INGRID MACINTOSH: Hello, and welcome to TDAM Talks. Today we are going to talk about one of my favorite subjects. We are talking fixed income bonds. Bonds are back, rates of return. Returns are back in fixed income. We are going to spend the next 15 to 20 minutes talking about the fixed income landscape, the rate landscape, and specifically how investors can be thinking about fixed income in their portfolios. On the podcast today, I've got the pleasure of being joined by Michael Augustine, who heads our fixed income franchise here at TD Asset Management, managing over $175 billion in assets, and Ben Chim, a senior portfolio manager who also leads our high yield fixed income team and, more broadly, our credit strategies here, really differentiating part of our fixed income business here at TD Asset Management. We're going to have this great discussion today about rates for both informed investors as well as those who are new to the fixed income market. And as always, we're going to have a little bit of a rapid-fire session at the end, so make sure you stick around for that. So Michael, welcome.
MICHAEL AUGUSTINE: Great to be back, Ingrid.
INGRID MACINTOSH: OK. So just last month, we had Dave Sykes, our chief investment officer, on the podcast, and we now have a really positive outlook for bonds. And we've been using the tagline of the return of fixed income. I love this. Bonds are back, the return. The punishment's over. Let's maybe dig into a little bit of that and make some meaning of that for our listeners. Can you tell us what we mean by the return of fixed income?
MICHAEL AUGUSTINE: Yeah. So it's interesting. So sitting here in January, it's a really good time to look back at last year. Lots of volatility and sort of see where the dust settled, right?
INGRID MACINTOSH: Mhm.
MICHAEL AUGUSTINE: Can you believe the Canadian bond market returned 7% last year? Probably goes--
INGRID MACINTOSH: Last year or last month?
MICHAEL AUGUSTINE: Last month. Well, that is a really good question and insight, really, because there was a lot of volatility, and a lot of it came in the last month of the year. If I think back to last year, we started the year quite calm. We went through the banking sector stresses, only to see global growth prove to be quite resilient. We saw healthy labor markets. We continue to see strong consumer demand. And central banks were able to achieve a meaningful reduction in inflation, coming from that 8.1% down to about 3% and change. But we kept hearing the word "sticky" last year, right? And inflation was challenging. And it pushed markets to essentially take rates higher all year. And then late in the year we started to worry about deficits and US debt. We worried about bond issuance, and that further exacerbated things and brought rates even higher, right? It is interesting. Towards the end of the year, we did see this turn. We often hear people say that monetary policy works with long and variable lags, and I think things played out but took longer than expected. We did start to see that pivot in central banks late in the year and a tremendous tailwind of returns in November and December.
INGRID MACINTOSH: I think it's interesting when we talk about returns and fixed income, because fixed income has always been that stable, safe part of an investor's portfolio. And literally for 15 years since the financial crisis, you've not been rewarded for being safe. People have had this sort of below real return on fixed income, and then we felt the pain of late 2022 and into 2023 where the market almost normalized a little bit so you had that capital pain. So I think bonds have been quite punishing. They've either been lazy or punishing for the last 15 years, and now we're really in a terrific place where bonds are generating return and have a positive outlook doing what they're supposed to in investor's portfolio, which is just a tremendous story. Ben, welcome to the podcast. This is your first.
BEN CHIM: Thank you for having me, Ingrid. It's a pleasure to be here.
INGRID MACINTOSH: Now, maybe tell our listeners a little bit about your role here at TD Asset Management. I touched on it at the beginning, but maybe talk about your background, your role here, and how we apply credit in our portfolios.
