December 18, 2020

VIDEO: Institutional Investors Forum | The Evolving Role of Fixed Income in a Low Rate Environment

In the latest instalment of our Institutional Investor Forum, we hosted clients virtually for a discussion focused on the role of fixed income in portfolios. With real yields in Canada well below than 1%, how should institutional and individual investors think about their fixed income allocation? Click the image below to watch a replay of the event, and click the link to download the slides. The full transcript follows, edited slightly for clarity.

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Catherine Heath (0:00): Hello, everyone. Thank you for joining us today for our Institutional Investor Forum. My name is Catherine Heath, and I'm a Portfolio Manager and a member of the Fixed Income Team here at Leith Wheeler. I'm joined today by my colleagues from the Fixed Income Team, Ryan Goulding and Ben Homsy.

We're going to be discussing the evolving topic of Fixed Income in a Low Rate Environment. Ryan is responsible for the government fixed income strategies at Leith Wheeler, including interest rate management and yield curve positioning. Ben is a Portfolio Manager, specializing in fixed income and a member of the firm's Portfolio Review Committee, which recommends asset mix across the firm's balanced portfolios.

We're pleased to have a broad array of clients on the line, including pension plans, foundations, First Nations, public sector groups and private clients. As such, the discussion today will be broad based and relevant to any fixed income investor.

We sit today with 10-year Canada bonds just under 1%, and much of the world's bonds in negative territory. With interest rates at these low levels, many investors are questioning the role of bonds in their portfolios, and what to expect from fixed income returns, in correlation with other asset classes.

How could these enormous budget deficits impact inflation, and therefore bond values? Finally, what are the alternatives to traditional fixed income? What should investors be considering and aware of, of those other asset classes?

The format today is Q&A. To explore these questions, I'm going to jump right in with my team.

(2:23) Before we dive into harder questions, perhaps you can elaborate on what the traditional purpose of fixed income is in portfolios.

Ben Homsy: Thanks, Catherine, and thanks everyone for joining the webinar today. I think the right allocation to fixed income really depends at the end of the day on each client's return and risk profile. Fixed income clearly has an important role to play in any portfolio. The reason is simply that fixed income and in particular government bonds, are the asset class that has the lowest correlation to equities and other types of risk assets.

As this chart shows on your screen, it's the rolling 12 month returns of Canadian equities, which is the black line, and Canadian universe bonds, which is the blue line. You can clearly see that fixed income has provided a much more stable source of returns over time.

More importantly, it's also provided a different source of returns and a source of returns that are uncorrelated to equities and to risk assets. For anyone who wants to lower the volatility in their portfolio, owning bonds as a complement to other types of risk assets is arguably the best way to do this.

Catherine (3:54): Thanks, Ben. We've heard that adding bonds to your portfolio, can improve the correlation or they have low correlation with other asset classes.

How does the current low rate environment change that role of fixed income in portfolios, particularly in terms of their contribution to portfolio returns, and their correlation with other asset classes?

Ben: Yeah, this is really a great question and the crux of what we wanted to get to in today's webinar. The challenge is that expected returns today are much lower than what they were even a year ago – unless interest rates and bond yields turn negative, which we think is unlikely, not impossible, but unlikely. Certainly, the Central Bank has suggested that it's not their favorite policy response. Without that, we just think that there isn't much more in terms of capital gains that really can be wrung out of the bond market from here. But that doesn't mean we should abandon the asset class entirely.

Firstly, the returns of a bond portfolio are not that bad and they’re also not just the yield. If you invested in a universe, a long bond strategy or any other strategy with a relatively constant duration, then your portfolio benefits from what we call “roll-down,” which is simply the decline in a bond's yield through the passage of time, as it rolls down an upward sloping yield curve. This additional return can be significant, particularly when the longer-term part of the yield curve is relatively steep. That's exactly what we have currently in the Canadian fixed income market.

To give you a sense about how much return this is, if the yield on the universe bond index is currently around 1.3%, the roll down will add in another 0.6% over and above that. That gets you to a total expected return from universe bonds, excluding any alpha from an active manager, of somewhere close to around 2%.

