Strategies to navigate Canada’s ‘worst ever’ bond selloff

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Earl Davis has never been this excited in his almost three decades of investing fixed income professionally. That’s because a combined threat of rising inflation and higher interest rates is forcing a “secular change” in the bond market.

The Canadian bond universe is facing a once-unthinkable reality of double-digit declines, setting the stage for an unprecedented second down year in a row. To Mr. Davis, managing director and head of fixed income and money markets at BMO Global Asset Management (BMO GAM) in Toronto, the situation represents opportunity.

“Active fixed income management has become critical,” he says. “For the past 40 years, interest rates have just been going down from a high of 18 per cent to basically zero per cent, [and] if you’ve been in a passive fixed income investment or [exchange-traded funds (ETFs)] … you’ve been winning every year by doing nothing.”

Now, Mr. Davis is among a growing chorus of experts warning that the bond market requires investors to pay closer attention. That means being able to alter duration and credit quality strategies nimbly or even moving part of a fixed income allocation into alternatives.

Ahmed Farooq, senior vice president and head of retail ETF distribution at Franklin Templeton Canada in Milton, Ont., adds he has never seen fixed income “so volatile” in his almost two decades of investing.

Chris Kresic, partner and portfolio manager with Jarislowsky Fraser Ltd., a division of National Bank Investments Inc. in Toronto, has been managing bond investments since 1994. He also says the latest selloff has been relentless and “the worst one” he’s ever experienced.

For advisors looking to hedge against rising inflation, Mr. Farooq warns even real-return bonds, which are linked to inflation, are down 13 per cent in Canada so far this year, “so you can’t even use that as a place to park your [money].”

Move to shorter duration strategies

One strategy that he, along with Mr. Davis and Mr. Kresic, points out is to move into shorter-maturity bonds as they’re less sensitive to interest rate hikes. That’s already a growing trend.

”From a flow perspective, advisors and investors [are] starting to shorten their durations if they can,” Mr. Farooq says. “There is also statement risk, where clients get statements at the end of a quarter and say, ‘Wait a second – that safe haven part of my portfolio that’s supposed to cushion me from equity volatility is actually down by as much or more.’”

To deal with that, some advisors are starting to tax loss sell early and move into shorter duration strategies because then, on the statement, the client is not down at all, he says.

Active management, which Mr. Farooq refers to as “unconstrained mandates,” is ideal in the current environment because it allows outsourcing to an expert who is going to make calls in a portfolio that can make up for an advisor’s lack of knowledge or time.

For example, he says the situation right now is similar to that of early 2020, when everyone thought rates were going to go up, but then COVID-19 happened and most investors were on the short end of the curve.

“If you went to the long end after March 2020, you would’ve been up by double digits by the end of the year,” Mr. Farooq says. “I wanted to do that, but I just didn’t have the courage. [But] that’s what an unconstrained manager could do for investors.”

Opportunities in alternatives

Another strategy gaining momentum is the shift away from traditional fixed income, with a lot of money moving to alternatives such as infrastructure, Mr. Farooq says.

User-pay infrastructure such as toll roads, ports, railroads and airports are becoming increasingly popular options, he says, as they provide a hedge against inflation as well as a reliable income stream.

Vinayak Seshasayee, executive vice president and portfolio manager at PIMCO in New York, says moving a portion of fixed income allocations into alternatives makes sense, but with the caveat that if the business cycle turns, alternatives can be vulnerable to more risks than public fixed income.

While sharper due diligence is recommended for any investments in alternatives, Mr. Kresic echoes the warning of a potential turn in the business cycle.

“Right now, you have a much flatter yield curve in which the risks of recession, which would help out the long bonds, have increased,” he says.

Meanwhile, Mr. Davis of BMO GAM is not as concerned. His team is preparing to buy “a lot of credit” because the economy is still good and they still expect above-trend growth for the next two years – even with rising interest rates.

He says now is not the time for advisors to start bulking up on fixed income products, but believes that time will come before the end of June, when he expects the Bank of Canada to hold off on further interest rate hikes for the remainder of the year.

“We anticipate a great opportunity to lengthen duration because we want to have that amplifier of lower rates from the peak rates that we expect will happen by the end of June,” Mr. Davis says.

However, he acknowledges the situation remains uncertain and reinforces the need to consider more active management.

“Right now, with higher volatility, inflation and interest rates, you need to get out of that sailboat and into a rowboat,” he says. “That is active management because then you don’t have to go in the same direction as the wind.”

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