Michael
Every day, businesses and households are making decisions around whether to spend today or wait, and that in and of itself is going to create an impact or transmit to how inflation plays out.
Ingrid
And we're leading into today's podcast with a good little giggle here. We know that bonds or fixed income might not always be the life of the investment party, but certainly it's the steady hand that stabilizes portfolios through market turbulence. Now, with inflation proving to be a little bit more stubborn than expected and interest rates keeping investors on edge fixed income is back in the spotlight.
And that's what we're going to be talking about today. What does it mean for returns? What does it mean for credit markets? What does it mean for all that cash that still sitting on the sidelines? Today I'm joined by Michael Augustine and Alex Gorewicz to break it all down and help you navigate the evolving bond and rate landscape.
Welcome.
Alexandra
Thanks, Ingrid.
Ingrid
As we're recording this, we've just seen January inflation data. U.S. inflation data has come in higher than expected around 3%. Maybe. Alex, I'll start with you. What does this mean? Like how do we think about this inflation that's proving to be a little bit stickier.
Alexandra
I think the cleanest way of assessing, you know, the macroeconomic backdrop is that the U.S. economy is resilient. and more recently, yesterday, in fact, we got, Canadian CPI data that despite the headline being around 2% or just shy of it, showed some, underlying strength. So I'm looking at the details not too dissimilar from what we've seen in the US.
And in particular, it's sort of the stickiness in services inflation that has policymakers worried that this inflation has stalled. Right. The path to, the 2% sustainable inflation target has stalled. and as a result, when we think about all of the policy rate cuts that we've seen, 200 basis points or 2% rate cuts from Bank of Canada since last June, 100 basis points, or 1% from the fed since September.
We now think that, you know, they have cover two parts. Wait and see what their rate cuts mean for the economy. from here on out.
Ingrid
We've talked about, you know, the rate environment in the context of inflation. But we now had this new wild card around tariffs playing on both north and south of the border. How do we think about that. Like if you had, a risk reward path six months ago or three months or a month ago, how has that changed?
Alexandra
That's where there are differences, between us and Canada. our economy is although it's showing some, some green shoots. We've had a couple of strong, you know, labor prints for the last two months. Again, some of the stickiness or resilience in, in inflation, all of that is in large part because, you know, consumption is holding up decently.
The economy is not great, but it's not horrible either. Unfortunately, because of that, walking the tightrope between and we'll call it great economy versus not-so-great economy, the threat of tariffs for Canada is, going to be highly negative. even just the general, like, looming, you know, tariff threat is going to be highly negative for our economy because it changes consumption patterns.
and it changes business investment, you know, intentions or plans, even with all of the rate cuts that I mentioned, Bank of Canada has delivered. But the good news is that Bank of Canada is still where it would call itself in the neutral range. In other words, its policy stance right now is neither accommodative nor restrictive. And that means that it has a lot of room to lower the policy rate to address any kind of negative economic impact from tariffs if they do materialize.
Ingrid
Yeah. So, looking forward from here, the status quo to another hundred lower lowers is all on the table. Let's say for the next 12 months.
Alexandra
Absolutely. But even without tariffs, Bank of Canada still has room, we believe to continue to lower the policy rate. It just won't be at every meeting the way that they have until now. but absolutely with tariffs, you know, they've shown that they think the GDP impact, negative GDP impact will be much more material this year if tariffs materialize.
And we therefore expect them to react by cutting, interest rates, not even 100 basis points, possibly more than that.
Ingrid
We're focused today on fixed income fixed income markets returns. But investors' portfolios are typically much broader. in terms of equity, fixed income and, and equities in different jurisdictions. Can you just take a moment and talk a little bit about what that means for a currency perspective and how we think about that?
Alexandra
What we've noticed, you know, you've talked about the different time frame. Sorry like last one month last three months. Right. So as the last one month has brought about a lot of volatility around tariffs, what we've noticed is that currencies are most reactive to those tariff developments. That's not to say that bonds or equities are not reacting. Its just currencies are reacting the most.
And this is where it's really hard to see or to have strong conviction that all the US dollar is very overvalued against all of its, you know, developed market peers. So, it's time to fade. The US dollar or the Canadian dollar, is very weak. It's time to go long. The Canadian dollar. Now, unfortunately, the tariff developments are still what I'd call binary right there.
That will happen or they don't. And it's hard to have strong conviction on how to, you know, balance those probabilities. so as a result, when we think about currencies, and again, just this sort of looming threat of tariffs, even if they don't materialize, I think it's going to result in a lot of the status quo that we've seen so far, which is, you know, a relatively weak Canadian dollar, and a relatively strong U.S. dollar.
