A Q&A about Fixed Income investing with Franklin Templeton’s Jon Durst

Jon Chevreau, Q1: Do you believe active management makes more sense in the fixed-income space versus the equity space? Perhaps it makes sense in both?

Jon Durst: There are merits to active management in both equities and fixed income; however, I feel recently, it has been a heavy skew towards active fixed income in this current market environment, and for many reasons. Early in March 2020, we saw a 50bps cut in interest rates by the Fed in the US: it was the first unscheduled rate cut since 2008 and the biggest cut since the financial crisis.  There also appears to be a strong consensus on the street that rates will be “low for longer” going forward.  If you own a passive fixed income strategy, the goal is to minimize tracking error to the index and what it cannot do is to adjust or try to anticipate any type of market events, like interest rate changes or changing company fundamentals.

This can certainly be a worrisome event for most advisors if they buy their own bonds directly or passive fixed income products covering different sectors/regions, as they have to scramble and figure out if they should continue with the same fixed income allocations in their portfolio, as the onus of making any changes to their portfolio will be on them.

Active managers with years of experience can focus solely on their investment mandates and can adjust to different types of market events, such as shape of the pandemic recovery or the consequences of the Democrats winning the 2020 US elections.

Outsourcing in this market environment and buying active fixed income exposures that align with your client’s outcomes will hopefully provide a calming effect that is certainly needed.  Not to mention, active fixed income ETFs in particular are now often priced very similarly to passive indexed products, which is even more important in this low rate environment to help maximize clients cash flow.

Jon Chevreau, Q2: For income-oriented retirees, do you generally see more opportunity in corporate or government bonds?

Jon Durst: I do see more opportunity in corporates debt, as the yields are higher, they also tend to be less sensitive to interest rate movement, but the risk level and volatility do tend to slightly go up.

A passive aggregate bond strategy that encompasses both corporate and government debt in Canada yields around 2.55%, a pure passive Canadian government bond strategy at 2.11%, and a passive Canadian corporate strategy around 2.77%.  On the other hand, for example, an active Canadian corporate strategy FLCI – Franklin Liberty Canadian Investment Grade Corporate ETF, yields 3.12%. An active manager can select certain bonds over others, perhaps looking for higher coupons and/or YTMs, or overweighting certain sectors that will benefit from the pandemic trade or the Biden Presidency.

Jon Chevreau, Q3:  How much exposure should Canadian investors have in US and international bonds and through what vehicle? On that note, what is your stance on currency hedging?

Jon Durst: We do need to think outside of Canada; even from a fixed income perspective, Canada’s total debt in comparison to the world is about 3-4%.  Also, there is no tax incentive to buying solely Canadian debt, unlike the Canadian Dividend Tax credit provided on distributions from Canadian equities.  There are many fixed income opportunities to take a look at – a solution based option via a Canadian Core Plus strategy is one – where you would still keep 70-75% in Canadian bonds and have an active manager select the 25-30% in the US and/or globally.  You could also consider a more broad-based global aggregate option, having the portfolio manager look for opportunities from a global stand-point, which offers the PM a lot of flexibility to diversify geographically and from a currency perspective.  Yields in different countries can vary significantly which can create a lot of opportunity for higher yields and capital appreciation, not to mention diversification benefits.

In terms of buying a pure-based exposure – in other words, buying direct US, EAFE or EM debt, either by purchasing individual bonds or a managed product — I find most advisors are still tippy toeing into pure US, EAFE or EM debt spaces: most still maintain a home country bias and the complexity of selection, weighting, and trading these exposures is difficult, to say the least. Those that see the value in investing outside of Canadian debt usually outsource this complexity by using active fixed income strategies that provide access to the US/Global exposure, in addition to Canadian bonds.

I am for 90-100% in currency hedging fixed income exposures.  With interest rates and yields being at historical lows, another level of worry should not be placed on how the global currencies are going to perform relative to the CAD$, especially in fixed income, which is supposedly the conservative component of a client’s portfolio.  In my opinion, currencies should be hedged out as much as possible in fixed income.

Jon Chevreau, Q4: Your blog back in February compared bond funds to GICs. Do you see a role for both and in what proportion?

Jon Durst: In this environment, it can get even trickier: do you really want to lock into GICs for a certain period of time at a certain rate? Or want to be nimble and have liquidity? It’s a question on how to balance stable income that is locked in (currently at historically low rates) and/or including a short term bond strategy that can yield a little more in this environment and provide liquidity in the event of a requirement. I am beginning to see a fair number of advisors who have started to allocate to short term bonds funds as client GICs mature. Usually cash, GICs and short-term bond funds make up about 5-10% of a clients portfolio, but GIC investors are being compensated very little, so short term bond funds are being used for those with a higher need for income, and cash now being used for those with a 100% capital preservation requirement (not taking inflation into the equation).  GICs appear to be losing some steam.

