TDAM Talks Podcast: Debt Duality - Fixed Income from Both Sides of the Market

Announcer: Welcome to the TDAM Talks podcast. Today, our focus is on fixed income. First, we'll be discussing the changing rate environment and the outlook for inflation and future rate cuts. And then we'll lead into a discussion on private debt, the enhanced yield offered by the solution, and how investors can get access to the market through expanded TD Asset Management offerings.

Ingrid: Welcome to this episode of TDAM Talks. As a reformed “Bondie”, I'm super excited to be talking about all things fixed income today and specifically we're going to be talking about tools in the toolbox for managing higher yielding return, seeking fixed income portfolios, and putting a spotlight on our expanded capabilities here around global private credit. On the podcast today, I have returning favorite Michael Augustine, managing director of Fixed Income and Asset Liability Management here at TD Asset Management and podcast newcomer... Louis Bélanger - not new to TD Asset Management. Louis is the lead portfolio manager of TD Asset Management's private debt initiatives and who is building a new global private credit fund and strategy for the benefit of both our institutional and retail investors. We're really excited to be talking about this new dimension today and we really hope you get something out of the conversation. Welcome, Michael and Louis.

Michael: Great to be here Ingrid! We can't start talking about fixed income without talking more generally about where we are in fixed income because, you know, at the end of the day, we can do everything we can to enhance the returns of the fixed income portfolio, but the rate environment is the foundation. So can you ... let me kick that off with you: look, we just saw some new inflation data yesterday.

Ingrid: We saw an early cut from the Bank of Canada in June - our first cut. Federal Reserve is being watched. What can you tell us about the rate environment?

Michael: Yeah, so one word that keeps coming back on our desk is divergence. So you kind of characterize Canada, U.S., we're watching Europe, Switzerland, Sweden, Czech Republic, Hungary. We got data out of Australia yesterday, so this concept of divergence is something that we're focused on. And in fact, last week we had a “Bulls and Bears” session on it. So Jonathan Lau and Lauren Bellai did a fantastic job. It is important to remember that the Canadian economy has reacted differently to monetary policy than the U.S. and there are a lot of good reasons for this divergence. If we think back to the pandemic, there was a really strong U.S. fiscal response or spending by the U.S. government. Right? This is a huge tailwind to the U.S. economy. And as a result, we keep hearing this word sticky. So if the consumer in the U.S. and inflation in the U.S. has been sticky, much different experience than Canada, sort of maybe on a more relatable level, if you think about the average Canadian in a five year fixed mortgage rate, a lot of people ... 2020 recession have repriced their mortgages into this higher rate environment. Compare that with U.S. products that have 30 year tenures, a lot of people that hasn't even impacted them. So if you think about the transmission mechanism where central banks are raising rates and how it hits pocketbooks, we've had a different experience in Canada.

Ingrid: Faster and more acute, right.

Michael: And when I left over for discretionary spending. So we've had a much different experience. So in some ways, maybe not surprising that we're cutting rates first, but there's this concept of how far can we cut ahead of the U.S.? Because at the end of the day, our economies are tethered together. They're our biggest trading partner. Our currencies are heavily intertwined. And the central bank has been out talking about that. They sort of said, you know, we can diverge from the U.S. There are limitations, but we're not at that limit yet. And I think some research on the team has sort of indicated, you know, maybe if we get three or four rate cuts ahead of the U.S., that would be problematic. But our estimate for the rest of the year is that we're going to probably see three more in Canada. We'll probably see two in the U.S. So this divergence will be there, but it's limited by the fact that central banks are starting to all move in the same direction.

Ingrid: I want to capture, Just because there's always a potential time lag between the moment that we record this and somebody listens to it. So as we're recording it, we saw the June 25 basis point cut. We've seen the 2.9 inflation print in Canada. We're on hold to see what the Bank of Canada does in July. So you're saying even with what we saw yesterday, we were still calling for another three rate cuts in the calendar ‘24.

Michael: That's still our thinking. I mean, after the inflation print yesterday, the markets priced out the July cut. What markets price in and out things quite quickly. And if we think back.

Ingrid: Data point by data point. Yeah.

