The Art of Being Early in
Go-Anywhere Fixed Income Investing
Tristan Sones and Tom Nakamura, Co-Heads of Fixed Income at AGF Investments discuss their outlook on fixed income, and their key strategic and tactical investment ideas for today's uncertain economic climate.
By AdvisorAnalyst.com in partnership with AGF Investments
2022 proved to be a significant year for fixed income investors. It was a year marked by noteworthy events such as war in Ukraine and disruptions in global supply chains.
The resulting surge in inflation pressures compelled central banks in North America to respond with an exceptionally swift cycle of interest rate hikes. Unfortunately, it turned out to be one of the poorest performing periods in the history of the fixed income asset class. Nevertheless, there is a silver lining. Yields are currently at their highest levels in over a decade, restoring fixed income's ability to fulfill its primary objectives for investors.
We recently spoke with Tristan Sones and Tom Nakamura, Co-Heads of Fixed Income at AGF Investments to discuss their outlook on fixed income, how they are navigating today's complex economic and investment climate to generate higher income, preserve capital, and provide stability to overall portfolio volatility in the go-anywhere AGF Total Return Bond Fund.
AA: Tristan, Tom, before we delve into our conversation, could you briefly share your backgrounds, your career arcs, and how you found yourselves at AGF Investments?
Tristan Sones: Certainly, I began at the University of Waterloo, studying computer science. However, midway, I switched gears to a more business-centric focus within mathematics. Before officially starting at AGF in 1993, I held co-op work terms in the IT department. Initially, I began my AGF career in IT, but after participating in a project that linked individuals with optimal portfolios, I was drawn to investment management. I was fortunate to join the expanding fixed income team, where I've remained ever since. Working in a globally-focused shop has provided a broad exposure that I appreciate.
Tom Nakamura: Similar to Tristan, I found myself at AGF early on. After graduating from University of Toronto, with a Bachelor of Commerce, I started as a data analyst in AGF's risk management group. After a couple of years, I transitioned into trading functions, including money market and forex. I officially joined the fixed income team in 2002. Over our careers, Tristan and I have had the chance to manage almost every type of fixed income mandate that AGF has offered, from money markets to global bond funds and beyond. We've been given the trust and opportunity to grow and develop our expertise. After working together for over 20 years, we've built a great rapport, often finishing each other's sentences. We've cultivated not only our individual growth but also our collective growth, which has been a valuable aspect of our time at AGF. That's our journey in a nutshell.
Outlook
AA: Can you provide a market overview and discuss the opportunities and risks in the fixed income space from your perspectives?
Tristan Sones: With the increase in yields, fixed income has returned as a viable asset class. Market participants who turned to equities or riskier bonds during the low yield period now have a chance to create higher quality portfolios with decent income. Monetary policy during last year's high inflation was clear; central banks aggressively raised rates, a proven strategy. However, future monetary policy is uncertain due to a resilient economy, despite expectations of a slowdown from the rise in rates.
Tristan Sones: That tug of war really creates
some...
...opportunities for active managers such as Tom and myself. The long end has been stabilized obviously, by the central bank action and also by signs of some disinflation. And the short end is being moved around with this tug of war between, "Are things slowing, are things more resilient? Are central banks going to have to do more than we originally expected or more than the market's expecting right now?"
We do feel that at some point, the economy will reflect the amount of tightening that's in the system or the residual amount that's probably left. And we likely will see the peak in central bank rates this year. And that should hopefully stabilize the short end of the curve. So that being the case, there's definitely an opportunity in higher quality fixed income to provide a decent level of yield without the need to take excessive credit risk. We're looking for credit markets to reprice themselves to some degree when we see more definitive signs of that economic slowdown.
The short end is being moved around with this tug of war between, "Are things slowing, are things more resilient? Are central banks going to have to do more than we originally expected or more than the market's expecting right now?"
AA: How do you plan to navigate the environment of persistent inflation and higher rates, ensuring portfolio protection?
Tristan Sones: A higher-for-longer rate scenario aids portfolio resilience and provides a strong starting point.
Tristan Sones: Carry can come from different sources...
...We know carry (the difference between the yield on a longer-maturity bond and the cost of borrowing) can come from other countries that maybe were more aggressive or are likely to stay higher for longer. EM is a good example of this where emerging markets were early in their fight against inflation, which was a bit of a uniqueness to this particular cycle as they have tended to follow in years past, so they were ahead of the game and saw inflation start to peak a little earlier than developed markets. Employing different categories such as emerging markets is a good example of how we can get carry from different sources and expose the portfolio to different forces basically that can provide opportunities and can also help on the downside.
