Benjamin: I'd say what excites me the most is just the return profile is great and there's a lot of places to find really good risk adjusted return yields. Even though spreads are quite tight, I can think of one part of the market in particular that I find appealing, which is in the hybrid space where you're getting subordinated debt of some fairly strong investment grade companies and they're providing yields 6 to 8% really
Sayada: Hi everyone, welcome to Portfolio Manager Views. I'm your host today, Sayada Nabi. I'm part of the client portfolio management team at TD Asset Management. And today I have with me Benjamin Chim. He is the managing director and head of credit at TD Asset Management. With over 20 years of corporate credit experience, Ben spends a lot of his days navigating credit markets, and I get the pleasure of peppering him with questions every day because he is my desk neighbor.
But today we get to do it with all of you. And so I love hearing about your experiences they’re better than reading something on Google for me and so let's start there. Let's talk about your two decades of experience in the credit market, What you've seen. You've essentially had a front row seat to a lot of seminal events.
Why don't we start there today?
Benjamin: Thanks for the introduction. Sayada, I really appreciate it and I'm really excited to be on this podcast with you going to confirm what you hinted at in that intro, which is (I’m) a lot older than I look, and I started my career in 2000 where I got to see the tail end of the dot com bubble rising and then the full part of when it burst.
I also managed high yield bonds through the great financial crisis. So during 2008, which is a fun default cycle and got to do it again in 2011 when we had the European financial crisis, there were about the volatility that came after that. But the most seminal one and most important one was COVID and what happened there, and particularly the ripple effects that it had in the market afterwards on the bond market.
Sayada: Amazing. And we're going to go through some of the lessons you learned as we have this conversation today. And when you brought up COVID, I think that was one of the marquee events for me as well. I remember extremely vividly, and I can't believe it's been six years since then, but we were holed up at home, stores were shuttered.
That was at the individual level. However, globally, that meant economies did come to a standstill and it was a very tough time in many respects. But when it comes to traditional portfolio management, it was very hard for traditional portfolios as well because bonds were expected to provide diversification. However, yet, bonds and equities both sold off at the same time.
So from your perspective, what made that period so unique, so different? Why did virtually all asset classes sell off?
Benjamin: Yeah, you're right to use the word unique. COVID was an incredibly unique period, not just for the markets, for humanity in terms of what we went through. And because of that, it's kind of difficult for a lot of people to comprehend the scale and the challenge of the economy coming to a complete halt and then trying to start it back up again and the supply and demand challenges that came with that.
You mentioned how a lot of consumers were stuck at home for a while with COVID. And so when things open back up, they were very anxious to get out there and spend and do things again. Companies were trying hard to oblige them and be a part of that as well. A lot of them were fueled or supported by country liquidity programs from the various governments, and so they had the capability to ramp up their demand there.
So we saw demand in general just increase and accelerate rapidly and supply wasn't able to keep up. The supply chains were broken. You had workers that were furloughed and it was a challenge to get them back into the workforce in a safe way. And a lot of times that needed retraining and that mismatch between the rapidly growing demand and supply that was struggling to get online created an inflationary pressure that we hadn't seen in over 30 years.
So central banks had to scramble to try to contain that, to try to keep inflation from getting out of control. And we saw a rate hiking cycle that we hadn't seen. I don't think ever in terms of the speed of the rate hikes. So we started the year in 2022 with the policy rate at 25 basis points or 0.25%.
We ended it with Canada, the Bank of Canada rate was at four and a quarter, The Fed rate was at four and a half percent, so roughly 20 times increase in the policy rate during that period. So interest rates were adjusted much higher. And as a result of that, there was a very painful adjustment in the bond market, much lower.
And that was not fun for anybody.
Sayada: Yeah, exactly. So two things there. I remember when we were talking about supply and demand, what the consumers were doing. I remember that whole debacle with toilet paper, how you couldn't get enough. It was kind of just a memorable time, I want to say. And then, of course, central banks, they did respond quite aggressively with one of the fastest rate hiking cycles in modern history, as you mentioned.
And so what that meant is bond yields went up. And when bond yields go up, prices behave inversely. So bond prices went down. And of course, bond investors, they experienced significant losses there. And as you said in Canada, it went from 25 basis points to 4.25. And what that meant for many consumers, investors, mortgage rates, they were higher financing a car that was higher.