Jon Chevreau, Q5: Clearly, after the Bank of Canada matched the Fed’s 50 basis points rate cut early in March 2020 when the pandemic began, GIC investors were not going to be paid much basically after that point. What do you expect GICs will pay for 2, 3 and 5 years out? Does it make sense to invest in the shorter 1 & 2-year issues in hopes of later rate hikes, or should investors take what they get and lock in longer in case the BOC contemplates negative interest rates, which has occurred in parts of Europe and elsewhere?

Jon Durst: There is no easy answer to this question, the Canadian Banks on March 5^th, 2020 have already adjusted their lending rates by 50bps down to 0.25%, which has trickled down to lower borrowing cost for mortgages alongside lower GIC rates for investors. The decision making will depend on your capital preservation needs in combination with your need to access the funds. If you are in no rush, then yes, locking in would make sense if you believe interest rates will continue trending downwards. Otherwise, to maintain liquidity and to be nimble, I would recommend investing in short-term bond ETFs/funds that generally can invest a few years out on the yield curve. This provides you flexibility to make a more informed decision as the pandemic plays out versus locking in over a number of years.  It also generally compensates you with higher yields than GICs.

Jon Chevreau, Q6: For the benefit of investors who may not fully understand the inverse relationship between interest rates and bond prices, could you review what the impact of that 50 basis points rate cut had for investors during the last cutting cycle in Canada? And what is the impact on fixed-income funds like the one you manage?

Jon Durst: Yes, there is an inverse relationship with interest rates and bond prices: when rates are cut, bond prices rise. The impact of a 50-basis point cut will be dependent on the duration of the bond or the average duration of a bond portfolio. For example, if a bond ETF was priced at $10 and the duration of this product was 5 years. A 50bps point cut would be calculated as = Bond Price x -(duration) x interest rate change = this would translate to $10x-5x(-0.0050) = 0.25

So a 50bps cut to a $10 bond ETF would translate to $10.25 price, or a 2.5% capital appreciation on the fixed income ETF.

The only issue here with this calculation is that not all duration is calculated equally. The Bank of Canada overnight rate cuts have typically been more impactful on shorter term bonds than longer term bonds (since the rate cuts were generally at the very front end of the yield curve); but other factors can impact the bond returns, including how much the market had priced in these cuts before the announcement. The yield curve is currently low and flat, with market experts believing this will not change dramatically in the short term.

The Franklin Bissett fixed income team has been adding to longer term bonds lately, based on relative valuations and a viewpoint that higher yields in longer term bonds will drive stronger portfolio returns.  Also, interest rate risk is low at the moment considering the extent of liquidity support by central banks.

Jon Chevreau, Q7: What about inflation and inflation-indexed bonds: TIPS in the US, Real Return Bonds in Canada? Is this part of your mix in broad-based bond funds or do you see a role for dedicated RRB exposure, perhaps through ETFs or mutual funds?

Jon Durst: Usually when rates are cut, inflation tends to rise, but the worry is will consumers go out and spend? It has been different then pre-pandemic, but consumers are still spending at reasonable levels, which is being aided by huge amounts of government stimulus (more expected in the US).  It could be an area of a portfolio you will need to think about from a medium to long-term perspective. Inflation risk has been quite low over the last number of years, Canada is treading around 2.4% while the US is around 2.5%.  Given the fact that governments around the world are injecting a lot of stimulus and liquidity into the system, it is something that should be monitored.

Currently, our fixed income managers have not been adding inflation-linked bonds to the portfolios and will monitor inflation in the short to medium term. The team does not believe the current fundamentals are supportive of long-term inflation boost.

Jon Chevreau, Q7. A final question for older investors. Do you agree with the general rule of thumb that Fixed Income should equal your age? For example, a 60-year-old would have 60% fixed income and 40% equities, a 70 year-old would have 70% fixed income and 30% equities, etc.? Or would you be a little more equity oriented by adding 20% equities in each case: i.e. the 60-year-old would be 60% equities and the 70-year-old 50% equities?

Jon Durst: The world has changed: we had a 36-year historical bull market in interest rates that ended in 2018 when rates started to rise and as we fast forward to 2020, we have seen cuts combat the outbreak of the corona virus. Based on the extremely historical low yield, the general rule of thumb that fixed income should equal your age probably doesn’t apply as you will likely be unable to generate the income you need to sustain your lifestyle and retirement goals. You will likely have to lean toward dividend paying equities and alternative asset classes  to give you the added boost that you will need to generate these income needs. This will come with added risk that will have to be managed properly.

Jon Durst is Vice President, ETF Business Development, responsible for directing and expanding the Franklin LibertyShares™ ETF business across major Canadian Investment Dealers and financial professionals. Jon’s responsibilities include providing ETF strategy, marketing and product development support. He has 10+ years of experience in the ETF industry and 13+ years in the investment industry overall. Prior to joining Franklin Templeton in 2019, Mr. Durst spent 6 years at BlackRock Canada supporting the promotion and growth of iShares ETFs, primarily as a wholesaler covering the GTA. Previously, he worked at BMO ETF’s for 2 years supporting the growth of their ETF business.

Mr. Durst earned his Bachelor of Commerce degree at McGill University. He has also completed the Certified Financial Planner (CFP ®) and has earned his CIM® & FCSI® designations.