BEN CHIM: Sure. I started my career in 2000. It feels like a long time ago now. It was in the heart of the dotcom bubble, and preceding that was, of course, September 11 and WorldCom and everything else. So I've been through quite a few of these cycles, and certainly this is not my first rodeo. But I was a credit analyst starting off at a rating agency. Moved over to the investment side, worked for one of Canada's largest mutual fund managers in 2005, where I began my career, really, in terms of looking at high-yield bonds specifically. And so I've had this high-yield bond focus for quite a while. I moved to TDAM in 2008, really right before the financial crisis. I'm sure you remember that, Ingrid. And I was a high-yield analyst as well as portfolio manager with TDAM for a while. Had a few stints with a fixed-income hedge fund managing credit for that. I managed investment grade and high yield for another small Canadian independent manager before coming back to TDAM in 2018. And so I've been here for the last six years, and my role here is pretty straightforward-- well, I guess as straightforward as bonds get. I'm the lead corporate bond manager, and so what that means is myself and my team, we're responsible for all the global investment grade as well as global high-yield portfolios within the TD Asset Management suite. And what that entails in terms of everyday activities is working with our team of portfolio managers, working with the deep and experienced credit research team, we have to really try to find opportunities to add incremental yields, find good yield return opportunities within specific bond situations, and, through that, build portfolios that then can pass on those incremental returns to our clients. So for example, with our credit allocation in Core Plus, we're able to earn a yield of about 4.9%, which is about 60 basis points or 0.6 percentage points above the Canadian bond market. We're able to do that through what we do in the credit markets and the work we do there. How we try to add value is it involves a lot of due diligence on our part. We meet with all the management teams that we invest with, really try to figure out which management teams are the most competent, which ones are conservative, which ones are a little bit more aggressive. We need to get compensated for that. So that's a big part of what we do, thinking about the assets behind the companies that we invest with. What are the quality of those assets? How deep, how broad is that asset base? Do they have some kind of competitive advantage? Is it a regional competitive advantage or a reputational or technology advantage that's really going to allow companies to generate free cash flow and profitability over the long run? So that's really important. And of course, the macroeconomic backdrop, as you guys have alluded to, is really critical. Just, what's going on with the global economy and what's going on with the individual economies that we're investing in and what does that mean in terms of sector allocation. Are sectors going to do well? Which sectors are going to do quite poorly? How should we position ourselves that way? And then how should we think about the quality of our folios. Should we be reaching for yield, trying to generate a lot of return for our clients, or should we get a little bit more defensive and really try to batten down the hatches? Those are kind of all the things we're thinking about how to manage.
INGRID MACINTOSH: I think you really captured it well because at TD Asset Management, we are active fixed income managers. For many managers, that is trying to predict the direction of interest rates, which is arguably incredibly hard. What I'm hearing is here at TD Asset Management we do it a little bit differently, which is we use the power of our research and we build higher yielding portfolios every single day through a higher allocation to credit, investment grade and even in some cases non-investment grade, to build higher returning portfolios day in, day out. Have I got that right?
BEN CHIM: Yes, absolutely. I mean, when you think about returns in the fixed-income space, the yield is the most--
INGRID MACINTOSH: Well, they actually exist now, so that's good news, right? They haven't for a long time, but yeah.
BEN CHIM: It is, and it represents an awesome opportunity for investors and their portfolios. And I think you're absolutely right. The role of fixed income and the role of corporate bonds specifically is to provide the ballast, the predictability of returns that sometimes you don't get with the equity markets because of volatility here and there. And just an example of that in how we're thinking about things right now in the market-- when you look at the last year and half, we've been through this very high inflationary backdrop with regard to cost. And of course, interest rates have risen a lot as well. And that has had a fairly outsized, negative impact on defensive companies versus cyclical companies. Just think about your typical defensive company. It's your electric utility, your telecom company. Your electricity bill, your cable bill hasn't been increasing 6% or 7% every year, right? It's been contracted, so it's not increasing by very much and it's regulated. And so the defensive companies have seen some margin pressure, significantly more than what we've seen from cyclical companies. And to us, that creates an opportunity because the bonds have underperformed. The equities underperformed. And if you can get that role of protection through companies that are actually very stable and have very predictable returns, that's what you want to find as the ideal fixed-income investment. So we've been really focusing our efforts on looking for opportunities in more defensive sectors these days.
INGRID MACINTOSH: Yeah, these fixed-income managers aren't just giving our clients the exposure to the rate environment and that return. But really that way that you're seeking that out quite dynamically and looking for those opportunities, especially in the Canadian fixed-income market, that credit continuum, there isn't a lot of diversification there. You start to talk about utilities. What about the banking sector within there? How are you feeling about that? Because I know banks make up a big portion of our credit sector.