Michael: I mean if you if you think about the Fed December 13th and December 12th, that was the pivot the market priced in seven cuts. And what did that do? Well, it signaled to the market that rates were coming down. The equity markets took off. Everybody felt a little richer. There was more spending. We kind of pulled forward those rates cuts and in a way that was almost an easing. So I think markets are going to price in and price out things, but I think we want to sort of step back, look at the fundamental data. And the Bank of Canada has said that they're going to be data dependent. We've got another print, so we're going to follow the data.

Ingrid: Yeah, that's what I'm taking from our entire dialog here is that, you know, Canada can go another two or three without being dependent on the US decision to do that. You also mentioned “Bulls and Bears.” And then just for our listeners, that's an internal session that we run across our portfolio management teams or we literally create internal debates on topics. So we know that we're feathering through every kind of permutation and combination of scenarios. Louis, I want to turn a little bit to you, and now we've talked about the rate environment, which is obviously a fixed income portfolio managers starting point and then we at TD Asset Management are known for our credit expertise and our ability to add the variety of different types of credit to our portfolios, whether it's traditional investment grade credit, high yield credit. Eight years ago when you joined, we started implementing investment grade private debt and now we're moving into the non-investment grade space. Can you talk a little bit about your background briefly and then a little bit about what that means? And in the credit space, what's actually in that non-investment credit space?

Louis: Sure. Well, thank you for having me on this podcast. So I have almost 30 years of experience in the credit markets. And actually, I started my career in asset liability management for insurance companies. So I well ingrained in the institutional asset management. Here at TD Asset Management, as you mentioned, I'm the lead portfolio manager for our investment grade quality private debt funds. That represents roughly $5 billion of that institutional money. There's a little bit of retail as well in there. And the reason why we designed this strategy eight years ago, was for number one, diversification. The Canadian bond market, corporate bond market is extremely concentrated by issuer and by sector...

Ingrid: Banks and pipes....

Louis: You got it. And number two, it was obviously a yield enhancement play because, you know, there's a trade off here for going private.

Louis: You give up liquidity of the public markets, but also you can harvest that liquidity premium over time. And most of our investors are buy and hold investors and they need the income above and beyond what they, you know, what they can get in in the public markets. So in a nutshell, that's kind of the strategy and as I mentioned, the diversification effect. It's great because if you were to look at a chart of the composition of our fund, it's kind of a mirror image of what you would find in a corporate bond market, you know, the corporate bond market in Canada, a lot of financials and pipes. And in our fund, you will see a whole lot less of that and they're going to be more industrial. So on and so forth.

Ingrid: So when we, you know, say about post-financial crisis, when the yield in the fixed income market wasn't (there) right. So the importance of private credit to yield to enhance that yield, who have been the key players like, you know, how do pension funds, how do insurance companies use that market and what are the types of investments because I don't know that our listeners necessarily would but understand all the vehicles that sit inside of that space. How do we think about that and how big is the market?

Louis: Yeah, in terms of investment grade quality private debt, we estimate that the market is roughly $1 Trillion U.S., if not bigger.

Ingrid: As we're speaking generally in North America first here, right?

Louis: Yeah, that would be North American. And the primary players and investment grade quality private debt. Our insurance companies who manage illiquid liabilities, it is a great match to, you know, to to manage these liabilities, get the enhanced return. But more and more what we've seen and I've worked with Mike on this for quite some time now, corporate defined benefits plan have been coming to the investment grade quality private market to get the diversification benefits as well as the enhanced income. And it's especially good for those very mature, defined benefits plans where they're almost all moving into fixed income because there's very few actives, very few deferred. A lot of retired. And you know, in that asset liability management framework or LDI liability driven investment, it's a great tool to to manage the liability promise like that pension promise. So that's kind of....

Ingrid: Yeah and I was ... I know we're going to spend some time talking about the non-investment grade space, which is the sort of the arrow we're adding to the quiver here. But before we go there, you speak of pension fads and insurance companies buying up these assets. So ... but I'm thinking about tourism availability, right? You lead the team that puts the the ingredients together, but maybe talk about origination and sourcing those deals, like how do we get access to the private debt market?

Louis: Yeah, very good question. It's the questions we get asked a lot. So we have an origination team, There's six or seven analysts there and that team and we get access to transactions three ways. One is the traditional, I'll say, a broker dealer route, you know, to the securities and you know the other players and market.

Ingrid: Underwriters, yeah...

