A paradigm shift in fixed income has occurred over the past two years. In this article, Earl Davis, Head of Fixed Income & Money Markets, Active Fixed Income, BMO Global Asset Management, discusses the resulting opportunities in one-year government Treasury bills, makes the case for cash as an asset class, and dives deep into the benefits of active fixed income management.
The Evolving Fixed Income Landscape
I began my career in money markets in 1994 and subsequently worked for one of Canada’s largest pension funds for 12 years. In such a role, a major consideration in the investment process is factor returns—the elements of fixed income that consistently add to your returns over time. The two biggest ones are yield and rolldown (the capital gain created by the fall in bond yields). Investors are currently getting generationally high yields, and we anticipate the rolldown opportunity to be significant by next summer; as an active manager, we are well positioned to take advantage of both opportunities.
The past two years have ushered in a paradigm shift in cash. By cash we mean Treasury bills, which are an investment tool; this is opposed to GICs, which are primarily a savings tool. As recently as late 2021, a Canada one-year government T-bill yielded only 13 bps or 0.13%. By October 24, 2023, that same T-bill yielded 5.25%—an over forty-fold increase. Returns on cash have not been this high in over 20 years, December 2000 being the last time yields topped 5.25%.
Canada 1-Year Treasury Yields (2000–2023)
Source: Bloomberg, as of October 3, 2023.
The Changing Calculus of Cash
Consider the following scenario. Suppose a few years ago an investor was receiving a yield of 13 basis points on a one-year T-bill. By moving to a GIC, that same investor may have been able to receive 50-75 basis points—an attractive trade, given that it represents 300-500% more return. Today, while GICs are still offering a roughly 50-basis-point edge over one-year T-bills—5.75% for GICs versus 5.25% for Treasuries—investors are only gaining 10% higher returns. In other words, for only 10% more, the GIC investor is taking on additional credit risk and locking up their funds. This is a risky proposition in today’s market dynamic and it is our belief that there are better, more liquid, and flexible alternatives.
Maintaining Liquidity Will Be Important at These Levels
Once a client adds cash to their asset allocation mix, the calculus changes. As of October 2023, the highest-yielding point on the yield curve is from overnight to one year. This means that investors now have short-term options that were previously unavailable. One of the key reasons why GICs were attractive compared to T-bills is because the latter’s returns, after taking inflation into account, were negative, so picking up an extra 50 basis points made a material difference. Now that interest rates are higher than inflation, Treasuries are earning a positive real return in addition to their liquidity advantage—investors can easily purchase or sell T-bills the same day. In short, thinking of cash as an asset class reduces risk, broadens the investment landscape, grants the client greater flexibility, and has the potential to impact both returns and one’s risk/return ratio for the better.
Bankers’ Acceptances Near Their End
Bankers’ Acceptances (BAs) are the second-largest investible asset class in Canadian money markets after Treasury bills, representing approximately 20% of Canadian money markets as a whole.1 However, the publication of the Canadian Dollar Offered Rate (CDOR) will cease in June 2024, meaning that BAs will no longer be issued by Canadian banks. This has significant implications for money market investors, as the assets invested in BAs is effectively going from approximately $90 billion to zero in a matter of months. Virtually all of that $90 billion is in shorter-term, one-to-three-month BAs, meaning that these developments are unlikely to significantly impact the one-year segment of the money market curve. They will, however, have a significant effect on the one-to-three-month segment. Due to supply and demand, it is likely that the interest rates on the shorter end of the curve will move lower while one-year bills remain stable. We anticipate three-month T-bills to rally on increasing demand and the spread to widen to at least 50 bps. This means that an active investor can buy a 1-year T-bill and then nine months later, if spreads widen to 50 bps or more, sell a three-month bill and reinvest in the one-year, thereby profiting from the change in spread. Buy and Hold, and passively managed strategies cannot do that, nor do they typically go out as far as one year.
Short Term Risks and Rewards
There will be a time to extend term on bonds, but we do not believe that will occur until early 2024. Much depends on the economic and interest rate outlook: will the recent inflationary bump evaporate within the next few years, or are we now entering a secular regime in which somewhat higher inflation will persist for the next decade or more as the result of onshoring, wage increases, and so on? We are in the latter camp primarily due to the loose fiscal policy in North America, and consequently believe that interest rate easing is unlikely in 2024.
There is no question that today’s fixed income environment is distinctly different than that which clients have grown accustomed to. As is so often the case in times of change, however, this new paradigm offers significant opportunities. For plan sponsors, short-term T-bills provide not only attractive yields, but also flexibility—the benefits of which GICs simply cannot match.
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