FTSE Russell experts explain why the Canadian fixed income market is particularly attractive for pension funds
Fixed income experts at FTSE Russell believe the fixed income landscape has become increasingly divergent across major economies. Some from the organization say Canada’s monetary policy stands out among the rest of the world, presenting potential opportunities for institutional investors, particularly for pension funds.
Sandrine Soubeyran, director of Global Investment Research and Robin Marshall, director of Global Investment Research at FTSE Russell, outlined some of the key factors driving the global divergence in fixed income performance. One such trend is around monetary policy divergence as the US has maintained a "higher for longer" narrative on interest rates compared to other economies like Canada and Europe, which have been cutting rates more aggressively. This has led to more volatility in spreads between these markets. Meanwhile, central banks trying to nudge rates lower has resulted in yield curves normalizing, with short rates below longer-dated yields.
The resilience of Canadian bonds has also been a focal point. While long-duration bonds have underperformed globally, Canada has fared comparatively better. Soubeyran highlights that the backup in yields, while negative, has been less severe than the sell-off seen in US Treasuries and UK gilts.
"It feels really overdone for Canada," she says, remarking that this presents an opportunity for investors. Both Souberyan and Marshall are quick to point to the performance of Canadian high yield bonds, which have delivered returns of around 11 to 12 per cent over the past year. "That's quite exciting compared to other fixed income assets,” she notes. “If we're seeing inflation being mitigated and corporate profits improving, while I’m looking at my crystal ball, there could still be some sweet spots there in regard to credits.”
This resilience in the Canadian fixed income market is particularly relevant for the country's pension funds, which have traditionally faced challenges in the low-yield environment. Marshall explains that the higher discount rates applied to future liabilities because of rising rates can ease funding strains for pension plans. "From the point of view of funding your pension fund, that bit comes easier," says Marshall.
They emphasized, however, that this is a double-edged sword, as pension funds must also navigate the impact of higher rates on their asset returns.
"The only bad news, of course, is that if rates go up too much, then the returns on some of the assets, as opposed to the liabilities, come down from the higher discount rates. But if the rates then crush the returns on the assets, then you don’t do as well,” explains Marshall, adding that it ultimately depends how much these rates change and what the asset returns are as well on the other side of the balance sheet.
Souberyan acknowledges that while long-duration bonds have particularly underperformed, Canada's milder environment has helped cushion the blow for domestic investors.
“As these rates have risen or normalized when we've gone back to these sorts of more Goldilocks type yields, as we would call them, the three, five type yields that we had in the early nineties, it's actually eased the funding strains on a lot of pension funds,” notes Marshall.
One other noticeable theme is the divergence in monetary policy approaches between Canada and its global counterparts. “Canada's inflation has fallen a little bit and stayed at 1.9 per cent. It’s been very aggressive with its rate cuts,” Soubeyran explains. The Bank of Canada has taken a proactive stance, with rate reductions creating more favourable conditions for consumers and businesses. However, this does not mean the central bank is entirely unrestrained as she says on the fiscal side, “it’s continuing to try to get its debt down.”
Marshall expands on this point, contrasting Canada’s approach with that of the US and Europe. "In the US, we’ve seen a higher-for-longer narrative, whereas Canadian rates have been coming down quite a bit faster. Europe has also shown volatility among its fixed income sovereigns," he says. This divergence has led to a decoupling of Canadian markets from their historical alignment with US Treasuries.
“The Bank of Canada has signalled that it's not going to be a prisoner of the Fed," adds Marshall. "If the domestic economy requires it, they will move rates down to neutral levels or even below."
Volatility in interest rates also remain a pressing concern for many, as Soubeyran says, “Easing is not over, but the question is how much?” Additionally, Marshall suggests a shift in market expectations, noting, “This is more likely to be a long U-shaped cycle rather than the deep V we saw during the global financial crisis or COVID.”
