FidelityConnects: Canada’s bond market: Where the yield is

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<b>Subtitles are AI Generated</b>

 

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Hello, and welcome. Happy Friday.

 

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Welcome to Fidelity Connects.

 

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I'm Pamela Ritchie. Canada and the US are telling very different

 

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interest rate stories at the moment and that divergence is shaping how

 

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investors think about it, fixed income broadly.

 

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With inflation risks lingering and growth slowing at home the question

 

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is whether this is a more attractive moment to add duration in

 

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Canada. Our next guest says that while provincial finances are getting softer

 

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valuations still look compelling versus corporate debt with clear winners and

 

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losers that have emerged. Are Canadian rate hike expectations

 

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mispriced? What do we do with inflation?

 

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Does duration finally pay again?

 

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Where do the real risks sit as we see growth cooling

 

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in this country? Joining us now to discuss all of this and

 

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more is Sri Tella. He is portfolio manager of Canadian Short Term Bond Fund and

 

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Corporate Bond Fund. Warm welcome to you, Sri.

 

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Happy Friday. How are you?

 

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Happy Friday. Good, thanks. Good to see you.

 

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Great to have you here. We'll invite everyone joining you here today to send

 

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questions in over the next half hour or so.

 

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Let's go directly to the discussion of

 

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whether or not there is sort of sticky inflation, which sometimes has a

 

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different word, but in any case, sticky inflation and low growth.

 

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That's where we are. Is that sort of where we should just sort of look in the

 

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mirror and say this is what we're setting with at the moment?

 

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I think that's a good way to characterize it.

 

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It's been a struggle that the central banks have been dealing with over the

 

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last number of months, this push and pull between growth slowing

 

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from what was a pretty rapid pace in the last couple of years and

 

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inflation really not coming down as quickly as

 

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they would have liked.

 

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On top of that you add to that the recent Middle

 

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East conflict which has, obviously, spiked oil prices and is adding

 

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sort of to the inflation story.

 

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The lower, slower growth was kind of the narrative but then

 

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tariff passed through and now sort of the oil

 

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price shock are a couple of things that are kind of balancing out

 

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the narrative again.

 

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For sure.

 

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Why don't we just address the type of risk you would call escalation of the

 

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war right now.

 

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Most people have read all these headlines, it's a fragile peace ceasefire at

 

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the moment. Do we call it a tail risk at this point?

 

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Can you see that clearly yet? How would you rate it?

 

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It's kind of hard to to handicap what the outlook is because we've got a lot

 

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of, obviously, volatile parties involved and

 

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anyone's guess is as good as mine.

 

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I think the base case, and you're starting to see this kind of

 

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take hold in the markets, is that there

 

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may be some ongoing pressure and concerns but the base case is

 

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that all sides do want to kind

 

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of find some resolution.

 

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While you've had this initial shock in the markets I think

 

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we've kind of repriced a lot of the risks that are out there.

 

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At this point I think a major escalation and additional

 

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shock in prices and so on is probably more of

 

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a tail risk but I will admit that that's

 

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low conviction, I think, on many people's parts.

 

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Just to add one more question to that, the discussion of having

 

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to fund a longer term war which is expensive

 

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and it has knock-on effects for the US economy.

 

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We're going to talk mostly about Canada here but I'm just sort of curious what

 

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that sort of funding output does to the overall story

 

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for inflation and just longer term risk there.

 

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I think the biggest thing is this was a concern even before the Middle East,

 

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the amount of funding that the US was going to need, deficits

 

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that it's running, and you've seen that sort of reflected in bond yields.

 

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If you look at the term premium that's priced into the

 

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market now it's much higher, and I guess you could say it didn't even

 

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exist a couple years ago.

 

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We're starting to see that. Interestingly, someone was showing me a

 

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chart this morning, if you look at kind of the overnight rate in the US versus

 

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the 10-year yield you've seen a decoupling over the last number of months

 

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because of that increased term premium so 10-year yields are

 

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higher than they historically have been relative to

 

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the overnight rate. You see a steeper yield curve.

 

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I think that that is something that's top of mind for

 

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investors and it's another reason why rates, while they'll go up

 

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and down they're likely to remain at a higher level than

 

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they otherwise would be for an extended period of time.

