Fixed income's revival as the ultimate hedge

Markets believe bonds will rally during a significant risk-off event. In other words, fixed income is now returning to its traditional role as a risk-off hedge. Why does fixed income sometimes have a positive correlation with risk assets, and other times a negative one? Simply put, inflation. When a central bank’s focus isn’t on inflation, fixed income and risk assets tend to move in the same direction. If there’s a sell-off in risk assets, you’ll see higher yields. 

“Historically, there has been negative correlation because central banks used to hike rates when growth was too hot, in order to get ahead of inflation. It was a different operating process. Now, with inflation being less of a focus, there’s a return to fixed income’s role as a hedge,” says Earl Davis, head of fixed income at BMO Global Asset Management. “There is an almost insatiable demand for fixed-income products currently.”

After Fed chairman Powell’s speech at Jackson Hole, he essentially took inflation off the table and indicated that employment is now the key factor guiding monetary policy. The reason for higher or lower rates is tied to growth, not inflation. This is why fixed income is now in a better place.

Echoing the sentiments in an insightful discussion with Benefits and Pensions Monitor, Tom O’ Gorman, senior vice president and director of fixed income for Franklin Templeton Fixed Income, asserts, “I like fixed income a lot.” The recent economic cycle, particularly since the pandemic, has seen equity markets deliver strong returns, but O’Gorman cautions that this “Goldilocks” period may not last. 

“I marvel at equity returns since the pandemic,” O’Gorman notes, “but I do wonder how long this can go on, given the tightening cycle and global dynamics.” As a result, O’Gorman remains firmly committed to fixed income, particularly as insurance companies and pension funds seek to lock in long-term yields to meet their liabilities. “There’s demand here,” he adds, “because pensions, after 10 to 15 years of fixed income not offering much, can now rebalance and capitalize on higher yields.”

Today’s yields, while still below recent highs, are significantly higher than they were pre-pandemic. Positive real yields – where bonds earn more than inflation – are essential for growing client wealth and providing the stability investors seek. Currently the yields are higher than they’ve been over the past 10 years. This is critical for providing a strong diversifying effect in portfolios.

Canada’s economic divergence and fixed-income impacts

The Canadian economy has recently diverged from the US, experiencing a deeper slowdown that has significant implications for fixed-income investors. This divergence underscores the independence of the Bank of Canada’s (BoC) policy actions. Typically, the Fed leads, and other central banks follow, but Canada’s unique challenges – driven by mortgages and disposable income – required the BoC to act ahead of the Fed.

The broader challenges Canada faces have strained per capita spending. “The number of jobs being created does not support our immigration policy, so that drain on individual spending is visible in housing and disposable income,” says Davis. 

O’Gorman also highlights the significant divergence in growth between the two countries. “Year-over-year growth is 3.1 percent in the US compared to just 1.1 percent in Canada,” he notes. He emphasizes the deep-rooted challenges Canada faces, particularly with record levels of debt across the government, corporate, and consumer sectors. “Canada didn’t have a housing crisis during the 2008 financial crisis, but it still cut rates to zero. Now, we are dealing with the consequences of that decision, with debt acting as a wet blanket on growth.”

Both Davis and O’Gorman point out that the BoC’s independence is crucial in navigating these challenges. While Canada typically has limited room to ease without the US following suit, that constraint has largely been cast away. The BoC will do what’s necessary for Canada, indicating that the currency has taken a back seat as the central bank shifts its focus toward domestic priorities such as employment and consumer spending.

The path forward for Canada is complex, especially as the BoC tries to thread the needle between controlling inflation and preventing further strain on the housing market. O’Gorman also reflects on how central banks have become deeply entrenched in financial markets through quantitative easing (QE) and are still trying to find their way out. “It’s not surprising that this cycle we’re going through is different,” he remarks, acknowledging the unique nature of today’s market environment, where central banks have more influence than ever before.

Bear market context and fixed income’s role

O’Gorman also underscores the importance of framing the recent bear market in fixed income within a broader context. “The bear market in fixed income needs to be looked at with regard to what happened before – two years of 10 percent-plus returns when spreads were at their all-time highs and yields were near zero,” he explains. Unlike equities, which can grow through earnings expansion, fixed income is inherently tied to prevailing economic dynamics. A functioning fixed-income market where yields reflect current economic dynamics is required. 