Louis: Yeah similar to that and also in the US you know I won't name them but you all know them so that's one rep. The second one would be very specialized intermediaries in the private debt market where they would have, for example, a specialty in arranging financing for renewables projects, for infrastructure projects, for real estate projects or buildings, so on and so forth. So we have a vast network of connections in that market. And the third way is forging relationships with the private equity sponsors. They always have needs for their portfolio companies, for projects on and so forth. And we have direct relationships with these players in the market. And I would say that preferably we'd like to go direct with this private equity sponsor, like direct lending, quote unquote, and also these specialized intermediaries, because we can keep small clubs. You know, there's a handful of lenders, max(imum), in the transaction, and it's much easier to drive the terms and conditions in the loan agreement. And as lenders get better protection and get an enhanced return.

Ingrid: And by pooling these assets together in structures, can we give the traditional retail investor access to those kind of enhanced returns?

Louis: Absolutely. At TD Asset Management, we do have a product that marries a liquid sleeve, the core plus fund, as well as our one of our private debt funds. And the investor comes at the top while we wait to invest in new transactions as they come in the private debt portfolio, their money is parked in that core plus fund. And then we draw from that pool to invest in private debt.

Ingrid: Okay. So I want to, you know, keep moving the conversation along. And Michael, you know, the team is now moving into this new category ... non-investment grade. So below triple B investment grade private debt. What's different about that category? And then we'll talk back again to Louis about like how we're sort of pulling that together. But, you know, when you look at the toolbox you have across all of your mandates, what is this giving you that you didn't have before?

Michael: I think that this is an additional plus, right, like we're always looking for ... to the earlier point about the lack of depth perhaps in the Canadian market. Right. We're 2% of global GDP and 2% of global investment grade bond markets. Right. So anytime we can add a “plus”, that's going to expand the opportunity set, give us increased yield, improved diversification. These are the things that are going to give us a better risk adjusted returns within portfolios. I think it's a great complement to what we already have. There's a lot of issuers that are going to be in the private markets that don't come to public markets. If you think about a hospital, a bridge, you know, these are things that are not correlated with the pipelines and banks, right? So these are going to be a great complement to what we do. And I also think just the robustness of discussions between the public and private teams putting together a portfolio, I mean, there's a lot of intangibles we get from having professionals like Louis complement some of the other people that listeners would know like Ben Chim and Rachana Bhat. And so I think the elevation of that discussion and the robustness will be great too. It's going to be helpful in many different ways.

Ingrid: So Louis and talking about, you know, the added capability, I think there's two new dimensions here. One is that it's non-investment grade in the private space because we've been in the private space for, you know, almost a decade and it's global. So can you talk a little bit about that? You know, ... , you've talked first on the investment grade piece, but now what are we getting access to? How much more yield are we talking about that once you take that step below the triple B, what does that kind of curve look like? Like what's the trade off in terms of the opportunities are looking forward and what they bring to the mix?

Louis: Right now, the spread between to go from investment grade to below investment grade is roughly 300 basis points.

Ingrid: In the private debt space, right?

Louis: In general. In general in general, I would say that that's about the ...

Ingrid: The Triple B to Double B - the jump off point is 300.

Louis: Yeah. So to give you a frame of reference, high yield bonds right now are just under 8%, about 7.2%. On average leverage loans are yielding roughly 9%. And the strategy here that we're targeting as of today, the yields would be about eight and a half to ten and a half percent. Just to give you a frame of reference, when we think about this new capability, I mean, we have to remember that TD Asset Management has been in credit for for many, many years. We have roughly ... I was looking yesterday about $60 Billion in credit under management that TD Asset Management, there's over 50 professionals involved at any level in private and public credit, both investment grade and below investment grade. So as Mike said, there's great synergies there and coming up with this new product is a natural extension of our existing capabilities. So it's not a big stretch for us to, you know, to dive into this world.

Ingrid: So when we're talking about investment grade or even non-investment grade private debt, how big is the landscape that you're accessing?

Louis: Yeah, the the below investment grade private credit world. I mean, depending on the numbers or the data sources, you're like I'd say probably around $1.7 to $2 trillion in size. And it's primarily concentrated in North America and in Europe as well.