 

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Bring it home to Canada and the discussion of how

 

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fixed income markets for Canada look, the government story broadly,

 

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that can be the provincials as well as the federal government situation and the

 

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corporate market. What are you seeing that is comparatively

 

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different and interesting about the Canadian markets?

 

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Is there sort of a more stable outlook broadly?

 

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I guess the way I would characterize Canada, we have to remember that the Bank

 

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of Canada was much more aggressive in cutting rates than the Federal Reserve

 

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was for reasons that were attributed to the

 

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Canadian domestic economy and signs of weakness.

 

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I think that the Bank of Canada at

 

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this point is probably pretty happy about where it is.

 

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That being said, when you look at the backdrop we went from

 

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... the US had been looking at pricing in some cuts going forward

 

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prior to the Middle East conflict, whereas Canada had already been more

 

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aggressive so rates were kind of expected to be on hold, maybe one more

 

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cut possibly in some people's minds.

 

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Now when you enter this offset and this this inflationary period,

 

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what we've seen now is that the US has moved from pricing in

 

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cuts to being on hold likely for the near future given the new

 

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concerns over inflation, whereas in Canada we went from maybe

 

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a partial cut to now ...

 

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we went as extreme as pricing in four rate hikes over the next year,

 

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now we're sitting at around two rate hikes.

 

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Clearly, given that Canada was much more aggressive on the way down

 

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the risks did potentially skew with inflation

 

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that maybe they would need to raise rates.

 

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My own personal view, though, however, is we're likely to see the Bank of

 

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Canada on hold for the foreseeable future.

 

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If you think about growth slowing down quite a bit,

 

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and still the verdict is out as to whether this oil price

 

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shock and inflation risks will persist, I don't think the Bank

 

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of Canada will act until it has more clarity on that front.

 

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Take us through what we need to be looking towards on the trade front.

 

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So much of what has been, we think, priced into markets is some of

 

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the tariff risks, at least the ones that we can see.

 

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Now this oil shock is being priced in as well.

 

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What's coming up are further trade talks, the USMCA or CUSMA, very

 

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little clarity on that for probably the Bank of Canada and really everyone, but

 

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they know it's coming. I guess my question to you, even though they're

 

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probably gonna be on hold according to you, or they might be on hold,

 

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would they move before that is set, those trade talks take place?

 

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What would they want to react to if they needed to on that front?

 

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My view would be that that's one input amongst all these other things that

 

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are going on. I think the driver of that

 

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is really the impact on growth is where we'll come into

 

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play. You don't know what the outcome of it is but the uncertainty

 

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alone is probably one of the factors that's kept

 

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growth somewhat a little more depressed than it otherwise might be because

 

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companies are reluctant to invest until they have more clarity.

 

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Consumers even, you know, in terms of spending, et cetera, all those things

 

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come into play. What I can say about the agreement, middle

 

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of this year is the expectation as to when they're supposed to sort

 

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of have the renewal.

 

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Our analysts' view, and I think generally my view, is

 

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that it's going to take longer than that.

 

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They're not going to come to agreement right away so there's going to be a lot

 

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of headline volatility and negotiating.

 

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As we know that, the US likes to negotiate in the media and in the press

 

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so there'll be a lot of headlines and volatility around that.

 

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I think ultimately the incentives for

 

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Canada, the US, and Mexico, are to come to some kind of an

 

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agreement because there's a lot at stake for all economies.

 

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I do think that this inflationary sort of pressures that

 

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we're potentially seeing actually gives

 

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Canada and Mexico a little more leverage over the US because

 

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the US is not going to want to disrupt trading relationships

 

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in a period of time where you have significant other concerns

 

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through inflation and so on. If they were to rip up agreements and

 

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add tariffs that's another inflationary thing

 

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that comes into play. I think that does on the margin

 

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help in terms of coming to some agreement but there are, obviously, a

 

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few sticky issues that need to be settled on.

 

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I think it's going to play out over a much longer time horizon.

 

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In the meantime, that uncertainty is going to be a factor

 

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to keep in mind in terms of how it impacts the economy.

 

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Yeah, and a longer term, perhaps, uncertainty that needs to

 

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have a lot of patience with for markets and those trying to

 

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dip their toe in.