Ingrid
So, Mike, you lead the fixed income teams here to the asset management, overseeing hundreds of billions of dollars of our client assets. How does the rate narrative play into some of the ways you're thinking about portfolio construction? Potentially.
Michael
Yeah. So maybe start by looking at rates. So last year we saw the Footsie in Canada return about four and a quarter right. So mid-single digits. The vast majority of that was income a little bit of capital appreciation I think Alex and I might have been here this time. Last time last year we were talking about income and that would be the primary driver going forward of returns. So, I think it's important to sort of step back and sort of see where we are in terms of rates. We're at a high watermark of the last 15 years, right. Rates. You know, there's a lot that's been said about credit spreads being tight, but underlying rates are quite high. I know one of the things that we always look at is, what's the starting position for investing and how much of a buffer do you have?
Right. So, Alex talked about some of the scenarios with which the Bank of Canada could lower rates. You know, what if rates went against us. So, they went a little bit higher. One of the things that provides comfort right now is that there's a certain amount of buffer, and it's higher than it's been in many, many, many years.
That's protecting portfolios. So, you may take a little bit of capital depreciation if the case of rates going up happens, but you're protected with the income that's coming in throughout the year. So, so we're going to have this constant focus around income. And then when we think about the sources of income, credit is going to continue to play a meaningful part of how we put we put portfolios together and think about portfolio construction.
Ingrid
You know, we think ever since the financial crisis, like we had, you know, a decade and a half almost of, investors being penalized, right? Savers were penalized with these historically really, really low rates. Then we had the rate shock as the rate environment normalized and people took that capital hit to their bond portfolios, both of which could really rattle investors.
But as you say, we're in such a better place now because barring any move in interest rates, your day in, day out coupon return is quite attractive now, more attractive than, than the alternative. Dix. And then you have the benefit of, you know, potential lower rates, all things equal, which is going to give you some of that capital appreciation potentially.
Right. So, you're right. It is. It's a really tremendous, environment. I want to talk a little bit about, I'm going to come back to the tariff piece because we've opened the door on the credit, conversation and credit. If our listeners, it's that part of the portfolio might be, either provincial credit or corporate credit. So, let's talk a little bit about the provincial sector first because certainly is some of the tariff threat can be quite damaging to the provincial landscape. How are we thinking about spreads in that space?
Alexandra
Well, spreads in provincials are not too dissimilar from corporate bonds. Not, you know, they're very tight and they're good reasons for that. you know, again, economies have been generally resilient. Provinces in particular have done a really good job in getting ahead of their funding needs. so, taking advantage of investor demand when it was, you know, red hot.
And I think that has served them well. Part of the problem, though, when we look forward is and this is true for all levels of government, is that the private sector will look to government to really create a bit of a buffer against tariffs if they do materialize. This puts, some of the larger provinces that have very diversified economies and diversified manufacturing basis in particular, like Ontario and Quebec, puts them in more vulnerable positions.
And so, while we're not overly worried about meaningful credit spread widening, in a tariff, you know, scenario, we do see some of the provincial names, to be more exposed than others.
Ingrid
Absolom still fairly stable, like we're talking some basis points, not wholesale move. And I think that's one of the important things we're talking about, is the role that fixed income plays in an overall portfolio to dampen volatility. You know the expected outcome is return income return plus a little. The worst-case scenario, as you say, is if we do have a backup and rates are still well protected from that through that day in day out income that you're earning in the portfolio for the fixed income funds type landscape, the types of strategies out there.
I want to go a little bit deeper. you know, when investors are looking at their options and I think there is some, you know, concern about fixed income performance, interest rate sensitivity or duration in this environment is a key driver of fixed income returns. I think many worry about maybe let's start by grounding our listeners on the concept of duration.
We throw it around as bonds. But what does that really mean?
Alexandra
So, you've mentioned interest rate sensitivity. So, let's take a typical corporate bond portfolio in Canada as well. We'll say plus or minus five years. So, what does that five years mean from a return potential point of view. If interest rates rise 100 basis points or 1%, which is a huge move, you take that duration at five years and the price impact to your portfolio, right?
The capital gains impact would be -5%. Now, we've talked a lot and you've heard my talk about income, right. And that being an important driver of, decision making and portfolio construction for bonds, if you look at the portfolio yield. So, let's say it's around 4 or 4.5%. That is income return that you're going to accrue throughout the year.