Also, inflation-protected securities can be effective in rising inflation periods. It's crucial to stay flexible and have liquidity for quick changes as the situation changes.
Currently, cash holdings are not unfavorable, but they won't benefit if the economy slows and yields drop. So, it's vital to tactically use cash for opportunities like adding duration or diversifying categories.
AA: Given that investors are leaning towards the short end of the yield curve due to its attractive yield and safety, do you perceive a risk that they might neglect longer-term opportunities?
Tristan Sones: While there's a natural inclination to maximize yield in an inverted curve scenario, it’s crucial to remain flexible and ready to move out of the short end. Timing a change in the cycle can be challenging, but our focus is on providing a better return over the full cycle, identifying strategic entry points and positioning the portfolio accordingly.
Tom Nakamura: To elaborate, when considering carry, it's crucial to weigh it against the risk involved.
Tom Nakamura: A strategy that just goes out
and...
...seeks the highest yield will probably be fine in the short term, but eventually something will break and cause a lot of pain.
In this situation, I think there is this feeling that cash is safe or short-term bills are safe. But there is that risk, that Tristan alluded to, that the market environment can change. Maybe it's the risk of missing out on a better opportunity, maybe it's the risk of being able to catch the right timing for when things change – we've seen this in prior periods of crisis or market stress or tremendous rallies.
One of the things that we really focus on and think about is why that carry is so high in various areas relative to others and what might be the risks that are being underappreciated. One of the things that we've seen in the past year, with the amount of inversion that's happened, is the risk that things can change very quickly. We only have to rewind the clock 12-, 14-months and there was a very, very different environment for fixed income investors.
One of the things that we've seen in the past year, with the amount of inversion that's happened, is the risk that things can change very quickly. We only have to rewind the clock 12-, 14-months and there was a very, very different environment for fixed income investors.
AA: Could you shed light on the ongoing tug-of-war in yield curve management, particularly bear steepening and bull steepening?
Tom Nakamura: For bear steepening, it's one in
which you likely have a...
... hot economy or inflationary pressure or both, that are driving longer-end yields higher, and the market starts anticipating the central bank to tighten which lifts also the front-end yields. So, you end up with higher yields, but generally the longer end performing and those yields rising faster.
In a bull steepening situation, is one where you are expecting growth to slow down and/or inflation to fall. And that would lead to the central bank to start easing conditions. So you end up with long-end yields falling and front-end yields falling, but led by the front end. And when we think about the current situation in that tug of war, what's really happening is we have a wide array of possibilities in terms of how the economy unfolds over the next several quarters.
For illustrative purposes only.
For illustrative purposes only.
The market is grappling with the Federal Reserve's potential pause in policy adjustments and speculating on the trigger point for policy change.
RISK Equals opportunity
The idea that we will just naturally coast into a soft landing is extremely unlikely.
AA: Given the volatile rate hike climate, what is the probability of a market shock causing swift rate cuts?
Tom Nakamura: I think (the probability of a market shock causing swift rate cuts) it's pretty high.
Whether you believe...
...it's the Fed that tightens things too far and breaks things, or whether you believe the Fed, by tightening and breaking things, avoids us breaking bigger things, I think that's the way our economies tend to work when we are in a growth mode, when you have inflationary forces at work.
And if you think, particularly for this example, when you have had a long time of very easy conditions, it takes something breaking to stop it. The idea that we will just naturally coast into a soft landing is extremely unlikely. You need to start to see demand retrench, and that's most likely to happen suddenly. That's been the history of modern economies – when you do see these situations, you do get these abrupt slowdowns.
AA: With such economic uncertainty, how do you manage duration in fund allocation?
Our three-layered approach involves a global perspective, focusing on specific points on the yield curve, and adopting a tactical stance.
AA: Can you explain any specific strategies employed to adapt to fluctuating interest rate expectations?
Tristan Sones: Absolutely. In a scenario where inflation, economic conditions, and policy responses are all volatile, strategies like carry can struggle. Last year, we saw periods where significant shifts in the economic and monetary policy landscape made carry a challenging strategy, especially in terms of currencies beyond the high-carry US dollar.
Tom Nakamura: As we move into the year, we
do see that volatility...
...has started to recede, as inflation has receded in general. But also, inflation has receded a bit more steadily. It's been less jumpy in terms of the data we've been getting. The policy response, as we near the peak, that you start to get is a bit more of a fine-tuning of the Central Bank as opposed to having really wide ranges of potential outcomes.
You could argue the message is sometimes ignored by the market. But by and large, that's led to reduced volatility, which has made carry more attractive. Again, we're still very mindful of the risks that we need to be compensated for, but carry has become more attractive as the market condition has become a bit calmer.