 

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Let's talk about the provinces. Most of them have had their budgets, their

 

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budgetary seasons, I think they all have now.

 

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Lots of deficits across the boards.

 

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It doesn't look like huge amounts of

 

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progress, really, on that particular area has been accomplished.

 

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Does it change how you take a look at them as

 

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investments, the provincial bonds?

 

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I think that it's important to note because the

 

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trend has definitely been negative for the majority of

 

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the provinces in terms of increased borrowing, increased

 

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deficits and debt-to-GDP ratios kind

 

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of moving up and then delayed in terms of their improvement.

 

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That being said, a lot of the provinces are generally

 

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in okay footing.

 

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When you think about it from a market standpoint

 

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the funding needs, for example, last year we had a significant amount

 

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of uptick in bond issuance that was very well received as

 

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the provinces were able to actually find new sources of funding abroad and

 

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in foreign markets so they were able to raise the money without any

 

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issues. This year, actually, all things said, even though

 

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deficits have increased actual gross borrowing is expected to

 

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fall. It's going to be at elevated levels

 

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and similar to last year but it should be a manageable amount.

 

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A lot of that's already reflected in spreads.

 

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The other thing to keep in mind is deficits by and large, I mean, every

 

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province has its own issues and specific things it's spending on but if

 

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you look at themes across, some of it is trade-related

 

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support and then healthcare is the other big spend.

 

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There's a few one-offs for wildfires, for example, in Manitoba that were

 

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much more impactful than in the past.

 

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The way we're looking at it really...

 

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And energy transitions which is a theme across the country.

 

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Correct, yes.

 

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The way we're thinking about it more is on a province by province basis.

 

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You have certain provinces that are struggling a little bit.

 

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For example, British Columbia has had a little bit more of a worsening of its

 

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fiscal situation. We've seen that reflected in their spreads versus the other

 

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provinces. Quebec, while its finances actually have looked pretty good

 

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there's the concerns over the upcoming election and what that might mean in

 

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terms of if ... depending on who gets elected and what that might means for

 

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resurrection of a referendum.

 

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A lot of it is more story specific from province to

 

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province but when we look at it in aggregate, despite sort

 

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of the deterioration provincial spreads

 

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versus corporates actually still look pretty good on a historical basis.

 

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Then you also have funding that's manageable

 

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and not necessarily increasing compared to last year.

 

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How will Alberta's deficit be affected one way or the other because the price

 

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of oil has gone so much higher?

 

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That's interesting because Alberta's budget, which came out earlier this

 

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year prior to all of this, had a pretty sizable deficit which was

 

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a big shift because of some spending initiatives, et

 

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cetera, and investment that's going on in

 

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Alberta. Now with this price of oil being significantly

 

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higher the expectation is that if that holds

 

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that those deficits will be cut pretty significantly, which is a positive for

 

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Alberta. The other thing that favours Alberta is when you look at

 

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population growth, and you talk about that broadly, population

 

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growth in Canada has slowed considerably but Alberta is actually still in a

 

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pretty good spot in terms of people moving into Alberta

 

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versus some of the other provinces that might be impacted more.

 

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More tax payers.

 

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Correct, yeah, and just more demand. If you have more people coming in

 

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you have more spending. That's what boosted Canada the

 

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last couple of years, the high level of immigration and

 

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population growth at record levels.

 

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That was really fueling a lot of the growth in the economy.

 

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That's part of the reason why we're seeing slower growth now because population

 

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growth has slowed to a standstill in aggregate.

 

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That's sort of seen more in Ontario and British Columbia

 

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while Alberta should still be in a decent spot.

 

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This is the question that I'm sure you're getting all the time, the

 

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correlations question, the concern that with elevated inflation,

 

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and we don't know if oil inflation ultimately is transitory or not,

 

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and it's not core but that doesn't mean it won't bleed into sort of

 

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secondary areas where it becomes core, the worry is that

 

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bonds and equities become more correlated in moments of inflation.

 

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What is the story in terms of calming those

 

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that want bonds as the ballast? The income's better in

 

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a way if rates are higher, if it's riskier to invest, but the correlation

 

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is the issue. How do you tackle that one?

 

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I think that there's a couple of things to think about.

 

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Yes, it's very true when you have an inflationary sort of period or

 

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inflationary concerns the correlations of bonds and stocks tends

 

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to move to positive.

