If you were looking for a clear signal from the multitude of central bank policy meetings this week, you likely found yourself staring at a yellow light. Both the Bank of Canada and the Federal Reserve opted to hold steady today—the BoC at 2.25% and the Fed in the 3.50%–3.75% range. Neither was a surprise, though Fed Chair Powell’s announcement that he is staying on as Governor beyond passing the Chair baton to the incoming Kevin Warsh was a bit of a headline grabber. But look closer at the fine print. For the first time in months, the "rate cut" narrative has hit a wall. With global energy prices surging and inflation showing a stubborn streak, some central bank members have even hinted that the next move might not be down, but up. The equity markets, in their typical state of hopeful delusion, seem to think that last quarter’s earnings and continued AI spending trumps a “blip” in central bank guidance (not to mention two wars). The bond market, however, is grounded in reality. Yields have edged higher as the market realizes that "higher for longer" isn't just a catchphrase; it’s the current state of play. And this stall-out in the rate cutting assumption is a good reason to step back and review why we hold bonds and how the strategy behind them is as important as our approach to equity investing.

Before we look at the strategy, let's look at the plumbing. In its simplest form, a bond is a loan you make to a government or corporation. In return, they pay you interest (the coupon). The most important concept is the inverse relationship between price and yield: When interest rates rise, existing bond prices fall. Why? Because if the government issues a new bond at 4%, nobody wants to buy your old bond that only pays 2%—unless you sell it to them at a discount. Conversely, when rates stall like they are now, the "coupon" becomes your best friend. You are getting paid to wait. A properly managed bond portfolio captures this income while strategically positioning itself to benefit from price appreciation if rates eventually move lower.

I have discussed at length the disconnect between investor perception of market volatility and the relative and shockingly low level of volatility that exists today, despite the screaming arguments to the contrary. This perception has caused some to abandon time-tested portfolio allocation strategies in favour of going to “cash”. In an environment like this, the temptation is to hide in a GIC. It’s simple and guaranteed (up to the $100,000 CDIC maximum), yet as the above chart shows, the current average 5-year GIC rate as reported by the BoC has fallen behind the 5-year Government of Canada bond.  But academic research and long-term market data (including studies by firms like Vanguard and BlackRock) have also highlighted that a static GIC ladder often leaves money on the table for three reasons:

1. The "Total Return" Gap: GICs only pay interest. Bonds offer interest plus the potential for capital gains.

2. The Reinvestment Trap: When your 1-year GIC matures, you are forced to accept whatever the market rate is that day. A managed bond sleeve allows us to "ladder" across a much broader spectrum of maturities and sectors.

3. Liquidity: You can’t sell a GIC to rebalance into a stock market dip. Bonds are a liquid tool that allows us to stay nimble. From a dynamic rebalancing perspective, this is the most important reason why we see an advantage in bond investing over GICs.

Now, when we look at a bond portfolio, we have to use some of the same thinking that we apply to our equity decisions, with some nuances. Similar to real estate, it’s all about “diversification, diversification, diversification”. What countries do we want to invest in, which requires a careful examination of not only the relative macroeconomic state today, but where we think it will be in the future. Then there is consideration of what sectors, but more importantly, the credit quality of the bonds we are investing in. As with most other assets, the higher the level of desired return, the higher the amount of risk we should be willing to accept. Investment grade bonds are rated BBB+ and higher (all the way to triple-A). The blend of these various types of bonds will, like stocks, depend on where we see the economy going. I will discuss our current positioning later, but let’s return to the decision of what global regions we want to invest in.

Most global bond indices are "market-cap weighted." This sounds sophisticated, but it effectively means you are lending the most money to the countries that are deepest in debt. Currently, this results in a massive (and in our view, dangerous) overweighting to U.S. Treasuries—often exceeding 50% of a global index. Many of you know the position Ally and I have with respect to the structural changes that have been put in place as a result of policy decisions being made in Washington. The path of least resistance, in our opinion, is that of diversifying away from US dollar exposure (in favour of not only other currencies, but gold in some cases). As such, we are intentionally diverging from the global bond benchmark for several key reasons:

• Sovereign Debt Stress: The U.S. national debt is now pushing $38.7 trillion. Interest costs alone are becoming a massive part of their federal budget.

• Fiscal Indiscipline: There is currently very little political appetite in Washington for spending restraint, regardless of the party in power.

• The "Convenience Yield" Erosion: For decades, the world paid a premium to hold U.S. dollars and debt because they were seen as the only "safe" game in town. As that appetite wanes—driven by geopolitical shifts and rising risk perceptions—investors will likely demand higher yields to compensate for the risk. Higher yields mean lower prices for those holding long-term U.S. debt and as you can see from the chart below, that debt keeps racking up.

This is why we recently integrated the DFA Global Targeted Credit fund into the portfolio. Dimensional Fund Advisors (DFA) uses a systematic framework founded on the research of Nobel laureates like Eugene Fama, Myron Scholes and Merton Miller (among many greats that I studied in graduate economics courses). Instead of blindly following a debt-weighted index, DFA targets specific "dimensions" of returns. Their approach allows us to capture high-quality global corporate credit with much more precision—and much less exposure to the fiscal drama currently unfolding in the U.S. Treasury market. We will be breaking down this academic approach in detail at our upcoming seminar on May 13th in Cobourg, featuring Wes Crill from DFA (email Darlene.wood@cibc.com for more information).

So, let’s return to the task at hand. How to construct a fixed income portfolio that reflects the current macroeconomic and credit landscape, but also the possible directions ahead. Does inflation become entrenched in consumer and business expectations as higher costs from energy and shipping get embedded in products seemingly unrelated to the conflict in the Middle East? Or does the very nature of higher energy costs create a true demand destruction across the planet, resulting in disinflation (or deflation)? Do credit spreads today (which are amazingly narrow) reflect the true risk that corporations and governments shoulder? Moreover, do the credit ratings that the agencies assign the above reflect that risk? The below chart shows the FTSE US Big Corporate BBB bond index, which represents the average spread of yields among triple-B corporate bonds in the US over treasury bonds. Again, it is simply amazing that spreads are holding this low despite the geopolitical/macro challenges out there today.

At this point in time, we definitely don’t want to be placing major bets either way. We don’t want a bond portfolio that is excessively short-term, nor do we want to stick our necks and buy a swath of long-dated bonds. And, with credit spreads tight, we want to stay closer to investment grade. This doesn’t mean we should be blind to the opportunities that a disinflationary shift could present. In other words, if economic growth were to slow down appreciably, bringing inflation and central bank rates down with it, we would want pivot away from corporate bonds to longer-term government paper. Bottom line, the flexibility and liquidity needed in the stock portfolio has to be reflected in what we are doing in fixed income.

On behalf of the Pyle Wealth Advisory team, have a wonderful week.     

Andrew Pyle