BEN CHIM: Yeah. I mean, the banks are interesting because they have underperformed a little bit with all the concerns around investment banking and lack of revenues from that. Of course, net interest margins are being pressured. But a lot of that concern is being priced in, and the reality for big banks-- particularly the big money center banks in the US and as well as the banks in Canada-- is they have very strong franchisees. They're going to generate good income, and they're very stable over the long run. So having a little bit of extra yield now to invest in that and have a little bit of that volatility we do think makes a lot of sense. There is some caution around where the economic outlook goes, and that could create volatility in terms of bank returns on the bond space. But for the quality of what we're lending to you, you're talking about most of the Canadian banks being A on the senior investment side, and you're getting yields that are close to the triple B's. It actually is a fairly attractive proposition right now.
INGRID MACINTOSH: Yeah. You sort of led me down the credit curve there when you started bringing in triple B's. Can you talk a little bit about how that near non-investment grade-- how that really drives some incremental return in the portfolios and your outlook for that part of the market?
BEN CHIM: Yeah, absolutely. It's an interesting backdrop right now because, as you know, growth is slowing, as we've alluded to, and interest rates are rising. And that certainly has created quite a bit of deterioration, if you will, in credit quality. But overall, things have actually been quite sanguine. The market has been, in terms of fundamentals, been fairly strong overall. And I think what's surprised most investors is how well most companies have held up. And specifically, because of the strength of the economy, consumers have continued to spend. Companies are continuing to employ workers, and that's given companies a lot of runway, a lot of lead time to be able to manage their balance sheets well, manage to this higher cost environment by using their discretionary cash flow to rightsize their cost base, rightsize their balance sheets. And so companies with the ability to do that typically are in the higher quality range, are larger and more diversified. And so when you talk about investment opportunities and where you want to be in terms of earning these higher yields, we see the crossover space, the double B's, the triple B's as sort of that sweet spot of companies that are diversified, have a lot of tools they can use in liquidity if things do get more challenging in a tighter financial condition market but still give you some good yields. So we liked a lot of the corporate hybrids for that. They're giving you 7% to 8% yields. A lot of double B's that are very well positioned, and defensive double B's, as I talked about earlier, are giving you 70% yields as well in a market where there's a lot of interest rate volatility, there's a lot of volatility in the macro backdrop. Getting that return, I think, is very appealing right now.
INGRID MACINTOSH: And having more coupon in your portfolio actually lowers the volatility of returns over time, too, I think, right?
BEN CHIM: Absolutely.
INGRID MACINTOSH: We've talked about the credit. We've talked about TDAM's unique focus on having a consistently overweight focus on credit to build higher yields. But I'm going to take it back to you, Michael, which is the overall biggest driver of fixed-income returns is the rate environment. So I know that that's what everyone's probably listening to. What are we thinking about about the rate environment? What does 2024 look like? What's your outlook?
MICHAEL AUGUSTINE: Yeah, so very timely. We had the Bank of Canada this morning. Maybe I'll circle back to that. But when we think about our forecast for rates, it's really anchored to our views on inflation. To start the year, we expect inflation in the first quarter to be around that 3% range. So it starts coming down from 8.1% to 3%. Things continue to be sticky in the medium term. We'd expect inflation to come down to that 2 and 1/2% to 3%. And then eventually, as we go into 2025, start to get towards the bank's target, sort of 2%, within that operating range of 1% to 3%. So if we think about that, at year end, if we think about also what the markets were pricing in, I think markets have got ahead of themselves. So 150 basis points of cuts this year-- aggressive. We would probably be somewhere about half of that, at least in terms of short-term administered rates. And then when the bank starts to cut, we could even see a situation where it's a cut, skip, cut, skip. So they could sort of prolong their cutting cycle. So this would put us at maybe three, four cuts by the end of the year. So if I think about that being the short end of the curve, we've also persisted in an inverted yield curve environment for a long time, and that's not normal. So as part of short-term administered rates declining, we would expect to see that reversion to a little bit of steepness in the yield curve. At the longer end, 10 year rates, if we saw them come down about 25 to 50 basis points, that'd probably be within our expectations for the end of the year. So getting back to a little bit more normal shape on the yield curve. Also some potential for capital appreciation with rates coming down a little.
INGRID MACINTOSH: Right. And we sort of break that out-- I think that's really important for our listeners to understand. You think about an equity market. Stocks go up. You get your return in bonds. You have your yield, which is sitting with just sub 5% on a portfolio right now, plus the opportunity for capital appreciation. So if I heard you say 25 to 50 basis points, could that be 2% to 3% potentially at the high end are expectations for capital gain in the portfolios?