 

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We've seen that in a couple of periods over the last

 

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few years.

 

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I think one thing to keep in mind if you compare it versus

 

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a few years ago, you think about the level of rates which matters.

 

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When you have a really low rate environment

 

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then it's hard for bonds to act as that ballast because

 

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there's really nowhere for them to go.

 

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Now that we're sort of at a higher level of rates, yes, we've

 

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seen the correlations on days when oil has spiked, equities go down,

 

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bonds cheapen up, yields go higher, but

 

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you still have the higher rates as a cushion and you're

 

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starting to see ...

 

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in periods of true risk-off you are still seeing bonds act as

 

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that ballast. That higher level of yield is what gives you some protection

 

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against that volatility.

 

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If you look at what's happened over the last few months, still over the

 

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past year bonds ... while rates have gone higher the

 

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returns in fixed income generally are still positive.

 

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That's not withstanding just a shorter term period like

 

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the month of March. If you look at it over a 6, 12 month period we're still

 

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getting positive returns because that higher yield level is compensating you

 

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for the volatility that we're seeing.

 

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We're not gonna be able to time the market. There could be more volatility.

 

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You could get days of that correlation moving to positive but in

 

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the meantime you're earning a higher yield and you do have

 

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yield levels high enough that in a true risk-off fear

 

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or recession, for example, where equities would be

 

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challenged you would then benefit from owning bonds.

 

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What does the policy shift mean,

 

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do you think, for bond investors across this country?

 

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I mean, you go to sort of material companies that may be trying to expand,

 

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essentially, take more things out of the ground.

 

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It seems the tide has shifted on that,

 

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or the winds have shifted, however you want to put it.

 

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What does it mean for opportunities, new issuance, and just different

 

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sectors opening up, it appears, across the Canadian economy.

 

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I think there's a couple of things to think about.

 

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One is what does this mean for longer term growth.

 

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That's probably the

 

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bigger thing to think about. A lot of the initiatives

 

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and the way things are moving are long term growth

 

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positive but there is execution risk.

 

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You need, one, people need to

 

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follow through, the government has to follow, the companies need to follow

 

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through with that in order to get the benefit, and then to your point,

 

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the funding becomes a key aspect of it.

 

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I would say that right now for the right projects and the

 

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right outlook there is ample demand for

 

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project financing, especially when it's infrastructure related,

 

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there is a lot of demand and you're

 

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seeing that. In Canada it's starting to build up.

 

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You're definitely seeing it in the US. We can talk about the AI buildout

 

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and the amount of funding required there.

 

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There is no shortage of demand to fund high quality

 

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projects.

 

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I think that's a positive going forward, but I think the

 

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biggest thing is the execution is what we have to watch over time and

 

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that's gonna be an important thing to monitor.

 

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How do you find foreign interest?

 

[00:19:51.156]

You mentioned, for instance, provincial debt being

 

[00:19:55.093]

issued in currencies abroad, some US, others.

 

[00:19:58.964]

There's interest in funding Canada.

 

[00:20:01.967]

Just to take it a bit further, how does Canada, the Canada trade, from a

 

[00:20:06.238]

fixed income perspective look to foreign investors right now?

 

[00:20:10.976]

Generally, I think domestically

 

[00:20:15.113]

people like to focus on how much funding needs to be done and

 

[00:20:19.184]

the government deficits increasing but if you think about Canada on

 

[00:20:23.155]

a relative basis to a lot of other countries we're still in a good spot.

 

[00:20:26.792]

Even though borrowing and deficits

 

[00:20:30.896]

have increased quite a bit over the last little while  comparatively Canada

 

[00:20:34.933]

still looks attractive as a place to invest.

 

[00:20:40.205]

I think that there is an appetite from foreign investors to invest

 

[00:20:44.176]

in Canada, whether that be in the Canadian domestic market but I think even

 

[00:20:48.213]

more so in Canadian companies and Canadian

 

[00:20:52.217]

government issuance abroad.

 

[00:20:55.520]

The provinces, as you mentioned, are a perfect example of that.

 

[00:20:58.523]

They actually had a higher proportion of funding

 

[00:21:02.594]

this year ...

