A conversation with Vice President & Head of Research, Dan Yungblut, which delves into the recent surge in investor demand for GICs, high-interest savings accounts and other cash like products. Surface the limitations, risks and challenges of cash as a long-term solution when compared to a portfolio of bonds. Further, discover why active fixed-income management is critical to healthier portfolio construction and your long-term financial goals when compared to passive investing.
Speaker Key:
GS Gregory Sweet
DY Dan Yungblut
VO Voice over
00:00:00
GS Hello and thank you for joining us for this very special podcast on rates, bonds and all things fixed income. My name is Greg Sweet, a director here at Scotia Securities Inc. And I'm thrilled to be hosting this conversation with you. In 1982, Canadians were living with mortgage and interest rates near 20%. Paul Volcker was running the US Federal Reserve and Steven Spielberg released the movie E.T.
Since that time, borrowers and lenders watched as rates fell for 30-plus years, with risks, as measured by duration, doubling every decade, while yields were halved almost every ten years, as we've seen by major bond indices. This was the case until July of 2016 when we actually found negative rates in places like Europe. And some banks in Denmark were actually sending borrowers a mortgage payment and not the other way around.
The world accepted that these very low rates would be here forever until about February of 2022, when key central banks implemented the most rapid escalation of rates in more than a generation, which has left investors confounded and borrowers struggling to find a footing. With this backdrop, we couldn't be more fortunate to have Dan Yungblut share his insights. Dan is a senior member of our fixed-income team.
00:01:19
He has 19 years of industry experience and he's been with our fixed-income group for the past 15. Most importantly, he has a breadth of experience across the bond universe as an analyst, portfolio manager and overseeing our research initiatives. Dan, thanks so much for joining us today.
DY Happy to be here. Why are we here? Why did we want to do this podcast? Investor demand for cash products, including GICs and high-interest savings accounts and others, have spiked over the past few years. And my colleagues, Tom and Jason, talked about a cash trap on the podcast a few months ago. And we really want to give investors some thoughts on why we think they should consider redeploying a lot of that cash.
And, one, we get it. There's been a generational reset in interest rates. It was well telegraphed. And as Lloyd just said, it was one of the fastest, most violent rises in interest rates in history. And fixed-income performance was obviously challenged the last few years. Cash floods, pretty reasonable place to hide. All-in yields were attractive for GICs. GICs do have a place in investment portfolios, especially for their short-term horizon needs for cash.
00:02:28
But cash products are unlikely to be a long-term solution that can meet the financial needs of many investors. And we generally look at cash as a tactic rather than a strategic solution. And interest rates and bond yields are now back to more normalised levels and we think there are compelling reasons for investors to redeploy from cash products into fixed income. And the current environment is actually especially attractive for fixed income.
GS Dan, I think this is a good place to start. Let's get started with those reasons why investors should think about starting to redeploy their cash.
DY Historically, bonds and fixed-income funds have significantly outperformed GICs and cash head-to-head. You've been more than compensated for the risk of being a fixed income, that we can go a lot of directions. But as a simple example right now, the all-in yield for five-year bond is meaningfully higher than the GIC rates. And for any uninsured part of GIC holding, that's actually the exact same credit risk.
00:03:30
Here's not the place to get into detailed math, but obviously, if interest rates don't change, you just continue to earn that higher yield from the bond than in cash. If interest rates go down, you get capital gains to support performance. If yields go up, yes, that’s where people are concerned with bonds. There is a capital loss initially. But you instantly start earning that higher yield. And over time, that higher yield skates you back on site.
Time is your friend and you generally end up in a better position by being in the bond long term than in cash. And that instant reset to higher yields or capital gains if rates fall, all of that is hard to time and you only get to reset at arbitrary fixed dates if you're in GICs or HISAs, rather than proactively and instantly with bonds. And obviously, if you're in a high-interest savings account, it's hard to jump back in the fixed income in anticipation of a rally.
As an example, last fall, you missed out on a big rally in fixed income if you were sitting in cash. And like equities, I think most investors understand, unless you stay invested, it's hard to time those big rallies and drivers of return. And between the generally higher all-in starting yields, that instant adjustment to the market environment and the varied sources of return, it's why bonds historically significantly outperform cash products head-to-head. And that's just straight-up performance, bonds versus cash.
At the portfolio level, there's also an important portfolio insurance function of fixed income that you don't get from cash. In periods of economic challenges, when your equity holdings are suffering from losses, interest rates typically fall and bond holdings provide capital gains to offset your equity losses. You don't get that offset in cash or GICs. And it's why balanced portfolios that include fixed income, like your classic 60/40, outperform on a risk-adjusted basis over the long term.
00:05:27
GS There's definitely an important role for bonds and fixed income in a portfolio. I know you wanted to get into how financial planning benefits can be connected to bonds and fixed income versus cash products.
DY The first we wanted to highlight was liquidity. With GICs and high-interest savings accounts, liquidity is typically at fixed arbitrary date, unless you're willing to accept a significant penalty on the yield that you earn. But with bonds and fixed-income products, on the other hand, you have daily liquidity without penalties. Unless your entire future is mapped out at arbitrary fixed dates, fixed-income products are going to provide a lot more flexibility for your financial plan over time.