And we know that depending on who the borrower is and how risky they are, those borrowing rates differ from one person to the next.
Benjamin: Yeah, you're right. The concept is the risk free rate, right? And for any bond or borrower or whatever loan that was created during or before that big hiking cycle, that interest rate on that needed to adjust to be higher than the policy rate because the policy rate was the ultimate risk free rate. So that is that credit spread that you're sort of implying there.
And beyond that adjustment, just on the rate side itself, because borrowing costs were higher, that created concerns around the market. That is the economy going to slow down and we're going to see a recession or we see default rates start to rise. So credit spreads are risk premiums also blew out and credit didn't perform very well. Equity markets were concerned about all of that.
And typically the recession, whenever you hear recession equity market sell off. So we had a big sell off there as well. And as you said, there was really nowhere to hide in 2022 that traditional benefit, if you will, from diversification. Owning stocks and bonds really didn't work that year.
Sayada: Fast forward to today. The fixed income landscape does look very different from where it was heading into 2022. So what we were looking at is a zero bound rate and then today we are significantly higher than that. But even though it felt like a reset, it does feel like rates are kind of at a really normal level because before the GFC, this is kind of where rates were historically.
And so when we're comparing today to 2022, what stands out for you? What do you think is really important for investors to take away?
Benjamin: Yeah, I think you hit on what is the most critical distinction between today and where we saw back then, which is that the starting point in yield is much higher today than we were at in 2022. So just take the ten year bond as a good example of that. At the beginning of 2022, the ten year bond with yielding 1.5% - today in Canada, the ten year bonds at 3.7%, in the U.S. it's 4.7%.
So you're getting more than 2 to 3 times the amount of return to be in the ten year bond today. So to put it simply, you're getting much better compensated for that volatility today than what you're looking at in 2022. Another really important distinction to think about is the inflationary backdrop is much softer, it's much more benign. It is, you know, a bit of causing a bit of pressure, but not to the same extent that we were looking at in 2022.
So right now, inflation, North America is running around three, three and a half percent and we're actually starting to see some signs that that's starting to slow down a little bit. And that contrasts with, if you remember, 2022. It just felt like inflation was going to keep rising forever. And there was questions about whether or not that could be contained.
We piqued out at 8 to 9%, so significantly higher. So that is much better as well. I do want to point out, though, that despite inflation feeling fairly contained, we are seeing a lot of volatility in interest rates in the last little while in the last month or so, and interest rates have moved significantly higher. In fact, the 30 year bond in the U.S. has surpassed the yield level that we saw at the peak of the yield in 2022.
We're now trading at the highest level since 2007. So what's happening there? Inflation subdued, what's happening there? There's a couple other factors that are contributing to that. The first is we have a new Fed chairman, Kevin Warsh, and he has been somewhat noncommittal and vague about how the Fed is going to react to changes in inflation and changes in the unemployment rate and growth and how he feels about where the right level is in terms of the bond yield curve.
And those uncertainties are being priced into the yield curve right now, and that's adding a bit of a premium to yields. And then the second factor, which is having a big impact, is just the sheer amount of supply that we're seeing in the bond market. So as you know, governments are running big deficits. That's going to be need to be funded with more debt.
And so that issuance is coming today, but also going to keep coming going forward. And then you have the corporate bond market, which has been an anomaly in terms of how much supply we've seen this year. So investment grade issuance in the U.S. is up 35% year over year. It's up 50% in Canada year over year. A lot of that is to fund nearly all of that, really to fund AI related CapEx spending from the HYPERSCALERS like Google, Amazon, etc. and others, and that is creating some indigestion in bonds, particularly in the long and some concerned because this is just the tip of the iceberg.
They're going to do this for the next few years as well. So there are three factors, including inflation. You've got the Fed and you've got supply that are causing bond yields to be higher today. But what's important to think about there is it's more about the long end of the curve tends to thirties, and we think that's where the volatility is really going to be felt and less about the entire fixed income complex.
Sayada: Got it. So it's isolated to the long end. So a lot of two sided risks. You've mentioned you've mentioned Warsh, you mentioned borrowing for CapEx purposes, borrowing to fund deficits and of course, inflation concerns coming in and out basically from what happened earlier this year with oil. So a lot of things to consider, a lot of ways things could potentially get messy.
However, given where yields are, there is potential for positive implications. So when you think about that, how should investors think about yields from that perspective?