MICHAEL AUGUSTINE: Yeah. I mean, I think last year is a good example. We averaged between 4.25% and 4% on the FTSE TMX all year, but we returned 7%. So we had a piece out last year. Keep calm and carry on.
INGRID MACINTOSH: Exactly.
MICHAEL AUGUSTINE: And really it's the carry, right? It's that incremental income that's now back, and that carry's going to give you that 4% to 4.25% what the yield was on average for the FTSE last year. But where did the rest come from? Well, it came from some capital appreciation and also some valuations on the credit compensation side. So we saw credit perform well. We also saw some compression on yields that was a tailwind for performance. So if we kind of put it all together, we're starting again the year about four and a quarter. Think about where we're going to end the year, we'll get some carry. But again, getting out of cash-like instruments and taking some bonds with the potential for capital appreciation is really important. And when we hear central banks like today reiterate that this pivot is coming and the next move would be down in rates, we think this is an opportune time to do that.
INGRID MACINTOSH: Yeah, and I think we're never really opportunistic about bonds because they are an anchor to a portfolio. But I think in the face of the interest rate environment, almost normalization again after 15 years of central banks keeping rates low, there was that price shock pain on the path back to where we are today, which is bonds generating a return. But there was that price shock that people felt, and then I think you're starting to allude to that. We've seen, in many of our channels, a huge swing towards, whether psychological or whether just rate based, the focus on GIC or GIC-like instruments. So maybe have taken some safe haven there or felt better about the guaranteed return, but with the central bank moves coming, those won't be around forever.
MICHAEL AUGUSTINE: Absolutely. I mean, the other side of the coin is, as central banks start to lower short-term administered rates, we're going to be continuously repricing down those credited rates on GIC. So I think it's quite akin or analogous to when mortgage rates were going up, and if you're in variable, when did you lock that in? I'm not sure everybody had the discipline to lock in when we were at the lowest rates. You know? This is very similar. As we start to see rates cut, those short-term credit rates will come down as well.
INGRID MACINTOSH: Yeah. And, well, I can't imagine that soon enough on this side of the house. So that's a great outlook for the rate outlook. And then, Ben, we've talked a little bit about this, but I just want to get a sense of where-- we're bullish on absolute rates and absolute returns. And on the credit side?
BEN CHIM: Yeah, we're very constructive on credit as well. I would say a little bit less so than on rates, but when we think about credit, the benefit there is you're kind of taking advantage of the great opportunity that government bonds are giving you and then getting a little bit extra in terms of return as a result of the strong fundamentals and taking advantage of that. Where we're a bit concerned about credit, of course, is the valuations, credit spreads or the credit risk premium for owning corporate bonds sitting at fairly low levels for the last 10 years. It's about 100 basis points in the US investment grade, or 1%. It's about 370 basis points or 3.7% in high yield, and those are very reflective of, I would say, near certainty that we're going to get a soft landing and very more mid-cycle-type spreads than something more late cycle. And so while we still are of the opinion-- our base case is that things are going to carry on fairly well, there is that probability that things get a little bit weaker, and that could result in some spread widening. So there is potential volatility for that, but at the same time, as Mike and yourself alluded to, there's also the upside from rates and rate cuts that come from that. So when you talk about that 5.3% yield in investment grade, the 7.8% in high yield, we can see that as achievable given those numbers, and maybe even a little bit of upside to that.
INGRID MACINTOSH: Yeah, and I think-- I want to double click on something there for our listeners. You talked about that differential between how an investor is rewarded for investment grade credit versus high yield credit, like almost four times the spread based on what you're saying there. And that really speaks to the power and the value of independent credit research and the ability within that world of high yield and arguably higher risk to be able to identify those names that you can add to the portfolio to create that consistently higher yield every day, which is awesome. So bonds are back. Yields actually no pay to hold bonds. We have a positive outlook on rates. We're constructive on credit, so that's all a good news story. I will never let my guests out of here without having to face off on some of our rapid-fire questions. So I'm going to start with you, Michael. And, Ben, jump in if you want. First rapid-fire word is "recession."
