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Traditionally, bonds are one of the safest ways to invest. But what happens when a global pandemic rocks its stability? Wealth management professional, Jacoline Loewen, sat down with Richard Pilosof of RPIA to get to the bottom of where the future of fixed income investments are headed. This was a part of the Canadian Alternative Investment Forum annual speaker series. Thank you Karen Azlen and Introduction Capital.

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Is it still worthwhile to invest in fixed income?

Global fixed income has long been considered “the meat and potatoes” of any steady-growth portfolio. Thanks to the pandemic, even our most stable of investments in the mix has been challenged, leaving investors wondering if there is still future growth potential in the bond market. Richard Pilosof, founder and CEO of RPIA, says yes: Wealth management professional, Jacoline Loewen, deep dives into why.

After spending over 25 years with RBC Capital markets and over 30 in fixed income, Richard has a heightened awareness of the 40 year evolution - or perhaps, devolution - of the bond market, “it's been a complete ride down in yields, and now we're unfortunately at zero.” Like Jacoline, many investors have relied on fixed income as an essential part of any portfolio for those seeking yield, serving as a “hedge in bumpy markets,” and now being affected by today’s rapidly changing interest rates.

So how has history, and now COVID, affected the rate of return of the traditional bond market, and how should we approach our portfolios given these current challenges?

“There’s been a distortion in what people perceive as the appropriate fixed income return and the risk-free rate of return that has had to be readjusted because of COVID.” Policy has changed, and so has the way we’ve had to think about return attribution with fixed income. The key element is to focus on the risk-free rate of return, and “the risk-free rate of return is now zero. So from that, what is the appropriate fixed income return profile? And clearly, it's lower.”

In Richard’s view, while the fixed income return profile may be lower, it still plays an important role within the portfolio mix now and going forward. “So long as that distortion is well understood, and the perspective of the true return profile going forward remains as being lower” then you can approach investing in fixed income with an understanding of the real risks being presented knowing that “the long-term perspective of what the return profile looks like, will be lower.”

If we remain in this pandemic-shifted environment for two or three years (a prediction that’s dually expected) with the lower for longer rates, “even though you have zero bounds in the short end, you still might have capital gains in tenure and in securities.” Having capital gains from other investments signal that perhaps an increased portfolio mix will shore up the lower rates from bonds, a discussion that Pilosof says is very much still in play. “Searching for active participants in asset allocation, continuing to look for ways to create income, or yield, or capital gains, in ways that are less traditional are going to be very, very important.”

The fixed income market is certainly evolving, and by being aware of the distortion, the risks and the long-term opportunity, investors will have a more realistic base to build a COVID-proof portfolio from a position of strength. In having that realistic expectation of the return rate - that rate being zero - it allows for the understanding that for “every extra unit of risk you’re going to take in the marketplace, you’re going to take another level of risk.” Pilosof compares the corporate bond market “which is essentially liquid” to buying a loan, mortgage or direct lending product where the return profile will be much larger, also meaning “you’re going to take a different level of risk.” That risk being illiquidity.

Assessing your client’s goals, presenting them with realistic expectations and an understanding of the distortion in the market will allow for a higher level of transparency, a line of communication that will be essential to a successful portfolio from a macro perspective. As we are likely headed towards another near-future crisis, opening the conversation to a more dynamic strategy over the long-haul will likely be the strongest route for investors.

As for fixed income bonds as part of this strategy?

As Pilosof suggests, “the purity of fixed income is important and an important part of that portfolio.” The bond market may have shifted, but through the macro looking glass, it looks like it's here to stay.

How to approach ETF investing

In the face of COVID-19 and the bumpy future ahead, there are opportunities in more active management as well as taking a more global approach to ETFs. Jacoline Loewen and Richard Pilosof deep dive into this topic.

Despite an initial panic in March, the past year has seen some of the fastest growth in unexpected areas, one of them being fixed-income exchange-traded funds or ETFs. While investors look to bond ETFs to get their fixed income exposure, the question becomes “with passive fixed income investing, are there bear traps?” What are the clues we aren’t seeing, and why should we consider making a few changes?

Much like our previous discussion on the traditional bond market, COVID led to a distortion in the markets, “in March, a significant amount of it was the fact that there was a liquidity gap that was created for a very short period.” The problem here arises out of the fact that we “mark to market. And the marking to market creates this distortion...it creates this reality of a price at that moment in time.” However, as the world began shutting down, the government stepped in and employed a stability mechanism within two weeks – a move that stabilized the markets much quicker than seen in previous crises.

It’s also a move that’s indicative that volatile movements should have less of an impact on these types of markets in the future. So if the government has found a way to mitigate future risk with fixed income markets, many investors, including Jacoline, want to know: Why bring global fixed income into our portfolios?

Well, according to Richard Pilosof, the answer is simple, “The Canadian bond market is very narrow. The Canadian corporate bond market is very narrow. So there are only so many telecoms, only so many safe companies that you can go to to create the return requirements as a Canadian investor.” That being said, how should investors approach a global market?

“What we've always looked at ourselves is the ability to buy similar types of companies on a global scale that create the same level of risk profile, but for more yield.” From Pilosof’s perspective, fixed income has a similar level of stability in international markets, so in understanding that and the risks at hand, global fixed income seems like a relatively steady, and smart strategy to adopt. Ultimately, it seems that “having a global capability is more important today than ever.”

Of course, with global capability often comes a more active management strategy. Specifically for the global fixed income market, this is true, or at least an aspect of it, “Essentially, in many ways, the underlying securities that encompass the ETF don't trade. So what we saw in March, for example, is that ETFs created a panic in the marketplace because people were selling them indiscriminately without an understanding of the underlying value of the securities.”

Investors were trading them with the same level of liquidity as securities, "’ I need liquidity. I'll sell them at 97,’ and that implied an overall yield on some of the securities of 6-7%.” In Pilosof’s view, “you have to compose the value of over-the-counter securities versus what an ETF proposed. I think they work well for in-market exchange. They don't work well, in my view, for the over-the-counter market.”

Going forward, regardless of the state of our economy, you will still have dispersion whereby some companies will do well, and others just won’t cut it. This is where, as an investor, engaging in that view of active management investing, will allow you to analyze the securities underlying the ETF you’re looking to trade in a way that directs you to the “hidden jewels in the rough”. This means taking a more scrutinizing look at the framework of the securities underlying your investment, “the environment has changed and certain companies, maybe a commercial REIT, may do a lot less well than an Amazon or an Apple. So those [hidden jewels] are very important considerations to make moving forward in the investment process.”

We can see that, where there’s distortion, there’s also opportunity. The coming crisis will look very different than the one we’re in now and in 2008, and as an investor that’s equipped with the clues of the marketplace, you’ll be ready when it does. “So that is something to look forward to... an ability, then, to protect capital for our investors.”