What a billion-dollar portfolio manager thinks about fixed income

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By Sandy Liang

It was great to be a bond manager in the 1980s, the period that inspired Michael Lewis’ Liar’s Poker and Tom Wolfe’s Bonfire of the Vanities. Interest rates peaked with inflation in 1980-1981 as the benchmark 10-year U.S. Treasury yield of 15 per cent was cut in half by the early 1990s (bond yields move inversely with price).

It was also great to be a bond manager in the years following the global financial crisis in 2008. Led by the United States Federal Reserve, global central banks pioneered the widespread use of quantitative easing (QE), effectively “printing” money to buy mainly government bonds from investors and issuers to drive interest rates lower and stimulate economic activity.

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But all good market cycles come to an end.

Inflation came roaring back in the wake of the global pandemic after a benign 40-year period, ending the central banks’ money printing to buy bonds because when too much money is chasing too few goods, then even more printed money from QE runs the risk of accelerating an inflationary spiral.

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In the post-pandemic years, it has not been fun to be a bond manager, at least for the traditional ones who mainly invest in government bonds and investment-grade corporate debt. The bond market has a high degree of correlation globally.

Over the five years ending May 31, 2024, the iShares Core Canadian Bond Index ETF, a broad portfolio reflecting the Canadian bond universe, delivered negative cumulative returns to investors even though 2020 was a banner year for traditional bonds. Five years of investment and nothing to show for it.

The traditional bond market is now at a crossroads. The playbook from years past would dictate that as the North American economy slows, and the Fed is on the verge of lowering short-term interest rates (following the Bank of Canada), then rates at the long end of the yield curve — generally regarded as bonds 10 years or longer — should decline, which is favourable for bond prices.

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This would include benchmark U.S. 10-year Treasury bonds that yield 4.3 per cent and 10-year Government of Canada bonds that yield 3.3 per cent today. U.S. and global inflation is past its post-pandemic peak, which is also favourable for bonds.

But is the bond market really at a turning point? What is different in this economic cycle compared with previous cycles and what does that mean for bond market returns?

What is different this time are the massive budget deficits. There’s been a shift in the supply and demand for Treasuries: from a pre-pandemic period of excess demand due to QE to a current state of excess supply driven by massive budget deficits in the U.S. and other major economies.

Government budget deficits are financed by borrowing, which is conducted in the bond market. An increase in borrowing means a greater supply of bonds, resulting in lower prices and higher bond yields, or the interest rate paid by governments, all else being equal.

The U.S. Congressional Budget Office (CBO) projects the U.S. budget deficit will be US$2 trillion in 2024, increasing steadily to US$2.8 trillion in 2034, up from a little less than US$1 trillion in 2018 and 2019 and a post-financial crisis low of US$400 billion in 2015.

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The fair value of Treasury yields includes an inflation component because investors must be compensated for the loss of spending power over time. In the entire post-financial crisis period up to the global pandemic, bond prices were above fair value and bond yields were below fair value.

There is a strong possibility that bond prices will be below fair value and bond yields above fair value for much of this next bond cycle, which has already begun with poor returns. This cycle could last as long as a decade unless the U.S. changes course on its fiscal deficit spending as projected by the CBO.

Compared with the post-financial crisis period, when bonds traded higher, this time is different. The Fed can’t just print money to cover deficits. And the supply of bonds coming from massive budget deficits is expanding even as a number of other traditional large buyers of U.S. Treasuries — including the Fed as well as China and Japan — have been reducing holdings.

We strongly believe it is important to now have a healthy portfolio weighting in alternative fixed-income funds run by skilled active managers whose investment returns are not dependent on long-term interest rates declining over time.

Massive budget deficits unique to the current economic expansion have the potential to pressure government bond prices lower and yields higher compared with their fair values. If there is an economic slowdown, the supply of bonds will be even more elevated as budget deficits grow.

Sandy Liang, CFA, is a portfolio manager and head of Fixed Income at Purpose Investments Inc. His flagship fund, the Purpose Credit Opportunities Fund, is celebrating a decade of strong returns this July.

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