 

[00:21:05.297]

their increase in foreign issuance in US dollars and Europe, et cetera,

 

[00:21:10.502]

was much higher than it has been in past years.

 

[00:21:13.739]

You had increased funding needs but they were also able to take advantage of

 

[00:21:17.776]

that demand in foreign markets and able to

 

[00:21:21.847]

diversify as a result of that foreign interest.

 

[00:21:24.816]

It's really interesting. You mentioned infrastructure a couple of times.

 

[00:21:27.352]

In terms of sectors, if you can divvy it up that way on

 

[00:21:31.590]

the corporate side of things, infrastructure obviously is of interest, are

 

[00:21:34.926]

there other areas you can point to broadly?

 

[00:21:38.830]

Interestingly enough, infrastructure broadly, I think, is of interest.

 

[00:21:43.068]

I will say when we think about the public markets, which is what we focus

 

[00:21:47.306]

on and what I focus on in my funds, infrastructure

 

[00:21:51.343]

debt, when you think about utilities and

 

[00:21:55.747]

toll roads and airports, in the public

 

[00:21:59.785]

market actually is less attractive.

 

[00:22:01.887]

It's kind of trading at relatively historical tights

 

[00:22:05.924]

compared to a longer term history versus provincial bonds.

 

[00:22:09.394]

As a sector

 

[00:22:13.465]

a lot of these other projects that may be more privately

 

[00:22:17.869]

funded, et cetera, I think is where there is interest.

 

[00:22:22.074]

I'd say sector wise one of the areas,

 

[00:22:26.244]

obviously, energy and energy infrastructure, for example,

 

[00:22:30.282]

pipelines are probably a decent spot to be.

 

[00:22:35.487]

That's a sector that won, is a

 

[00:22:39.658]

high demand area.

 

[00:22:41.593]

There's been a shortage of pipelines, as we all know, and we hear about it

 

[00:22:44.596]

every day in the news. Also, when you have energy spikes in

 

[00:22:48.767]

demand that also helps the energy infrastructure

 

[00:22:53.138]

and the oil producers, et cetera.

 

[00:22:57.542]

Those are some areas to look at.

 

[00:23:02.714]

Generally speaking, I will say in the corporate sector in the public market

 

[00:23:07.018]

valuations actually don't look that attractive.

 

[00:23:11.423]

Even in this last period of sort of weakness we saw credit

 

[00:23:15.660]

spreads maybe widen at most 15-ish basis points from

 

[00:23:19.631]

their tights. We're only about 10 wider on the year

 

[00:23:23.802]

so far.

 

[00:23:26.405]

I talk about how attractive yields look, if you look at where yields are over

 

[00:23:30.509]

the past 15 years we're at some of the cheapest levels.

 

[00:23:33.745]

When you look at where corporate spreads are we're at some of the richest

 

[00:23:36.448]

levels. That's reflected in our positioning.

 

[00:23:40.485]

We do have credit exposure because there

 

[00:23:44.689]

are certain names that look oaky and attractive and you're also going to boost

 

[00:23:48.059]

the yield in your portfolio, but if you look at historically how we're

 

[00:23:52.464]

positioned compared to history we are

 

[00:23:56.535]

actually at the lowest sort of credit exposure that we've generally

 

[00:24:00.839]

had over history compared to

 

[00:24:05.811]

times where spreads looked much more attractive.

 

[00:24:08.313]

We're focused much more on idiosyncratic specific names where

 

[00:24:12.384]

there's maybe a catalyst or something looks attractive versus sort

 

[00:24:16.588]

of broad corporate sector exposure.

 

[00:24:19.691]

I wanted to ask you, you're a Canuck, you are from Canada,

 

[00:24:24.496]

in your time watching fixed income markets and Canada,

 

[00:24:28.500]

in particular, what's changed?

 

[00:24:31.436]

Is there something to note about this moment particularly?

 

[00:24:35.540]

There's some great excitement, there's also worries about how everything is

 

[00:24:38.710]

going to be executed, you've mentioned that a couple of times, a lot of it is

 

[00:24:41.646]

in the execution and there is execution risk for any big,  new

 

[00:24:46.384]

way of trying to build out a country.

 

[00:24:50.288]

What would you say has changed in terms of maybe optimism,

 

[00:24:54.493]

I won't put words in your mouth, but what do you think over the course of the

 

[00:24:57.329]

last X years has changed and looks better or worse right

 

[00:25:01.500]

now?

