Multi-Manager

A Year and a bit in fixed income

Welcome to the 7th edition of BMO Multi-Manager PassiveWatch, an annual review and analysis of the passive fund industry.
April 2021

Adam Norris

Investment Analyst, BMO Multi-Manager People

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Risk Disclaimer

Please note that this is a marketing communication and does not constitute investment advice or a recommendation to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. Views are held at the time of preparation.

Past performance is not a guide to future performance. Stock market and currency movements mean the value of investments and the income from them can go down as well as up and you may not get back the original
amount invested.

Fixed income investing is often considered the dull and boring part of the market, where returns are a gradual grind out over time. But that narrative could not have been more wrong over the past 18 months. In place of our usual weekly markets note, I will spin through the key sub-asset classes that fixed income managers have at their disposal and discuss how the large dispersion of returns show how ripe conditions have become for active investors.

Conditions in Q1 2020

With the forced lockdowns between March and May last year, economic output collapsed by amounts unseen since WWII. Fear spread across financial markets – who would want to lend to corporates when their revenues are dissolving? The only game in town was the certainty of lending to governments (or holding cash) – investors assumed at least governments would be able to repay them in these uncertain times and scrambled into ‘safe-havens’. Central banks began utilising their now standard reaction functions to falling growth and inflation: cutting interest rates to record lows and buying government bonds, thus reducing the funding costs for fiscal spend. Broadly speaking, the more sensitive a bond was to interest rate movements, the better the returns were. Conversely, the more sensitive a bond was to the real economy or cash flow changes, the worse the returns were.

Fixed income returns Q1 2020

Best & worst passive returns per sector in 2020

Source: BMO Global Asset Management and Lipper, as at 14 April 2021

Risk Disclaimer

Please note that this is a marketing communication and does not constitute investment advice or a recommendation to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. Views are held at the time of preparation.

Past performance is not a guide to future performance. Stock market and currency movements mean the value of investments and the income from them can go down as well as up and you may not get back the original
amount invested.

Use our handy glossary to look up any technical terms you are unfamiliar with.
March to year end

Further central bank intervention came with the Federal Reserve in the US buying – and more importantly its stated willingness to buy – huge amounts of corporate bonds in the market…the premise being that if they could stop funding costs from spiralling, companies would be able to borrow in the market, providing a lifeline of cash to see them through the Covid-19 crisis. And it worked. The central bank backstop unleashed a record $2.4tn worth of corporate bond issuance to year end in US markets alone! Moreover, it allowed investors to invest in the asset class knowing that if debt costs rose further, the central bank could be there to bring it lower – it’s not often investors are provided an opportunity to make returns with reduced risk. In addition, investors grew increasingly confident that the Covid-19 pandemic would be finite in length and that even through periods of stringent social lockdowns, there would be large parts of the economy still functioning.

The returns of risk assets from March onwards were spectacular versus sideways to negative returns for government bonds – take a look at the chart below:

Fixed income returns Q2 – Q4 2020

Fixed income returns Q2 – Q4 2020

Source: BMO Global Asset Management and Lipper, as at 14 April 2021

Year to date

With vaccine breakthroughs and strong take-up in developed economies, risk assets have continued to perform well due to the strong growth anticipated from a post-lockdown society economy. Meanwhile, the perceived safer area of government bonds has significantly underperformed. Investors are starting to consider the implications of the large fiscal spend by governments, most clearly seen in the US, with President Biden’s $1.9tn Covid-19 relief plan and, more recently, an infrastructure bill considered to be around the $2tn mark. Just how inflationary this could be and whether this marks the end of the disinflationary era of ‘Secular Stagnation’, which has dominated financial markets for the past 30 years, remains to be seen.

Fixed income returns Q1 2021

Fixed income returns Q1 2021

Source: BMO Global Asset Management and Lipper, as at 14 April 2021

Our asset allocation

We frequently review funds that claim to have an edge in asset allocation, but our 19-question ‘IQ’ scoring process often reveal these funds to be less consistent at generating outperformance than their more structured-process counterparts. We therefore similarly do not consider our core skillset to be in large asset allocation decisions, but instead at finding the best fund managers in the areas of the market we deem credible for investment. We prefer to let our deeply research-driven, active managers generate the performance. That said, we will tilt our portfolios in different directions, particularly at extremes, where we consider more value to be or to styles which may outperform in firmer (or weaker) economic conditions.

For those invested in our Lifestyle portfolios (for the following we did also make similar moves in our Navigator portfolios), you will likely know the strategic asset allocation of the portfolio is set by a third party. As you can see, we rotated the portfolio away from safe havens in government bonds last year, reaching a 3% underweight versus the benchmark, after the extreme outperformance in Q1. We added to corporate bonds at the end of March last year, an area which had underperformed dramatically for the security of the cash flows on offer, reducing this as the market normalised through the latter half of the yearly. However, we do not expect such conditions to arise again quickly. Indeed, we now consider corporate bonds to be richly valued. Recently, we have been rebalancing the portfolios with more safe havens and less corporate bonds.

Lifestyle 5 – relative asset allocation versus the benchmark

Lifestyle 5 – relative asset allocation versus the benchmark

Source: BMO Global Asset Management, as at 14 April 2021

Final thoughts

It’s been a rollercoaster journey for perceived “dull” fixed income markets. Above-average returns have been available for those active allocators willing to take on risk at opportune moments. It should go without saying that those spectacular returns made since March are unlikely to be achieved again in the near future, given the starting yields now on offer. For now, we remain patient, with a more balanced portfolio, looking to tilt our asset allocation once again when more advantageous opportunities appear.

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