On the Money with Dynamic Funds

PARTICIPANTS

Lloyd Perruzza
Head of National Accounts

Dan Yungblut
Vice President and Head of Research

Mark Brisley: You're listening to On the Money with Dynamic Funds, from market insights and analysis to personal finance, investing, and beyond. On the Money covers it all, because when it comes to your money, we're on it.

Lloyd Perruzza: Hello, and thank you for joining us for this very special podcast on rates, bonds, and all things fixed income. My name is Lloyd Perruzza, Head of National Accounts, and I'm thrilled to be your host for this very timely topic. In 1982, Canadians were living with mortgage and interest rates near 20%. Paul Volcker was running the U.S. Federal Reserve, and famous Canadian actor Michael J. Fox began his stardom on Family Ties. 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 10 years, as seen by major bond indices.

This was the case until July 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 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 to share his insights. Dan is a senior member of Dynamic's Fixed Income team. He has 19 years of industry experience and he's been with our fixed income group for the past 15 years. Most importantly, he has a breadth of experience across the bond universe as an analyst, a portfolio manager, and overseeing our research initiatives. Dan, our thanks for joining us today.

Dan Yungblut: Thanks, Lloyd. First of all, happy to be here. Why are we here? Why did we want to do this podcast? Investor demand for cash products, including GICs and higher interest savings accounts and others, have spiked over the past few years. My colleagues, Tom and Jason, talked about a cash trap on the podcast a few months ago.

We really want to give investors some thoughts on why we think they should consider redeploying a lot of that cash. One, we get it — there's been a generational reset in interest rates. It was well telegraphed, and it's like you said, like it was one of the fastest, most violent rises in interest rates in history, and fixed income performance was obviously challenged last year.

Cash floods, pretty reasonable place to hide. All-in yields were attractive for GIC. GICs do have a place in investment portfolios, especially for their short-term horizon needs for cash, but cash products are unlikely to be a long-term solution that can meet the financial needs of many investors. We generally look at cash as a tactic rather than a strategic solution.

Interest rates and bond yields are now back to more normalized 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.

Lloyd: Thanks, Dan. I think that's a great place to start. Let's get started with those reasons why investors should think about starting to redeploy their cash.

Dan: 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. For any uninsured part of GIC holding, that's actually the exact same credit risk.

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 on the bond than in cash. If interest rates go down, you get capital gains to support performance. Now, if yields go up, that's where people are concerned with bonds, there is a capital loss initially, but you instantly start earning that higher yield.

Over time, that higher yield gauge you back on site. Time is your friend. You generally end up in a better position by being in the bond long term than in cash. And so that instant reset, the higher yield 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 HISAa rather than proactively and instantly with bonds. Obviously, if you're in a higher-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. Like equities, I think most investors understand, unless you stay invested, it's hard to time those big rallies and drivers of return. Between the generally higher all-in starting yields, that instant adjustment of the market environment, and the varied sources of return, it's why bonds historically significantly outperform cash products head-to-head. That's just straight-up performance, bonds versus cash.

At the portfolio level, there is also an important portfolio insurance function of fixed income that you don't get from cash. 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. It's why balanced portfolios that include fixed income, like your classic 60/40, outperform on a risk-adjusted basis over the long term.

Lloyd: There's definitely an important role for bonds and fixed income in the portfolio. I know you also wanted to get into what we'll call financial planning benefits of bonds and fixed income versus cash products for instance.

Dan: Yes, perfect. The first we wanted to highlight was liquidity. With GICs and higher interest savings accounts, liquidity is typically at a fixed arbitrary date unless you're willing to accept the significant penalty of the yield that you are. 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. 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.

We do have a dedicated discount bond fund, but that tax advantage is true across all of our fixed-income products. 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.

We think fixed income is an essential component of the concept of a paycheck 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. Fixed income should be a key component of the strategic financial plans for many investors.

Lloyd: 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?

Dan: 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 GICs rates like that example we shared earlier. Better liquidity, similar credit risk, better yield, it's compelling.

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 relative yields and credit spreads between Canada and the U.S. 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.

Great example, the difference between the U.S. and Canada 30-year government bond yield is at an all-time record and there are ways to take advantage of that. 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. 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 U.S. allocation, there are countless others. 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. Just for reference for those maybe wondering, when you sell a new bond or new equity to the market, you typically have to sell it at a discount to entice new buyers. 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.

Now, this isn't one that often doesn't get thought about—unlike an equity, you hold a passive exposure to an equity index. Your largest holdings are the best-performing companies. Just being in an index, you 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, high risk, and because they have to refinance a lot of debt. It's not necessarily the best performer in the index. Also, whether it's cash or fixed income, it's important not to blindly stretch for yield. Credit selection matters. Active managers can rebalance, they can better target the most attractive risk-adjusted deals 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.

Look, us at Dynamic, we've got the active management across three leading fixed-income teams. We've got long track records of success. Our specialized 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, focused on active credit selection. Again, they also have some top-performing preferred share mandates.

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. Lastly, we've got Payden & Rygel has proven themselves as one of the top-tier global fixed-income managers through really one of the worst periods of fixed income in history, had really stellar performance.

Look, we get it. It's rare to give all your fixed income, especially your active fixed income in one firm. We have many other active fixed-income peers out there that we respect, but the main point is that, as you redeploy that cash, think active management is especially compelling in the fixed-income part of the portfolio. You can access that active management through both prospectus mutual funds and active ETFs.

It's relevant for some, just want to mention as an aside, look, it's easy to move out of your high-interest savings account ETFs, which are now paying a lot less attractive yields after recent reforms, and move into active fixed-income ETFs, if that's your preferred vehicle. That is really compelling right now. Really, just to finish off, we want to reiterate that we've lived through a generational reset in interest rates. 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. 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.

Lloyd: Dan, that was excellent and greatly appreciated. Thanks to our audience. Dan left us in a great place to have a conversation as it relates to investing in fixed income and the need for real active management in this space, compared to what is an industry that is often filled with what we call closet indexing. You're basically getting a passive product with an active fee. By all means, pay close attention to that, and we'd like to thank you for your participation in our podcast and wishing you the best. Thanks again, Dan.

Dan: Thanks, Lloyd. My pleasure.

Mark: You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website at dynamic.ca. Thanks for joining us.

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