed now, Thiru says. “We haven’t seen yields for government, corporate and investment grade bonds like this in over a decade.”

The prospects for bonds have rarely looked better, he says before explaining why: inflation is a little sticky but clearly slowing, major central banks appear to be nearing the end of their interest rate hikes, and the credit outlook for investment rate borrowers is very stable.

Duration and geography

Asked to specify where he sees the most attractive investment opportunities, Thiru divides his answer into two parts: duration and geography.

“At the beginning of last year, we held maybe 2% long term US treasuries, now we own 13% long term US treasuries, Thiru explains. “There's a great opportunity here to add duration as North American central banks approach a pause.”

Thiru says his long duration is biased towards North America because he expects the European Central Bank still has a number of interest rate hikes to come in order to tame inflation. The Fed and especially the Bank of Canada, however, are at the end of the tail.

“We remain concentrated in North America because it's sheltered from issues in emerging markets and Europe,” he says. “And let's face it, given the current valuations there's really no need to search for yield outside of North America.”

Higher quality credit like investment grade bonds in Canada are particularly attractive because they are trading at relatively cheap levels from a yield and spread perspective. Thiru says his portfolio is ramping up its holdings of high-quality bonds while increasing duration. He also likes hybrid bonds of Canadian investment grade issuers. Hybrid securities combine the characteristics of two securities, usually debt and equity.

The US is flush with opportunities as well. While increasing quality within the portfolio, Thiru’s team has reduced exposure to high yield from 55% at the beginning of last year to the mid-30s as of May 31st.

“How do we do that? Early last year we had up to 20% in sub-investment grade, mostly single B-rated instruments,” he explains. “Then during the rate selloff we started selling our term loan exposure at high 90s and buying investment grade debt, which increased both the quality and duration within the portfolio.

“We really like duration, we like high quality bonds, and we like high yield bonds.”

Looking ahead for inflation, rates, and the economy

After the torrid increase in prices fueled by supply chain disruptions and the low cost of borrowing, Thiru expects inflation to decline meaningfully over the next 12 months, and then continue to decline over the following 18 to 24 months

“We are very comfortable saying the worst is over,” he says.

However, the impact of higher rates will persist and this will continue to slow the economy as companies lay off workers, slow down hiring, and pull back on capital expenses.

While Thiru expects a soft landing instead of a recession, he acknowledges that the markets and central banks remain sensitive to uncertainty, especially as they weigh the impact of recent bank failures and look to the impact of other issues like a Congressional showdown over the US debt ceiling.

“We’re at a stage where the central banks have done most of their heavy lifting, but now they're grappling with how much more needs to be done,” he says. The Fed might need to raise a little higher because the labor market is still tight and inflation is cooling slower than they would like.”

Thiru says they are expecting interest rates to probably start falling by the first half of next year, but perhaps not to the extent seen in past cycles.

Adding value beyond GICs

Thiru makes a point about investing in Canadian Guaranteed Investment Certificates (GICs), a popular source of income for retirees and other risk-averse investors.

“While GICs provide a sense of safety, there’s an opportunity cost to a GIC investor who is foregoing the high single-digit returns found elsewhere in the fixed-income markets today.”

He says the Manulife Yield Opportunities Fund gives investors an opportunity to benefit from these potentially higher returns. Founded in 2009, the fund has delivered consistent income for its clients despite having to weather a number of storms over the last decade.

Looking ahead to the next 3 to 5 years, Thiru says the fund is targeting returns of 5-7% per annum. “I think we are very well positioned to hit those targets. These are ideal markets for a bond manager to work in.”

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