Benjamin: Yeah, the yield is, as you implied, the most important metric to think about when you're investing in fixed income security or fixed income fund, it is your best predictor of long term returns, particularly for higher quality securities like government bonds or investment grade corporate bonds. A higher yield, all things being equal, is better in really three ways. The first, of course, is your return profiles better.
Who doesn't want higher returns? And higher yield definitely gives you that. The second is with a higher yield means you have more income coming into your portfolios and that income can offset some of those price movements that you could see in terms of volatility because of interest rate risk or because of credit spread risk. And having a higher yield helps provide a buffer around that and keeps you from having losses in your fixed income portfolio.
The third benefit, which is I would say the most underappreciated benefit is if government bond yields are trading at a fairly high level. What that means is there's a considerable amount of fear and uncertainty being priced into government bond yields today. Should those uncertainties get clearer, should the fear start to subside, you could actually see interest rates fall, and if that happens, you're going to get some mark to market improvements and capital gains that can enhance your returns on top of the yield that you're getting right now in fixed income.
So taking all of that in balance, when you look at where yields are today and then the balance of the risk versus the return, it actually makes a lot of sense. It's pretty compelling to be in bonds given given that.
Sayada: Absolutely. So what I'm hearing is higher return potential income being the buffer, if not cushion for future returns. And this is the kicker. If rates happen to move lower from where they are because there's so much fear built in, there's that potential for a price appreciation from mark to market returns, which will also bolster performance. And so while this applies to the asset class as a whole, bonds are different from one to the next.
There's government bonds, there's corporate bonds. And within corporate, just to keep it simple, there's investment grade, there's high yield. And so that indicates that there is a range of risk and return for each individual bond across the spectrum. So that makes the opportunity set even broader. So when you think of building portfolios, when you think about these types of bonds, talk us through some of the opportunities available in today's market by using these types of bonds.
Benjamin: Yeah, it can be confusing to investors just to think through like what's the best way to attack the market. And I would say if you're an investor looking to allocate to fixed income, it's important to answer this question first, which is what's my objective with this allocation? What am I trying to achieve through being invested in fixed income?
So, for example, if your objective is generating a good incremental or additional income to your portfolio, so, you know, adding to what you're currently earning at work or some other sources of income, there's a few ways to think through that and options around that. You can do that through owning government bonds and high quality investment grade corporate bonds or a blend of the two.
So core or core plus type strategy. And there you can be very confident in the income that you're going to generate because there isn't a lot of risk around that from a credit perspective. And so those right now, the yields around 4.2 to 4.7%. And so you can feel confident over long run, you're going to earn that kind of yield going forward if that's if you want to get a little bit more than that, if that's not quite enough, then you can move further out the credit risk spectrum.
So investing in a high yield bonds, leverage loans, private debt, they're your yields more like 7 to 10%. You are introducing, however, a significant amount of credit risk into your term profile, which means, you know, companies will default, companies will have impairments that's going to take away from that overall return, that 7 to 10% that we talked about. And so it makes more sense.
It's more prudent to if you're moving out the further out the risk spectrum to be invested in active solutions rather than passive ones. So this way you've got expertise, you've got managers sorting through the opportunity set and making sure you're investing in the good companies and avoiding the bad ones compared to if you're doing it passively, you're investing along with an index, and that's going to own everything.
Now, another scenario that I often hear from clients around investing is I have, you know, a client might have a pool of cash that they have right now. They have some kind of expenditure that they want to do in a couple of years. As you mentioned, something like buying a house or buying a car and they want to make sure that money's going to be there in two years.
But they also want to earn some kind of return on that. What do we do? And we find we think the best solution for that is investing in the fixed income market with something, an instrument or a fund that has a hard maturity. So it can be either done through individual bonds like an individual government bond, a two year government bond can ... is very liquid.
You can be very confident about the yield and the return on capital. You're going to get your money back. But the tradeoff there is that the yields are somewhat low right now. A two year government bond of yields, 2.9%. So maybe to get a little bit more return, you can invest in an individual corporate bond. And there you're getting an extra 50 to 75 basis points of return to be in the corporate bond.
But the tradeoff there is it's a little bit less liquid. So it's going to the trading in and out of that is going to take away from that return a little bit. And while most investment grade companies are very safe, you do run the risk of being very concentrated in your credit risk and owning that one company that doesn't do well over the next couple of years.