AA: Given the challenges posed by the rapid 500-point hike, how does AGF Total Return Bond Fund address these and offer potential benefits?
Tristan Sones: Prior to 2022, rates were incredibly low, and we were concerned about central banks' ability to handle the next downturn, as well as how fixed income could anchor risk in diversified portfolios. However, after a significant repricing of fixed income, we now have a buffer where rates can be reduced significantly if necessary.
AGF Total Return Bond Fund aims to benefit during periods of elevated stress, providing an offset to negative equity returns and anchoring the downside of portfolio construction with its high yield. Despite the disappointing absolute returns last year, we believe our strength lies in our measured approach and readiness for the next market phase.
Our sovereign exposure is currently near its highest, while our credit allocations are at the lower end. We're preparing the portfolio for a slower economic environment and remaining as flexible as possible. We also keep a balance, potentially through higher duration or US dollar exposure for Canadian investors, to offset times of stress.
Tristan Sones: It's all about trying to position
the Fund for ...
...the next phase. And if we do see a real downturn in the economy, whether it's a severe recession or some shock which causes the global economy to really fall and central banks kick into action with aggressive policy cuts, we want the portfolio to benefit in that scenario. And we believe the only way you really benefit in that scenario, is having much more duration on than if you were hugging the short end of the curve. Sure, rates can come down aggressively in the short end, but we know that they're not geared to providing the capital appreciation as much as if we saw yields aggressively fall in the mid to longer term bonds.
If we do see a real downturn in the economy, whether it's a severe recession or some shock which causes the global economy to really fall and central banks kick into action with aggressive policy cuts, we want the portfolio to benefit in that scenario.
AA: So economic resilience has been a key factor?
Tristan Sones: Indeed. The economy has proven more resilient than anticipated after such a drastic adjustment in rates. The experience varies depending on initial positioning. For instance, US investors with fixed 30-year mortgages have had a different experience from Canadian investors on floating mortgages.
The pandemic, I think, introduced a live-for-the-moment mentality which has led to a shift towards services and experiences. This resilience in spending, supported by strong employment, has helped sustain the economy. However, as interest rates stay high, spending could be challenged and the economy might slow down, especially if central banks raise rates further.
Strategy
AA: How does AGF Total Return Bond Fund complement a traditional Canadian bond portfolio amidst today's rate and inflation conditions? What unique traits does the Fund bring to investors navigating these market conditions?
Tristan Sones: We feel our strength is in our
ability to stay....
...measured and set the portfolio up for what the next phase of the market cycle is likely to be. And that's being called into question the more that the economy stays resilient.
But we have been tactically adding duration. Our sovereign exposure is probably at or near the highest levels that we've had it since Tom and I have been managing the fund, which is a long time. Similar to that, our allocations to, to credit and some of the other areas are towards the lower end of the historic range, and we're really setting the portfolio up for a slower economic environment and the stresses that come with that. And, trying to stay as flexible as possible is a real mantra.
And through managing the fund through times of real stress, which Tom and I have, unfortunately, or fortunately from an experience standpoint, parts of the portfolio are going to be illiquid during those times. That's just the way it is.
And there is always some form of an offset, and that can be in the form of higher duration, and for Canadian investors, higher US dollar exposure; two things that worked amazingly well in the credit crisis of 2008 and have also worked at various other times in providing stability and offsets when other parts of the portfolio are under pressure.
And there is always some form of an offset, and that can be in the form of higher duration, and for Canadian investors, higher US dollar exposure; two things that worked amazingly well in the credit crisis of 2008 and have also worked at various other times in providing stability and offsets when other parts of your portfolio are under pressure.
Tom Nakamura: There's probably three standout things: Being global....
...Thinking about being able to have exposure to those different economic cycles and understand and play the relevant parts of different curves around the world is one of the key complements to traditional Canadian portfolios.
The second one is the categories that we expose the Fund to. Whether it's government or investment grade corporates or high yield corporates, the one category that we have a fair bit of experience with and do utilize through the economic cycle is Emerging Market exposure.
Perhaps not for this exact moment right now, we think when we get to the point where we feel central banks, but particularly the Fed, will be cutting rates, that's usually a very powerful tailwind for Emerging Market assets, including Emerging Market credit, Emerging Market local rates as well as for FX.
And then that leads us to the last one, which is FX. While we are not expecting FX to be a big driver this year or in this environment, when we get to a more definitive part of the policy cycle, where the Fed has stopped or has turned to a pivot, we do think that's going to trigger another re-pricing of the U.S. dollar and there will potentially be some opportunities for us around the world again to take advantage of.
We're patient and look for standout opportunities, aiming to capitalize on them when they arise.