The second thing we want to highlight is taxation and after-tax returns. GICs and high-interest savings accounts, the yield is entirely taxed as income. Whereas, at any given time, a portion of bonds will be trading at a discount. And part of the return you earn in fixed-income products will be taxed at a lower capital gains tax rate. Your after-tax returns are actually even more compelling in a fixed-income product than cash.
And of course, as an aside, after the record rise in interest rates the past few years that we've highlighted, the majority of the bond universe is still trading at a discount and provides those tax advantages. And then lastly, we want to highlight the timing of cash flows. In GICs, the yield is typically only paid out at maturity. There isn't a regular stream of cash flow over time. However, when you're in bonds and fixed income, there is that regular cash flow stream of coupon payments.
00:07:01
And we think fixed income is an essential component of the concept of a paycheque portfolio that we've been articulating, which we think is actually going to be especially important for those entering retirement. Outside of just performance considerations, fixed-income products can provide much more flexibility than cash products. And fixed income should be a key component of the strategic financial plans for many investors.
GS Bonds can help enhance performance, lower overall portfolio risk and provide more flexibility in financial plans than cash. But why should investors think about deploying into fixed income now and how should they actually think about approaching it?
DY We've highlighted some general reasons why fixed income is important. But we also want to highlight why we think investors should consider redeploying some of their cash into active fixed-income products now in the current environment. Interest rates and bond yields have now reset to higher levels. We're seeing many low-risk corporate bonds yielding more than GIC rates, like that example we shared earlier.
Better liquidity, similar credit risk, better yields, it's compelling. But we're also seeing dislocations in bond valuations. With the wide range of expectations on the path of interest rate cuts, there's significant divergence in the relative yields and credit spreads between Canada and the US as an example, which provides opportunities to generate strong returns outside of just making a call on the direction of interest rates or credit selection.
00:08:31
Great example, the difference between the US and Canada 30-year government bond yield is at an all-time record and there are ways to take advantage of that. And there was a recent research report from professors at Notre Dame and other universities that highlighted that, unlike in equities, the majority of active bond managers outperform their index than passive bond strategies over time. And that's looked like there's been many research reports, prior to that one, that reached the same conclusion.
Now, I don't want to be misconstrued. I'm a firm believer in active management and equities. Categorical with that. But it's a different conversation. In fixed income, active managers have a lot more potential sources of return to capture between duration, credit selection, yield curve management, your Canada versus US allocation. There are countless others. And that recent paper, as an example, highlighted that because bonds are liquid…
That's true for almost the entire universe, relatively. Many passive strategies, they're forced to hold only the most liquid bonds and sacrifice performance because of their constraints. Active managers don't have that same constraint. They can take advantage of liquidity premiums. Companies regularly issue new debt, whereas new equity issues for companies are relatively rare. Which allows bond managers to more frequently capture the new issue concessions that you see in the market.
00:09:55
And just for reference for those maybe wondering, when you sell a new bond or new equity to the market, you typically have to sell at a discount to entice new buyers. And passive indices and strategies don't usually get to capture that new issue discount. It's a potential added source of return. And because, again, the frequency of new bond issuance, bond managers can capture that. This isn't one that often doesn't get thought about, unlike an equity.
When you hold a passive exposure to an equity index, your largest holdings are the best-performing companies. Just being in an index, you've got the benefit of Nvidia’s recent performance as an example. But in fixed income, you have to think about it. There's an adverse selection problem. Who's the biggest weight in the index? It's the biggest issuer of debt. Your biggest holdings are often higher risk, either just higher leverage or, at the very least, higher risk and because they have to refinance a lot of debt.
It's not necessarily the best performer in the index. And then also, whether it's cash or fixed income, it's important not to blindly stretch for yield. Credit selection matters. And active managers can rebalance. They can better target the most attractive risk-adjusted yields in corporate bonds. It could go on and on. The point being active management is especially important in fixed income if you want to capture all the benefits of fixed income in portfolios we've talked about.
We’ve got long track records of success. Our specialised credit team, one of the more innovative fixed-income teams in Canada, they've got a variety of products that add alpha across the North American credit universe, focussed on active credit selection. And our core fixed-income team is a deep team of professionals, add value across the North American bond universe, core investment-grade mandates and they're active in both interest rate and credit exposure.
00:11:47
And really just to finish off, we want to reiterate that we've lived through a generational reset in interest rates. But that's played out. We think it's now important for investors to focus on the best solutions, thinking long-term about their financial goals. And we think, for many investors, that's going to mean redeploying at least some or a lot of that cash in the fixed-income products.
GS Dan, this was excellent. Really appreciate your time with us today. I know our audience will get a lot of great value out of this discussion. To the listeners of our podcast, as always, thank you so much for spending your time with us, investing into this important topic around fixed income, the active management that can add value over time.
VO This audio has been prepared by 1832 Asset Management L.P, and is provided for information purposes only. Views expressed regarding a particular investment, economy, industry or a market sector should not be considered an indication of trading intent of any of the mutual funds managed by 1832 Asset Management L.P. These views are not to be relied upon as investment advice, nor should they be considered a recommendation to buy or sell.
00:12:54
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