So a third way to think about this and a solution that we provide our clients is a target maturity Bond ETF. And there you own a portfolio of bonds in high quality investment grade bonds that about 30 to £50 in total, all maturing in that maturity year. And another in that fund will mature during that year as well.
And when it does, it distributes the proceeds from what it got from all the bonds back to its unitholders. It solves a lot of the concerns around an individual corporate bond in that you don't you're spread out in terms of your credit risk. It's an ETF, so it's traded actively. Trading costs are significantly lower and then your returns are still pretty much the same as you were before.
So that's that's the best way to approach that issue. And just just some of the issues that we hear from clients overall.
Sayada: One thing that resonated was the fact that there is a lot of dispersion when it comes to the credit markets right now and why active management really makes sense, because you don't want to just have just be passive, buy everything, follow the index. Whereas with active management, you get that selection, you get you get the picks and pans, you choose where you want to be allocated.
And so from what you said, the question really isn't if somebody should own fixed income, but rather how they should own fixed income and how they should build out their sleeve. And it actually reminded me of something I like to do. It's it's it's a bucketing approach, really. So I use core as kind of the stability pillar of my portfolio.
And then I will have two more buckets where one is for a liquidity need. So target maturity bonds could make sense in there ... shorter term bonds. And then the other bucket. So the third one is for those high octane pieces. So I'm thinking high yield, I could put it in that bucket. So something that will give me a bit more juice, but that's not the only way to build a fixed income sleeve.
There's other ways to use target maturity bonds to build that sleeve, one of which is laddering.
Benjamin: Yeah. So you're right about the sleeves, making a lot of sense if you are looking to invest in fixed income but have or be able to adjust to different needs, that can change over time. When it comes to laddering, it makes a lot of sense for that liquidity sleeve as a ladder, as a possible solution there. That liquidity sleeve can be expressed in many different ways, right?
You can own a short term cash like ETF. You can own some something floating rate that's super safe. And with those type of investments, they're really great in terms of the risk of losing any capital is almost nothing. Right. It's going to hold in very well. But the tradeoff there is you run into what's called reinvestment risk and what that means is as interest rates changes, typically if they fall, your returns fall as well.
So just an example of that. If you my money market fund is yielding 3% today. Next week, if the yield, the money markets fall to 2.75%, let’s say, or two and three quarters, then that's your return going forward, right? You're not going to get 3% and you'll get 3% for a week and you may not see that again. So a bond ladder really kind of helps to diversify out that kind of interest rate exposure so you can limit the amount of reinvestment risk you have, but at the same time, you're not fully concentrated, say, in a five year bond where you have more interest rate risk in volatility.
When rates go up or down, you have something in between there. A bond ladder would be a situation where instead of 1 to 5, you have investments across five different same maturity buckets every one year, two year three or four year and five year. And there your yield or return profile is going to be better than being in the short end.
But at the same time, you can have better liquidity than being fully invested in long end because at every given year about a fifth of your portfolio will mature and you're getting that liquidity back into your cash accounts and interest on top of that as well. And then you're free to do what you want with that.
Maybe if you have a big purchase you want to make that can help with that or you can reinvest that into the market. You know, if yields are higher. Right. And things like that.
Sayada: Exactly. So we've covered a lot today. Why the environment today is different from 2020 to the opportunity set in fixed income, how you can get exposure through different types of bond, different types of products, and how to construct fixed income sleeves of portfolios. And so as you look ahead over the next several years, what excites you the most when it comes to fixed incomes?
When it comes to bonds?
Benjamin: I would say what excites me the most is just the return profile is great and there's just a lot of places to find really good risk adjusted return yields. Even though spreads are quite tight, I can think of one part of the market in particular that I find appealing, which is in the hybrid space where you're getting subordinated debt of some fairly strong investment grade companies and they're providing yields 6 to 8% really.
And in certain sectors like the energy sector where you've got power utilities in as hybrids, they have some really good earnings profiles going forward. You know, you talk about, AI spending it all, everything that's going on there they need to spend on power as well. But unlike the uncertainty around, you know, what's the optimal compute level or how much land you need, it's very clear that power needs is is going to keep going higher and higher to power these more powerful chips. And so the fundamental backdrop is good and you're getting really good carry with these stories.
Sayada: Amazing. Thanks so much, Ben. I am excited because we get to continue having this conversation. But for everybody else, thank you for joining us today and hope to see you next time.
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