Looking back at historical trends, O’Gorman remarks, “When I was a young guy in this business, you’d look at nominal GDP and say, ‘US nominal real GDP inflation is three percent, so the US 10-year should be at six percent.’ Today, that seems laughable, with the US 10-year trading at 3.82 percent – even 70 to 80 basis points lower than recent highs.” O’Gorman believes the current market has become more balanced, with fixed-income strategies delivering solid year-to-date returns of four percent to 5.5 percent through July. 

Davis adds that while central banks have indicated that inflation is no longer their primary concern, “Inflation isn’t back in the bottle yet.” He highlights the need for investors to maintain a risk premium on longer-dated bonds. “We are likely to see structurally higher yields and a steeper yield curve, whether it’s a bull steepener with lower long-term rates or a bear steepener if inflation or growth accelerates.”

The combination of these dynamics suggests a complex environment for fixed-income investors, with a potential for both lower short-term rates and upward pressure on longer-term yields. The easing process is still unfolding, and shorter-term rates will likely fall, but several factors, including bond supply and longer-term inflation risks, could keep long-term rates elevated.

Duration strategies and reinvestment risk

Davis also discusses the shift in his BMO Core Plus Bond Fund strategy from being underweight in duration for most of 2022 and into 2023 to now overweight. The trigger point in Canada was the BoC actually starting to ease. This shift introduces reinvestment risk, a key factor in conversations with clients.

Now is the time to stand out. While clients may be attracted to the higher yields offered by shorter-term bonds, reinvestment risk becomes a significant factor when those shorter-term bonds mature. Locking in yields above inflation is critical, and there is value in extending duration in this environment.

Additionally, Davis has allocated half of his overweight duration into real return bonds (RRBs) and Treasury Inflation-Protected Securities (TIPS). The real return bonds in Canada yielding close to two percent is a significant shift from their negative yields three years ago. While RRBs and TIPS are less liquid and more volatile, as they provide important long-term value and protection against inflation. “The volatility is worth it, and we’re comfortable with it because it aligns with our view of where inflation is headed over the long term.”

Divergence on the US dollar

While both O’Gorman and Davis share similar sentiments on the importance of fixed-income and duration strategies, they diverge when it comes to their views on the US dollar. O’Gorman is notably more bullish on the US dollar, seeing it as a crucial hedge against volatility in his core plus strategies. “I love the US dollar,” O’Gorman says, emphasizing its role in managing volatility. “We manage core plus strategies with a lot of credit risk, and the dollar provides a hedge. We might have at least five percent long USD at any given time, and it’s an important part of managing volatility for Canadian investors.”

O’Gorman views the recent fall in the US dollar as part of a larger unwinding of the carry trade, and he sees it as a strategic opportunity. “The Canadian economy has more leverage, and I like the US dollar better,” he explains, adding that it’s an essential tool for navigating volatility. For Canadian investors managing multi-asset portfolios, the US dollar can serve as an important balancing factor.

Davis, on the other hand, takes a more measured approach and is currently flat on the US dollar, noting that his team uses duration as their primary risk-off hedge. “When we are overweight in duration, that becomes the hedge in itself, so we don’t need to take an explicit position in the US dollar.” He acknowledges the importance of the US dollar as a reserve currency, but prefers to take positions in it only at extremes. “While we see a structural drive toward a weaker US dollar in the long term, we only like the US dollar at extremes as a risk driver or alpha driver,” Davis says, suggesting that the dollar is not a core part of his current strategy.

Davis’s cautious stance on the US dollar aligns with a broader shift in focus for many investors, as attention turns away from currency plays and toward the attractive opportunities emerging in the fixed-income space.

With inflation no longer the central focus and yields significantly higher than they have been in recent years, fixed income offers both stability and growth potential. For investors – particularly those in pension plans or insurance portfolios – the current environment is ripe for capitalizing on the renewed role of fixed income as a risk-off hedge.

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The viewpoints expressed by Earl Davis, head of fixed income & money markets, active fixed income at BMO Global Asset Management represents his assessment of the markets at the time of publication. Those views are subject to change without notice at any time. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only. 

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