MICHAEL AUGUSTINE: Yeah. So I guess technical definition, two consecutive quarters of negative GDP. Q3 in Canada we had negative 1.1% GDP. Canada today is expecting slow growth. The numbers aren't in for fourth quarter. Could possibly be positive or negative, so it's kind of-- I think the market's almost 50/50 on whether we will have those two consecutive quarters. But what I would say is that bonds would outperform in a recessionary environment. So if we get a mild recession, that will probably accelerate the rate cuts. If we get a deeper recession, that will accelerate them more. And even if we sort of have this sanguine beginning to the year, again, we'll get that carry. So I think, in all situations, when I think about recession, I think this is a good time to be in bonds for that diversification and safety as well.
INGRID MACINTOSH: Love that. And recession view on credit?
BEN CHIM: Well, I mean, I would agree with Mike in terms of where we're headed in that regard. What I would say is when you look at the earnings environment, we look at the corporate environment, there really isn't any sector that is particularly concerning and that's going to drive things weaker. So if we do start to see things getting more challenging than just a mild recession, it will take something beyond what we're seeing today in terms of the current backdrop. And so when you talk about active management, that's something really critical to keep watching out for and that we're constantly managing for in our portfolios.
INGRID MACINTOSH: We couldn't have predicted the things we've seen over the last couple of years, so my next question or my next rapid fire for you is global tension. A lot going on around the world. What do you think there, Mike? We couldn't have predicted the Ukraine. We couldn't have predicted what we're seeing since October 6.
MICHAEL AUGUSTINE: Yeah. So absolutely horrific humanitarian events. When we think about things we can't predict and volatility in the markets, again, from a portfolio construction perspective, I think the defense we have against things we can't anticipate is diversification. And when I think about bonds, they play an important role in a diversified portfolio. So again, I come back to this fact that, where we are right now in the cycle, bonds are an important part of that portfolio.
INGRID MACINTOSH: As a bond investor, I want to peg you as a pessimist, but I'm just not getting that from you today. All roads are to good. A last one, and I know this one might be a sensitive one, but we are heading, in the US, into an election year. What might that look like for investors, and what should we think about?
MICHAEL AUGUSTINE: Yeah. I mean, I could begin, and certainly chime in if you've got some thoughts. I know Alex Gorewicz on our team often reminds me about credit default spreads on sovereigns. And when we look at the US, they've actually widened out. I mean, it's an indication of the market's concern with a sovereign issuer. And they are actually at 10-year wides. They're sort of blinking a little bit about concern. That's something we're mindful of. The way it's shaping up right now, it feels like this could be a little bit of a run off or a rerun of the last election. And if we think about what it means for the markets, we can sort of distill it down to geopolitical and policy. So I think all the things that we just talked about on the geopolitical front, we would need to parse through what each administration and their reactions would be to certain events that are occurring right now. And on the policy side, I think we turn our attention to things like trade, tariffs, reshoring, friend-shoring. We also look at sectors where there's more government spending right now. What would that mean? So I think we're going to be parsing through this throughout the year. This is something we're going to be talking about all year. But again, I think when it comes to volatility, this is when you, again, turn to that diversification, and this will certainly be one of those volatile years as well.
BEN CHIM: And just to add something probably more micro in terms of sector specific, but as we think about how we manage the different sectors and how they perform during an election year, one of the sectors that typically does fairly well is advertising because the political spending starts to lift that. And that is a sector that has had its challenges over the last few years, so that's one area where we're constantly looking for potential value. On the other hand, health care is always very topical as an election topic. So that's an area where we're treading a little bit more closely. And of course, geopolitical, as Mike mentioned, emerging market exposures and whatnot are going to be quite volatile. So we've kind of retrenched there a little bit going into this year as well.
INGRID MACINTOSH: Gentlemen, thank you so much. That's a lot of ground covered. I hope for our listeners they're hearing loud and clear that the environment for fixed income is much better than it has been for quite some time. The outlook seems to be positive through any of the lenses that we look through, and certainly we'll be having lots more conversations as we go through the year about the fixed-income link. Ben, Michael, thank you so much for joining us.
BEN CHIM: Thanks for having me.
MICHAEL AUGUSTINE: Thanks, Ingrid.
INGRID MACINTOSH: And thank you to all of our listeners for tuning in today. Remember, you can now subscribe to our podcast on Spotify, Google, Amazon, or Apple to make sure that you're not missing out on our latest conversations. Thanks and have a great day.
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