We usually look at yields on an annualized basis. So, if it's four 4.5% that's about what you're getting as income return throughout the year. What that means from a total return perspective is that you have that negative price impact of -5% plus the 4 to 4.5% offsets, right. So, then the total return impact, even if interest rates rise, which is a concern, as you mentioned, that some investors have about bonds right now, you would end up in a scenario with almost flat, slightly negative fixed income returns.
Ingrid
And I think and I think that's really important is for our listeners to understand that component of income in a fixed income portfolio is that buffer to rising rates, because you have the two components of return. And even in the 100-basis point rate environment rise, which we don't anticipate, income is always that buffer and cornerstone to how we invest in fixed income.
Here at TD, Asset Management is typically more yield, more income, more exposure to credit. And then typical that is our belief that it is one of the most consistent ways to add value to our portfolios. But what other tools are you using or adding to the portfolios to support that generation of income?
Michael
Yeah. No, it's a great point, Ingrid. If we start from what we do at TD m, we do, you know, extensive independent credit research. And the confidence in that research allows us to overweight this in portfolio construction. When we think about that, there's many different ways to express that credit confidence. First is in the public markets. And you know, we've been doing this for a very long time.
But one of the nice things that we introduced almost a decade ago now was an extension of that sort of a tangential capability, which was extending the same methodology to private markets. So, I know David Sykes always says the only free thing, the only free lunch in investing is diversification. And that's one of the nice things about moving into sort of private fixed income, for example, is that you're getting diversification, you know, in the Canadian marketplace, you're not getting exposure to hospitals, you're not getting exposure to solar panel companies, you're not getting exposure to real estate directly.
So, when you go into the private markets, it gives you that diversification, right? Which is welcomed. The other thing that we like is the yield enhancement. So again, you can get the diversification but get paid for it. A lot of private fixed income deals don't fit into traditional bank lending. people want customized schedules. They want to draw down when they're building something they want to pay off.
Once something's built, they want that uniqueness. And we refer to that as a uniqueness premium or an illiquidity premium in some respects, and that you're getting paid for some liquidity. And then lastly, you'd think if you're getting more yield, how can it also be safer? But it is when you think about public securities, they're often unsecured. When you go into private markets, there's something standing behind that loan that you've made.
There's something you have a claim to if there's ever a problem. So, you get that safety. So, putting these all together, it's a great complement to the public fixed income allocation. So, we like private fixed income. You can kind of think about commercial mortgages. In the same vein. You can think about leveraged loans. You can think about high yields.
So, the opportunity set in credit at TNM for fixed income is quite large. And then if I just think, you know, just to put some numbers to that, if I think about the returns of a core plus strategy last year being sort of 5.5% roughly, you can think of a commercial mortgage allocation of being 7.75% return last year, private debt, 7.25% return.
So, you start to get meaningful enhancements to your corporate allocation when you start to go into the private markets as well.
Ingrid
Yeah. And they can't be accessed by just anybody. We have teams that do that for us, that get us the access to those markets, which we then spread across all of our investors through the vehicles that we manage, which is which is. Try this again, because I think that any allocation to fixed income is dampening the volatility of the portfolio, but it comes at an opportunity cost in a great equity year.
So, the more that you can have that, you know, unique ways to add yield to that allocation, incredibly powerful. One of the themes that we've probably talked about so many times, it's one that, you know, worries me so much. We've seen so much money from investors parked in Giss. Right. We had some attractive rates a year and a half ago.
People went there amidst a very choppy market. But today, like, we're starting to really see an acceleration of the move out of G6 into fixed income. Can we talk a little bit about the return environment for traditional fixed income portfolios today versus what we're seeing into assets?
Michael
So, we were talking a little bit about this yesterday, Alex. Right. I guess investors have to ask themselves why they're indices like do you need that safety. They do play a role, but do they need to play such a role within a diversified portfolio? If we're thinking about it just from an opportunity cost perspective, I think you could start from the basis that a one-year GIC right now yields about 3%.
And then if you start to look into the fixed income market, what can you earn relative to that? So, the Footsie Canada corporate index right now is approximately 4%. And Alex was talking about duration. So, you take on a little bit more duration exposure. But again, you get that protection. It's another way of thinking about duration. We do get sort of this no tariff scenario play out.
Investors should expect to get around a 4% return. But if we do get this tariff scenario, you'll get that protection on top of the 4%. And then you could start to get into meaningfully, higher rates sort of in and around sort of the high single digits, eight, 9%.
Ingrid
I want to take us more now to the rapid-fire section, because we're going to throw a few things at you. If you could describe Alex, today's bond market in one word, what would it be?
Alexandra
Income.
Ingrid
That's the tramway. It's always about the income. What about you, Michael?
Michael
I'd say opportunity again. I think this is a unique window that we're in right now, and I think the opportunities are quite high.