 

[00:25:03.668]

I would say optimism is probably

 

[00:25:07.739]

not a bad word for it.

 

[00:25:12.377]

In a pun sort of manner I was gonna say I'd use that word cautiously, cautious

 

[00:25:18.750]

optimism is probably the way to think about it.

 

[00:25:26.224]

Again, everyone has different views politically and so on

 

[00:25:30.295]

and I'm going to try to keep this balanced, but

 

[00:25:34.232]

I do think there's optimism around the fact that you have a government in

 

[00:25:38.203]

place that is kind of willing to meet in the middle somewhere

 

[00:25:43.375]

in terms of investment, like opening up the possibility of pipelines, for

 

[00:25:47.512]

example, thinking about more

 

[00:25:51.683]

long term investing and what that means for longer term

 

[00:25:55.987]

growth versus just trying to solve

 

[00:26:00.058]

the problem immediately with throwing money at certain programs.

 

[00:26:05.196]

I think that that, if it can be

 

[00:26:09.334]

executed and be seen through, sets a foundation for longer term

 

[00:26:13.405]

growth, which I think people are feeling positive

 

[00:26:17.375]

about. I think that that sort of more pragmatic approach

 

[00:26:21.913]

is what's got people feeling a little bit better.

 

[00:26:25.850]

Now, again, the proof is in the pudding.

 

[00:26:27.953]

They've got to really execute and follow through.

 

[00:26:32.324]

The other thing to think about, and I've said this even from the outset

 

[00:26:36.461]

when Mark Carney got elected, do

 

[00:26:41.232]

people have the patience because the benefits

 

[00:26:45.604]

may not be realized in sort of the initial term.

 

[00:26:48.974]

Is there a belief that this will continue over

 

[00:26:53.011]

the years and continue to happen?

 

[00:26:56.815]

That, I think, is what sort of the big change has been.

 

[00:27:02.287]

The other thing is I think Canada's continued to show

 

[00:27:06.324]

... I think the world generally needs a reminder every so often but it's shown

 

[00:27:10.328]

its resilience throughout sort of the cycles

 

[00:27:14.432]

and

 

[00:27:18.436]

with good policy on the monetary side, et cetera, and

 

[00:27:22.741]

good place to invest in and I think that it's benefiting from that as

 

[00:27:26.811]

well.

 

[00:27:27.345]

So growth, better growth in the future, though, but better

 

[00:27:31.483]

growth is sort of the antidote to the right now which has some

 

[00:27:35.520]

version of sticky inflation which is tricky, along with low growth

 

[00:27:39.724]

right now. But the idea is to see through this, would you say a volatile

 

[00:27:44.095]

moment to get to the growth?

 

[00:27:46.197]

Is that sort of the hold on message?

 

[00:27:47.599]

In isolation I think things in Canada are

 

[00:27:56.608]

in a pretty good spot if you've looked at Canada on

 

[00:28:00.645]

its own, but you've got a lot of global factors that

 

[00:28:05.016]

are ...

 

[00:28:06.851]

unfortunately, just given Canada's size in the global economy they're more

 

[00:28:10.889]

dominant at times so you've got geopolitics,

 

[00:28:14.893]

you've got trade negotiations, you've got sort

 

[00:28:18.897]

of just global growth and deficit spending concerns

 

[00:28:23.702]

so the markets will react on

 

[00:28:28.339]

that basis.

 

[00:28:30.041]

On a relative basis, again, and even if you just look at stock market

 

[00:28:33.745]

performance Canada's stock market has done better than

 

[00:28:38.683]

other markets, than the US over the more recent time

 

[00:28:42.754]

horizon partly as a result.

 

[00:28:46.925]

We'll leave it there. We're grateful for your wisdom and foresight and

 

[00:28:51.162]

steady hand. Thank you, Sri Tella.

 

[00:28:52.864]

Have a great weekend.

 

[00:28:53.698]

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[00:28:56.334]

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[00:29:30.034]

The views and opinions expressed on this podcast are those of the participants,

 

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and do not necessarily reflect those of Fidelity Investments Canada ULC or

 

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[00:30:03.501]

Thanks again. We'll see you next time.