Ingrid: So when we talk about our traditional portfolios and part of our mantra even in our core plus mandates has been, you know, we go and get that opportunity for incremental yield in the non-investment grade space, public market or private market. But we don't go into the deeply distressed. We don't you know, we don't go to the Wild west of added risk. We're trying to get the most incremental return for an appropriate level risk in our portfolio. So maybe talk about that in the private credit space. How much like how far are we going? What's different about the way we're approaching it? Because this is not a new asset class category, but how do we approach it?

Louis: That's a good question. I mean, you're right. Like at one end of the spectrum, you can go and buy distressed debt. At the other end of the spectrum, you can go and buy some Double B highs and so on and so forth. So we're going to be more the latter. We're going to be at the upper end of the credit quality for our portfolio because at the end of the day, what we're looking for, the goal of the strategy is to generate stable income for our investors. So, yes, you know, if you want to generate 8.5% to 10.5%, you have to take some credit risk. But we want to take calculated credit risk and we want to make sure that there's not going to be lost principal, i.e., we're getting it repaid at the end of the term ... the loans.

Louis: And two, that we can clip that coupon along the way. So that's the strategy. We're not trying to knock it out of the park and buy something at $0.10 on the dollar and trying to restructure it to a par value that's not the strategy we're pursuing.

Ingrid: And whereas, institutional investors may make a direct investment in a fund or a vehicle that captures this source, return for the more traditional retail investors were overlaying it into our solution set, right? So it's a marginal incremental but a meaningful increase in return that we're generating, right?

Michael: Absolutely. The nice thing there is, you know, when you compare it to the public opportunity set, we'll be able to access a well compensated credit, but at the same time not take on interest rate risk. So we can also use tools in our toolkit to take more tactical or strategic views on rates. But it's nice that this is a floating product.

Ingrid: Yeah, I think that's an important point, right? Because traditionally every credit that we'd have in the portfolio has a duration as well attached to it. So you always have a combination of credit risk and interest rate risk in the credit. But talk about how that's different with these being more floating rate vehicles.

Louis: Yeah, and the below investment grade private credit world, most of the underlying investments have the floating rate component. They are floating rate. They're based usually on “SOFR”, which is the Secured Overnight Financing Rate published in the United States. And right now these loans pay sulfur between 300 to 500, maybe 600 basis points. So to go back, you know, to that 8.5% to 10.5% percent in total yield that we're expecting to generate.

Ingrid: And actually then a pretty stable reserve source of return because you don't have that relative duration volatility attached to them. What do advisors need to know about investing in this space? Right. Like, as I think, you know, we do have advisors come to us and say we'd love that. We want liquidity and we want to be able to do this right. They want they want all the benefits sometimes without some of the restriction that creates the benefits. So what do advisors need to know about the private credit space?

Louis: Well, I think the reason why one would invest in private credit, one, is for the diversification effect, away, two, there’s less sensitivity to interest rates and three, for the stable income. So these would be the main reasons.

Ingrid: But institutional investors don't have the need for liquidity. Advisors often do. And that's why by embedding it in within our solutions, they're getting the benefit without giving up the liquidity here. How does an advisor then think about private credit in their portfolio, particularly the non-investment grade?

Michael: Yeah. So I think one of the nice things is that when it's embedded in a solution, essentially you're handing over to the manager the ability to create that solution and embed these less liquid securities in a portfolio context. So that really takes away the need for the liquidity planning because it's really at the vehicle level.

Ingrid: Yeah, they think they're getting the benefit of the enhanced yield for sure, but in a moderate amount because they're still sustaining the liquidity of the overall exposure, right? And they're not going to participate the same way as an institution might. But it does play back to this theme. And, you know, for our listeners who've listened to my recent podcasts with Colin Lynch on the private asset side, or Hussein Allidina.

Ingrid: On the commodities side, we've had great conversations about the democratization of asset classes and the embedding of returns beyond the traditional public market returns into client portfolios. And that's really what we we excel at here. It's management, it's this building of solutions. Okay. So I want to pull the narrative back up again, right?

Ingrid: Because underpinning everything in fixed income and this is what our listeners also want to know about is let's talk about the market environment again, the things that drive the overall rate environment. What's the outlook on inflation? I know we touched a little bit on the beginning, but sort of looking forward, what are you thinking for the overall rate environment?

