Why increased risk may be the only option

Is stepping away from traditional long duration bonds a smart move in the current environment?

With central bank policies pushing bond yields to record lows and with rates set to remain low for some time, the investment environment in Canada is going to remain challenging. Investors, asset allocators and advisors have some tough waters to navigate.  

“We are currently confronted by a number of challenges, which include extraordinary policy stances, low and negative nominal and real rates and low growth combined with high debt,” says Scott Colbourne, Co-Chief Investment Officer and Senior Portfolio Manager of Sprott Asset Management. “Fixed Income options need to evolve to address these challenges to include low volatility solutions, global unconstrained diversification, benchmark agnostic investing and illiquidity premium harvesting.”
Unless investors are prepared to borrow from the future, which could be lucrative if rates were to drop from 2% to 1%, expectations on returns simply have to be lowered. With government bonds so low, central bankers and policy makers are ultimately encouraging investors to increase their risk. “That increased risk can come in a variety of formats including liquid capital markets and investment grade and below investment grade credit, which have done well,” Colbourne say. “The rates are forcing people to take more risk in other asset classes such as commercial real estate, which can be bubbly.” 

Advisors should be sitting down with their clients and giving serious consideration to their portfolio composition. For Colborne, big liquid equity benchmarks make a lot of sense in the current environment, bonds, however, make no sense whatsoever. “Negative nominal and real yields, in particular, present a challenge,” he says. “Over $8 trillion, or greater than 40%, of all global government debt now has a negative yield. As bonds approach and go below zero bound, they are less effective as a traditional hedging vehicle.”

To generate decent returns in the current environment, Canadian investors need to be more goal oriented and, on the fixed income side, that means stepping away from traditional long duration bonds. “That could mean looking to other solutions like private debt, which is hedging out interest rate risk and is more flexible,” Colborne says. “It’s not the sole solution but it helps you achieve a goal of generating a real return with lower volatility. Step away from the old model: if you don’t do that, you have to substantially ratchet down expectations.”

How about you: how do you plan on managing the current investment climate in Canada?