The bond renaissance

Katherine Klingensmith of Brandywine Global on investing in a market poised for inflation’s retreat and interest rate reversals

The bond renaissance

This article was produced in partnership with Canada Life Investment Management.

A prevalent sentiment among investors today is that high-quality U.S. bonds may have stabilized. Consensus is that interest rates have peaked for this economic cycle, bringing an end to the pain bond holders have been experiencing over the past two years. 

The macroeconomic maneuvers by central banks, primarily aimed at curbing inflation, have thrust the bond market into the spotlight. In conversation with Wealth Professional, Katherine Klingensmith, Senior Vice President, Investment Specialist with Brandywine Global Investment Management (BGIM), begins by addressing the turbulent nature of recent years. She says, “We are essentially positioned for a soft market landing but still with some concerns that things could get rougher. It’s a pretty interesting environment in which to invest and we’re not urging people to design portfolios for hard landings, but rather, to look for opportunities.”

A key conviction shared by Klingensmith is the belief in the gradual decrease of inflation rates. She attributes the initial surge in inflation to pandemic-induced disruptions in the global supply chain, likening the scenario more to a natural disaster than a typical economic cycle. Much of the reduction in inflation can be attributed to a return to normalcy, rather than being directly a result of monetary policy actions, particularly in the United States. With both Canadian and U.S. economists expecting interest rate cuts, on the back of encouraging inflation rates, long-term bonds are in high demand. 

The multi-sector approach: a diverse path to returns

Klingensmith says, “Last year, our outlook on bonds was highly optimistic because we anticipated benefiting from the curve shifting from an upward to a downward trajectory. This year, the situation is more subtle. It’s really important to think about asset allocation in the bonds versus anything else, particularly when comparing the potential of bonds of any duration against holding cash.”

Klingensmith elaborates on the strategic importance of accessing a vast global fixed income universe while diversifying risk to enhance returns. This approach is crucial at any point in the economic cycle, as it prevents the fixed income portfolio from mirroring the volatility of equity portfolios. The multi-sector strategy, particularly through funds like Canada Life Global Multi-Sector Bond Fund, also available in Segregated fund as Global Multi-Sector Bond, aims to identify pockets of value and opportunities for better returns with lower correlation to traditional risk assets.

“Equity markets have performed impressively relative to other risk assets, yet there are compelling reasons to believe they are currently overvalued. In contrast, when considering risk assets, it's essential to evaluate the valuation and total return potential of bonds. This year marks a significant departure from previous years in terms of our investment focus. While the yield curve was once a primary concern, our attention has shifted. We still consider our position within the curve, but our emphasis is now on exploring opportunities across multiple sectors and countries,” she emphasizes. 

Dual, dynamic and defensive

BGIM’s fund management strategy is guided by “three D’s”. Firstly, a dual approach ensures that the asset managers understand the fund holdings well, avoiding the pitfalls of over-diversification and liquidity challenges. The managers assess the top-down macroeconomic and bottom-up fundamental factors. This deliberate strategy contrasts sharply with other funds that may spread their investments too thinly across numerous sectors with less regard to the big picture themes.

Secondly, the strategy is dynamic. “We prioritize income generation throughout the economic cycle but do not commit to a specific income level at all times. This flexibility allows us to navigate different market conditions by moving between sectors based on macroeconomic factors and valuation opportunities, rather than being confined to specific sectors.

“Lastly, our defensive awareness emphasizes critical risk evaluation and downside management within the fixed income markets. This proactive stance on risk helps in safeguarding investments against potential downturns,” Klingensmith notes.

The expectation is that the U.S. yield curve will steepen, as the Fed eases and economic momentum is sustained. This outlook leads to a preference for income-oriented investments positioned in the short to intermediate sections of the yield curve and selective duration positions. Additionally, from an asset allocation standpoint, U.S. bonds present a persuasive argument for preference over equities, given the current economic climate and market expectations.

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This interview is part of an ongoing series about Canada Life Investment Management’s approach to investing with its partners around the world. Previous stories discussed value investing, fixed income, real assets and risk-managed portfolios).

The views expressed in this commentary are those of this investment manager as at the date of publication and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.   

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