Ingrid
What's the biggest misconception you still get when you talk to advisors or investors about bonds?
Alexandra
that all fixed income instruments are the same. I know there's supposed to be rapid fire, but I think it's important for investors to realize that in bond land, we have double bonds. We have investment, investment grade corporate bonds, high yield bonds, leveraged loans, friends, and close inflation linked bonds. I mean, the list goes on and on. And each one of them, even before we get to talking about the different credit risk profiles of the issuers, have such different risk characteristics.
So not all fixed income instruments are the same.
Ingrid
Michael, I want you to expand on that a little bit because I think we talked a lot about this. You know, in in preparing for this chat is the way that you knit those things together is quite powerful. maybe talk a little about that portfolio construction piece.
Michael
Yeah. I was going to say, okay, initial answer is going to be that bonds are complicated.
Ingrid
Except Alex just made duration easy so you can't get away with that. Less we're going down to. But that's a misconception.
Michael
You know, I think, you know, I've worked a lot with institutional investors, and they think about the role that each asset class plays within a multi asset class portfolio. Right. So fixed income plays that safety role that pays protection role. But as Alex mentioned when you start to expand the opportunity set you can get meaningful yield enhancement. When you start to use that entire fixed income set.
So, I'd say not complicated, but at the same time can add a meaningful, component to a total portfolio solution.
Ingrid
Try to make bonds look as cool as equities. That's what's happening here. Here's one for you. you do this all day, every day. You look at everything. Alex, what's the one economic indicator that you're always keeping an eye on?
Alexandra
It's not just one, but it's anything and everything related to labor markets.
Ingrid
Expand.
Alexandra
So, and unfortunately, there's, you know, a bit of a lagging nature to, you know, official jobs numbers. But whether we look at claims, whether we look at hours worked earnings, obviously official, job numbers, that are released on a monthly basis. anything and everything related to people's ability to earn a living wage. Those are extremely important metrics in this environment where there is so much volatility, there's so much uncertainty.
At the end of the day, it just comes down to other people have work and whether they're able to earn wages that help them stay above all of this volatility.
Ingrid
Yeah. Because those are the indicators that the central bankers watch and the central bankers hold the keys to the first, you know, decision on rates. I'm going to change the question a little bit for you, Michael. What's the one news headline or the news flow that you're watching really closely when you're thinking about markets?
Michael
I think Alex alluded to it earlier. I'm going to say inflation expectations. Every day, businesses and households are making decisions around whether to spend today or wait. And that in and of itself is going to create an impact or transmit to how inflation plays out. Even Alex's comments around labor, you know, when you start to think about wages, you know, when you start to think about expectations and demanding more wages like that in and of itself creates inflation.
So, it's those inflation expectations. You know, how people are making decisions around deploying capital or consuming or going out and buying something. I mean, ultimately, at the end of the day, that's what central banks are trying to create an environment of low, stable and predictable so that we can make decisions in an orderly fashion to have a healthy economy.
But it's those expectations. If those become unanchored, I think that's where we've really got to be focused and.
Ingrid
I think that's where, you know, this concept of the chaos that we're seeing now, you know, in the headlines and so on. It is destabilizing and it causes people to pause, and it sort of has this trickle down, all the way through. So, any last thoughts? as you look forward to the balance of 2025, Michael, as you look at the markets through the rest of the year, what would you say to investors?
Michael
I think stay invested. We knew there's going to be volatility. Having a diversified portfolio and staying invested is the key.
Ingrid
Alex, any last thoughts.
Alexandra
You're coming into this year? We said we acknowledge that there would be a lot of political uncertainty noise. Yeah right. And not just noise right. There's genuine I mean look at look in Canada right. We have an election in Ontario. We're going to have a federal election later this year domestically or internationally. There's a lot of political noise and uncertainty.
Alexandra
And so, we came into this year saying the best way to play this is, you know, to use bond slang terms is to carry. Right. and what that really means is finding income stability, using a diverse set of, of credit levers in our portfolios. And that's exactly how we continue to navigate, you know, the sort of volatility tightrope.
So, keep calm and carry on.
Ingrid
And so, if I wrapped it up for our listeners, the rate environment is stable to lower which is net positive for fixed income. The fixed income environment is attractive now from a yield perspective and enhanced with all the tools that we can add to the mix in our toolbox. And it's going to be bumpy. But you're in good hands.
So, we'll say to our listeners, not to worry, we've got to. So, to our listeners, thanks so much for your time, and we hope you enjoyed our conversation on the fixed income markets and the rate outlook. stay well, stay safe.
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