The Importance of Fixed Income Diversification


What are the challenges facing fixed income investors today?

Daniel E. Chornous, Chief Investment Officer

Yields are very low right now and likely to rise for maybe years - could be a decade, could be longer - as we get to historically normal levels of interest rates. The returns that you're going to earn through that period are probably below those that you've embedded in the savings plans, so how do you add to that? The traditional way of boosting returns above yield would be to anticipate interest rate movement: sell bonds before they go down, buy bonds before they rise... but the testing that we've done on that is that is a really low predictable source of returns. A more predictable and stable source of returns is to accept additional risk premia in your fixed income exposure so rather than owning all sovereign bonds, how about blending in a little bit of provincial bonds, or even some investment-grade securities or with even a smaller amount, how about some high-yield securities, securities outside of this country. Maybe some emerging market debt, maybe emerging market local currency debts. There's quite a rich palate of risk premia available to blend together. When we do that, we get higher returns or yields into the portfolio that reflect the additional risks that you're taking, but by blending it through financial mathematics, or optimization, sometimes you can get higher returns with lower levels of volatility and that's actually our goal.

Why is it important to diversify your fixed-income holdings?

Dagmara Fijalkowski, Head, Global Fixed Income and Currencies

Fixed income is not what it used to be twenty years ago, fifteen years ago, or even ten years ago. There has been a massive evolution in fixed income over my career. I would say there are three key drivers that I would highlight. One is the growth in the stock of debt, particularly in the era of quantitative easing since the financial crisis, but remember, interest rates were low even before. If I look between 2003 and 2018, so the last fifteen years, the global stock of debt has grown from 100 trillion dollars, roughly, to 250 trillion dollars so one factor is abundance of debt. The other factor which is also aided by low interest rates is an increased number of issuers. Even if we look just at sovereign issuers, for example emerging market countries, the emerging market sovereign index in 2003 had 32 countries in it. Today it has 67. Again, a huge increase in the breadth of the index. That's a sovereign example, but the same applies to corporate. And finally, over the past 15 or 10 years in particular, the growth in data availability and computing power has created massive opportunities for analysts to dig deeper and be able to extract more information from the data to help them make decisions to add value. The abundance of these opportunities has created more opportunities for tactical asset allocation and active management in fixed income despite the drop in interest rates that accompanied these events. Generally, I would say that fixed income management became more specialized over that time, and fixed income portfolio management has more opportunities to add value than at any time in my entire career.

What are some of the levers RBC GAM uses to manage fixed-income portfolios?

Dagmara Fijalkowski, Head, Global Fixed Income and Currencies

Let's start with a description of our credit abilities. We go through the entire range of credit opportunities from investment-grade to high-yield and emerging markets and we have deep credit teams doing analysis on the ground in several locations globally. Another lever would be a decision about investing within Canada or outside of Canadian fixed income markets. The management of a yield curve, or yield curves actually since we're investing outside of Canada, active currency management and of course, interest rate management duration decisions.

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