Fixed-income roundtable: Why fund managers expect yields to remain low

Brian Miron, portfolio manager for Fidelity Investments in the fixed-income division of Fidelity Management & Research Co. Based in Merrimack, N.H., Miron manages mandates that include Fidelity Canadian Bond Fund, Fidelity Corporate Bond Fund and Fidelity Tactical Fixed Income Fund. In all, Miron is directly responsible for assets of $16 billion.

Michael McHugh, vice-president and head of fixed-income at GCIC Ltd., the sponsor of the Dynamic stable of mutual funds. McHugh and his team manage assets of $8.7 billion. Their responsibilities include Dynamic Canadian Bond Fund and Dynamic Advantage Bond Fund, as well as the fixed-income components of the balanced offerings

Steve Locke, senior vice-president and head of the fixed-income team at Toronto-based Mackenzie Financial Corp. Locke and his team manage about $18 billion in bonds and some $2 billion in money-market assets, for a total of close to $20 billion. The team has a wide range of mandates including Mackenzie Sentinel Bond Fund, to be renamed Mackenzie Canadian Bond Fund in mid-July.

Q: It has been five years since the global financial crisis. Is the global economy out of the woods yet?

Miron: A leading central banker, who was recently asked about the outlook for the global economy, said: “I would characterize it as sunny, with a chance of Armageddon.” There is still a lot of risk out there. The financial markets are more uncertain now than they were six months ago, when we last met for the fixed-income roundtable.

The U.S. Federal Reserve Board has undertaken additional quantitative easing (injecting liquidity into the economy). It’s in the process of buying US$85 billion of U.S. Treasuries and mortgage-backed securities every month. That will increase its balance sheet to roughly US$3.7 trillion by the end of this year, if it stays the pace. It started this process in 2009 after the financial crisis. At that time, its balance sheet was US$800 billion. Right now it’s just under US$3 trillion. By contrast the European Central Bank is not doing quantitative easing. What has changed recently is that the Bank of Japan has undertaken significant quantitative easing.

Locke: As fixed-income managers, we have to follow the global trends in central-bank policy. The additional liquidity being pumped into key economies and the policy support behind this is driving financial markets. But we haven’t seen this translate into growth in the underlying economies. Only certain areas of the economies have responded. One example is the U.S. housing market.

In Japan, the new head of the Bank of Japan, Haruhiko Kuroda has embarked on an expansionist monetary policy, including quantitative easing. Near-term, this has helped to drive the Japanese stock market, which has been on a tear. Japan’s quantitative easing is much greater relative to its gross domestic product than is the Fed’s program relative to the U.S. economy. Japan has been struggling with deflationary conditions and growth headwinds for some 20 years.

Q: Why this quantitative easing?

Locke: The extensive quantitative easing in the last 18 months by central bankers speaks to the amount of risk that they see to the underpinnings of global economic growth. The rapid increases in central-bank balance sheets have been the driver of most asset-price trends over the past couple of years, rather than the fundamentals, such as earnings growth in the case of the stock market and credit ratings in the case of the bond market.

McHugh: The policy makers are responding to a need to address a deleveraging environment. The high levels of debt create significant fragilities. The central banks are trying to orchestrate a relatively orderly transition to lower leverage. The risk is that many investors in the bond market don’t appreciate the fragilities that are in place. There’s no template for this.

Progressively and depending on the country, there has been a transfer from private-sector debt to public-sector debt. The United States is a good example. Canada is less so, as household debt continues to rise. These excessive debt levels might compromise the ability of the borrowers to service their debt. The loans can default. This is a significant problem as the debt largely resides on the balance sheets of financial institutions. If their loan portfolios are compromised, this can impair their capital ratios and their solvency. It’s been tough for financials in parts of Europe and, until recently, in the United States, to recapitalize. Canada is an exception.

Q: Does this mean that interest rates are going to stay low?

Miron: The environment will have a depressing effect on yields. The International Monetary Fund is projecting a 3.3% growth in global GDP for 2013. Canada is trending around the 1.5% to 2% range. The United States is a little stronger with a 2% to 2.5% range. Europe is still mired in recession and Japan is struggling for growth. The low-growth environment will keep interest rates fairly low to range-bound. We’re not going to stay here forever. Rates are too low and they will normalize at some point in time. But it won’t be in the foreseeable future.

McHugh: The question is: Will it be in our lifetime? There is a grain of truth in this. Central banks have migrated to and anchored policy rates near zero. The challenge is that this is not low enough to stimulate economic activity. Hence quantitative easing has been introduced to create easier borrowing conditions for the public and private sectors. This addiction to low borrowing costs persists almost five years after the financial crisis.

Miron: The famous book by Carmen Reinhart and Kenneth Rogoff, This Time is Different: Eight Centuries of Financial Folly, examines a series of previous crises. The authors conclude that it takes at least a decade on average for the repair process to be complete. As Michael points out, we are barely half way through that.

Locke: Central banks have fallen into a trap where they need to pull yields low or hold them low for a very long time to encourage the return of economic growth.

Q: There is talk that the U.S. Federal Reserve Board will pull back on quantitative easing sometime soon.

Miron: This is why I would characterize the situation as being more uncertain today than when we met six months ago. The Fed had been explicit about ensuring that monetary policy remained accommodative until the U.S. unemployment rate declined to 6.5% and the inflation rate increased to 2.5%. By its own predictions, this would be sometime in mid-to-late 2015. It previously said it would wait until those specific targets were met, before starting to normalize interest rates.

More recently, the Fed has hinted that it might start this process sooner, when conditions in the labour market improve substantially. This has created additional uncertainty. The consensus view is that the Fed is looking to reduce its quantitative-easing program.

Q: What will the impact be?

McHugh: It’s tricky. The removal of the policy stimulus will likely produce a rise in market interest rates. Key is whether there will be an impact on the health of lenders’ collateral and borrowers’ debt-servicing capability? This could, as discussed, adversely affect financial institutions and thereby cause a crisis of confidence. The banking crisis of 2008 was a global phenomenon. There are now more limited policy options available to governments and central banks to stabilize the financial and economic landscape than there were in 2008.

Locke: There’s been a mispricing of financial assets as a result of this accommodative monetary policy. Some asset valuations have become stretched, beyond the fundamentals. This is particularly the case with higher-risk investments. It’s part of the fragility we’ve talked about. We’ve seen that over the past few years, when central banks back away from their stimulus policies, both the bond and stock markets begin to correct.

The round table on fixed-income continues on Wednesday and concludes on Friday.