Canadian retail investors are demonstrating a marked shift away from traditional fixed income exposures, seeking alternative avenues for income generation. This trend has been observed by Rose Devli, VP & Portfolio Manager with the Core Fixed Income team at Dynamic, through her interactions with financial advisors and individual investors. Devli attributes this newfound reticence towards bonds and corporate credit allocations directly to the challenging market environment of 2022. During that period, post-COVID inflation surged, leading to an unusual positive correlation between bond and equity markets. This dynamic reintroduced the specter of inflation risk into the consciousness of retail investors, a factor they had largely become accustomed to seeing absent from fixed income considerations.
While inflation continues to be a significant contributor to ongoing volatility in bond markets, Devli expresses a renewed optimism for the asset class. She highlights that the current volatility, driven by a confluence of factors, is actually creating new opportunities for active managers to capture upside potential. Devli further elaborated on how mutual fund and ETF issuers, including Dynamic, are proactively adapting their fixed income offerings. These adjustments are designed to directly address the lingering concerns of investors regarding fixed income’s perceived risks and to more effectively deliver the income and portfolio ballast that have historically positioned fixed income as a cornerstone of diversified investment portfolios.
The present market landscape, characterized by heightened volatility, is a scenario that actively excites portfolio managers like Devli. She contrasts this with periods of exceptionally low yields, such as the depths of the COVID-19 pandemic when 10-year U.S. Treasury bonds yielded around 0.5%. In such low-volatility environments, where daily price fluctuations were minimal, outperforming a passive index became a formidable challenge for active managers. "This environment makes me very excited because I can go to a client and say to them, now is the time for active management," Devli stated. "Now is the time where you as an investment advisor can focus on your areas of expertise and leave the active fixed income managers to focus on your defense." This sentiment underscores the perceived value of skilled active management in navigating complex and volatile markets, providing a defensive layer for client portfolios.
The Multifaceted Drivers of Current Fixed Income Volatility
Devli identifies three principal factors contributing to the elevated volatility and rising yields across the fixed income spectrum. The first, and perhaps the most widely discussed, is the significant fiscal deficits prevalent in developed economies. Many developed nations are currently grappling with debt-to-GDP ratios that are at or exceeding 100%. This includes major economies such as the United States, Japan, and the United Kingdom. The sheer volume of government debt in circulation, coupled with investor concerns about these elevated debt levels, is necessitating higher borrowing costs, thus driving yields upward. The International Monetary Fund (IMF) has consistently highlighted the growing debt burdens of advanced economies, projecting that global public debt is expected to remain elevated in the coming years, placing further pressure on government bond markets.
On the corporate credit front, the ongoing and substantial infrastructure buildout in the artificial intelligence (AI) sector has triggered massive bond issuances from technology companies. Many of these companies, previously characterized by strong cash flow generation and limited debt, are now tapping debt markets to finance their ambitious AI-related capital expenditures. This surge in corporate debt issuance creates increased competition for investor capital, forcing these new corporate bonds to offer higher yields to attract investors, thereby pushing overall market yields higher as they compete with government debt. Analysis from financial data providers indicates a significant increase in technology sector bond issuance over the past 18-24 months, directly linked to AI development and deployment.
The third significant factor influencing fixed income markets is the pervasive impact of geopolitics. The ongoing oil shock, exacerbated by conflicts in the Middle East, is demonstrably contributing to higher inflation expectations. Devli pointed out a historically strong correlation between oil prices and bond yields. When oil prices surge, bond prices tend to fall in near lockstep. This relationship can be attributed to oil’s fundamental role in global supply chains and its direct impact on transportation and energy costs, which are key components of inflation. Geopolitical events that disrupt oil supply or create uncertainty around future supply can therefore directly translate into inflationary pressures and, consequently, higher bond yields as investors demand compensation for this inflation risk. For instance, the escalation of tensions in the Middle East in late 2023 and early 2024 saw crude oil prices react sharply, and this volatility was closely mirrored in the bond market’s yield movements.
Navigating Unforeseen Correlations and Emerging Themes
These driving forces are leading to increased volatility within investors’ fixed income allocations. Furthermore, they may inadvertently expose investors to certain investment themes they had not anticipated. The correlation with oil prices is one such example. Another is the exposure of credit investors to the AI capital expenditure theme. Investors who purchase corporate bond index products with the intention of diversifying their equity holdings might be surprised to discover the growing allocation to AI hyperscalers within these indices. For instance, approximately 3.5% of the U.S. investment-grade corporate bond index is now comprised of bonds issued by these AI giants. This trend is also evident in Canadian credit markets, where major AI players like Amazon and Google are increasingly issuing debt. While the volatility currently observed in fixed income might prompt some investors to recall the challenging conditions of 2022, Devli asserts that significant shifts in macroeconomic conditions and the evolution of fixed income strategies warrant a reconsideration of these anxieties.
Evolution of Fixed Income Funds and the Resurgent Case for Bonds
Speaking on behalf of her team at Dynamic, Devli highlighted their strategic efforts to launch more Exchange-Traded Funds (ETFs) that provide portfolio managers with enhanced flexibility in managing duration. The newer fixed income funds being introduced are designed to empower active managers to reduce duration exposure to zero if they foresee a recurrence of the 2022 scenario, where fixed income and equities exhibited sustained positive correlation. Other fixed income products, she explained, have been engineered to hold duration at approximately half that of the predominant index. This structural feature was notably implemented following the 2008 financial crisis, a period when index duration levels were significantly lower than they are today, averaging roughly half their current state.
"We are hearing investors loud and clear on products that they want that can protect them from another 2022 event," Devli emphasized. This direct feedback loop is crucial in shaping product development and ensuring that investment solutions align with current investor sentiment and risk perceptions.
With these protective measures increasingly integrated into fixed income products, Devli believes there is a compelling and growing rationale for increased bond allocations. This case begins with the attractive yields now available from investments traditionally considered "risk-free." While price volatility in assets like 10-year U.S. Treasury bonds has indeed increased from historical norms, the 10-year Treasury bond remains a critically important global asset, underpinned by the U.S. dollar’s status as the world’s reserve currency. The inherent security of this asset, combined with a yield now exceeding five percent, presents a significant opportunity that Devli argues financial advisors must seriously consider.
Devli also pointed out that while inflation poses a risk of positive correlation between bonds and equities, periods of economic "growth scares" typically imply a negative correlation. Although economic growth in the United States has demonstrated robustness recently, it is largely concentrated, with AI capital expenditure playing a substantial role. The recent discussions among prominent industry leaders regarding a potential "AI slowdown" could signal a deceleration in the AI infrastructure buildout. This, in turn, could trigger a growth shock for both the U.S. and global economies, thereby presenting an upside opportunity for bond investors. For financial advisors, particularly those managing portfolios for retirees, the dual benefit of attractive yield and a hedge against economic slowdown should be sufficient motivation to re-evaluate the role of bonds in their clients’ portfolios.
"For an investment advisor with clients going into retirement, who might not own bonds right now, this is a way to bring down the growth scare probability in the overall portfolio," Devli concluded. "And a way to do that while still gaining income." This perspective underscores the tactical advantage of fixed income in the current environment, offering both income generation and a crucial element of portfolio risk management, especially for a demographic with a lower tolerance for capital erosion and a higher need for stable income. The renewed emphasis on yield, coupled with the potential for capital appreciation during economic downturns, positions fixed income as a valuable component for investors navigating an uncertain economic landscape.