Michael: Maybe… maybe two things. We're focused on Fed speakers, which is always exciting. I trying to get tidbits of what they're thinking because they vote. Earlier in the week it was interesting, the San Francisco Fed participant, Daly, was talking about the balance of labor and inflation and over the last couple of years primarily focused on inflation. But things are coming back more in balance. I would also say, you know, I used the word sticky earlier on. The other thing that we're doing is digging deeper on the sources of inflation, because obviously early in the pandemic, you know, we all lived on supply chains and (had) problems getting things ... and chips. And so goods inflation is well behaved right now. Everybody's digging into services inflation and they get a little bit more granular there. We think about housing service inflation that is eased, but we would expect it to ease more. The component there that we are looking at quite a bit is rent, right? If you think about the amount of time it takes to reprice the rental market, even though rents are coming down in the U.S., landlords could only adjust rents periodically for tenants that are in place. Obviously a new tenant, it's a bit more freedom. So we think there's these underlying trends that are going to cool inflation, but they're going to take some time to play out and certainly when they look also how the consumer is behaving. So the other thing we look at is the “Beige Book.” I know that's not an inspiring title. It's a lot more colorful in the data, but, you know, there's suggestions that consumers are starting to push back on price increases. Right. And a lot of retailers are starting to lower prices. And there's also this migration down to more cost effective purchasing by consumers. And then you put on that inflation expectations. You know, when people are thinking about wage increases and what they're expecting, those are also coming down. So a lot of underlying trends that point to this cooling in inflation in the back half of the year, it's still going to be a bumpy ride. There's still going to be sticky components, But we think this is going to lend itself to an environment where the Fed can start to cut rates. And this softening narrative is in place.

Ingrid: And again, you know, central banks, moving rates is one thing our investors care about, where we're going to move the money. So as head of fixed income, and ALM here at TDAM, and a member of the Wealth Asset Allocation Committee (WAAC), what are the views of the WAAC right now?

Michael: So if I think about fixed income where moderately overweight fixed income, right, we still like fixed income. And then I think about credit, we're modestly overweight credit within the fixed income allocation. So we do like that incremental compensation that you can earn on corporate credit over a comparable government bond. But we are mindful right now that the compensation, like a lot of risk assets, has become a little bit more expensive. So we're going to do our homework, we're going to make sure that we're going up the quality spectrum a little bit more of a protective stance and make sure that we're prepared for any turbulence that occurs in the second half of the year and be well prepared to take advantage of it.

Ingrid: But still have that ongoing running yield, which is now further enhanced by the addition of the non-investment grade global private credit tool in the toolbox.

Michael: Yeah, so, so definitely income and some capital appreciation when rates start to lower.

Ingrid: Because you’ve both been “Bond guys” for a very long time, doesn't it get exciting when fixed income becomes a return seeking asset because we like the boring bond people? Anyway, that's awesome. As we always do, we love to finish our conversation with rapid fire questions, I'm going to throw them out. You guys can jump at all them. First one throw up in the air:

Ingrid: And I think you touched on this a little bit earlier. How about “government deficits?”

Michael: So I'd say slow moving train for the markets. I mean, I think we saw a UK experience and sort of a moment where people were worried about deficits. The markets seems to be swinging back and forth, the pendulum, you know, at one point of the year we're focused on auctions. The other part of the year we're not so much. But this is really a longer term story. I think we'll be fine in the short term.

Ingrid: “Hedging” for the advisors that hedge their books?

Michael: On that one. I'd say it's really a risk appetite decision when we think about hedging, the one that comes to mind the most often is currency. In a downward scenario, the USD is a flight to quality, flight to safety, and that provides a little bit of offset to capital depreciation. So in that regard, we like it for for protection. But again, it comes back to what you're trying to achieve in your total portfolio and your risk appetite.

Ingrid: Exactly. And then we've already touched on the final one, which was credit spreads. So my lightning round will pivot and at least at the time of recording, we already know the outcome. But did you get your call in the “Stanley Cup” right?

Michael: No!

Ingrid: The answer should be we're fixed income portfolio managers, so we're not betting men, that should be the answer.

Ingrid: Gentlemen, thank you so much for this discussion. I always love talking to you about, added capabilities, more tools that we have to help our clients reach their goals. For our listeners, please know that you can access our podcasts now on all of your favorite streaming devices Spotify, Apple, Google and Amazon. And as always, can find us on TV Asset management dot com.

Ingrid: Follow us at LinkedIn. And as always, have a great day and stay safe.

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