Being early
AA: Your ability to make early decisions is invaluable to investors. Rather than reacting, you're preparing for probable outcomes. Your strategy is forward-looking, designed for both defense and offense.
Tristan Sones: It's even harder to be early...
...I remember hearing a presentation that was well over a decade ago where they were talking about everyone’s access to information, how fast you can move things around. To be early, is going to require you to be even more uncomfortable in that decision than you have been previously because everyone's ability to react to things is that much better.
You're probably going to have to go into trades when you're nervous about them, and you're probably going to have to exit trades when you know you're leaving a bit on the table because the most opportune time is a bit elusive in terms of trying to position. It is more difficult to try to be contrarian.
To be early, is going to require you to be even more uncomfortable in that decision than you have been previously because everyone's ability to react to things is that much better.
Tom Nakamura: We also maintain diversification in our portfolio. Despite our patient outlook, we understand that unpredictability is a part of the market. So, we layer our strategies to complement each other, to provide capital protection and reasonable income and returns even if our predictions are off. Being able to diversify across global categories helps us to add value irrespective of market conditions.
team dynamics
AA: Can you shed light on the team dynamics at AGF?
Tom Nakamura: Tristan and I are on the fixed income
team...
...and we work very closely with the other fixed income portfolio managers and analysts. We really take a collaborative approach where each of us shares our expertise. We critique each other, we seek to understand the best opportunities and risks in our markets.
I think that's a really powerful element to our approach, to be able to really expand our body of knowledge, expand the set of eyes, expand the research that's being done in a very healthy collaborative team environment.
Secondarily, it goes beyond just the fixed income team. We have a very tightly knit investment management operation where we sit amongst our equity portfolio managers and analysts. We meet with them regularly, we collaborate, we discuss both macro and micro. It really allows us to understand and appreciate different perspectives, that’s an important thing.
Tristan and I have spent our entire careers on the fixed income side. It's been extremely valuable for us over the years to hear the different perspectives. Sometimes there's debates, sometimes there's disagreements, but almost always, we’ve learned something from it and that's a really important part of the way our investment teams are structured.
AA: Tom and Tristan, thank you for your incredibly valuable time. This has been enlightening.
About AGF Total Return Bond Fund
Key Reasons to Invest
- The Fund's mandate enables the team to be tactical and focus on what they believe to be the most attractive fixed income opportunities from around the world.
- Offers the potential for higher yields than traditional bonds with exposure to a range of fixed income securities including high yield bonds, convertible bonds and emerging market bonds.
- Use to diversify traditional core bond holdings while seeking higher yields.
Investment Approach
Top-down fundamental approach determines the Fund's category allocation and is combined with a bottom-up approach to corporate bond selection using proprietary corporate credit research
About AGF Investments
Founded in 1957, AGF Management Limited is an independent and globally diverse asset management firm. AGF brings a disciplined approach to delivering excellence in investment management through its fundamental, quantitative, alternative and high-net-worth businesses.
AGF Investments represents AGF’s group of companies who manage and advise on a variety of investment solutions managed by its fundamental and quantitative investing teams.
The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
This material is for informational and educational purposes only. It is not a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. It is not intended to address the needs, circumstances, and objectives of any specific investor. This information is not meant as tax or legal advice. Investors should consult a financial advisor and/or tax professional before making investment, financial and/or tax-related decisions.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
The commentaries contained herein are provided as a general source of information based on information available as of June 2023 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.
This document may contain forward-looking information that reflects our current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein.
Holdings are subject to change and do not represent all of the securities purchased, sold or recommended for the portfolio. It should not be assumed that investments in the securities identified were or will be profitable and should not be considered recommendations by AGF Investments.
Investments denominated in foreign currencies are subject to fluctuations in exchange rates, which may have an adverse effect on the value of the investments, sale proceeds, and on dividend or interest income. Investors may not necessarily recoup the full value of their original investment. Investors should be aware that forward-looking statements and forecasts may not be realized.
AGF Investments is a group of wholly owned subsidiaries of AGF and includes AGF Investments Inc., AGF Investments America Inc., AGF Investments LLC, and AGF International Advisors Company Limited. The term AGF Investments may refer to one or more of the direct or indirect subsidiaries of AGF or to all of them jointly. This term is used for convenience and does not precisely describe any of the separate companies, each of which manages its own affairs.
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Publication date: July 12, 2023
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Footnote:
Bear steepening, Bull steepening (diagrams), The Macro Compass, 2023. For illustrative purposes only.
Chart, Core inflation remains sticky, "Economic outlook: Lost in transmission," p. 4, Christian Keller,et al., Barclays Economics Research, June 22, 2023.