Now, that doesn't sound like that much. I appreciate some of you on the call might be hoping for better returns than that, but it is still positive. It's stable. It's uncorrelated to other sources of return on your portfolio. Really importantly, it's above long-term inflation expectations, which currently are well below 2%.

Ryan Goulding: Let's talk about that correlation here, Ben. Although they are uncorrelated to equities, there is a common misconception that when equities go down, bonds go up and vice versa. That's not entirely true. There are a couple of reasons for that. The first one is a dampening effect.

Generally, when we look at the yield on a bond, there is a risk-free component. Then there is a credit component when we own any type of credit bond, provincial, or corporate bond. When equities decline, the risk-free rate will go lower. That will push up the price of the bond, on the risk-free component.

But that credit component will actually go higher. It'll slow the decline or the rising price of these bonds. When rates are just low, that dampening effect of those wider credit spreads and those higher credit components, really drops that correlation to equity, such that we get down to near zero with Canadian equities.

Ben: Yeah, and I think the other point I would just add, Ryan, is that, where we are now, with government bonds between 0% or 1%, it becomes quite difficult for bonds to perform as strongly when equity markets sell off, as what they have in the past.

I mean, unless you think bond deals are going to go negative, you just don't have much further for them to go up in price. Now, when constructing portfolios, it's therefore important because it also means that this negative correlation between the interest rate component on the bonds, and equities and other risk assets, just isn't likely to be as negative maybe, as what it has been over at least the last couple of decades.

Ryan: That brings us to the chart here, Ben, which is quite interesting, I think. When we look at this chart, the positive area of that chart is when bonds and stocks are positively correlated. The prices are moving together. Now, most of our memories in the past 20 years, is when we get this negative correlation. You can see that it drops drastically negative there, shortly after year 2000. These negative relationships, they're actually driven by drops in bond yields, not by moves and equity prices.

So that big move to negative, that has held for the last 20 years, was actually post-dotcom and 9/11 when interest rates fell drastically, in order to address those situations. Since we have relatively stabilized after that, we've had moderate moves, lower rates, you can see that that correlation is drifting back up to zero.

When we look at the long history, going back to the late 1800s, we've actually spent about two thirds of the time with bonds and equities not correlated at all. Then when they were correlated, they spent more time positively correlated, so prices moving together, than they did in negative correlation. This drift higher is actually a function of credit being created faster than it can find a home. We'll get into that later with another graph.

Catherine (9:25): So you're saying that investors should be aware, that bonds may not move in the opposite direction of stocks, but will still dampen the portfolio volatility.

A lot of this conversation has been contrasting equities to bonds. What about other asset classes, including real estates, private markets, which have recently been strongly in favor with investors recently?

Ben: Yeah, at the end of the day, as an investor, when we talk about other asset classes, what matters the most really is where they are in the capital structure rather than the name of the asset class itself. Definitely more important than whether it's maybe publicly or privately traded.

In terms of the capital structure, although there are different parts of the capital structure, ultimately, they tend to fall into two parts. You either own the entity, or you lend to the entity. This is just the same as owning different companies in the stock exchange, and they have different risk profiles of their businesses, so too do different real asset markets for example. Ultimately, in each one of these – maybe with the exception of private debt, which is really fixed income – otherwise, in each of these real assets, what you're really owning is the equity of the asset, as opposed to lending to the entity.

We tend to think therefore about these different asset classes as really being different asset classes. In reality, their true characteristics are much more akin to owning equity and having equity risk.

Catherine (11:13): Thanks, Ben. The other important role that fixed income plays, particularly in pension portfolios, is the impact of changes in interest rates on their liability valuation and therefore the plan’s surplus or deficit. How should the current low rate environment impact a pension plan's decision to immunize the impact of interest rates?

Ben: Yeah, this is a really tricky question. We deliberated our response quite heavily here, because we manage money for clients on a fully immunized basis. We have different degrees of matching for other clients as well.

The first and foremost thing I want to say and emphasize here is that the decision for a pension plan to immunize your portfolio, is really one about reducing risk. That decision is made, we would argue, somewhat independent of where rates are.

The only point we did want to mention though, is that there is an opportunity cost that's involved and it can impact this whole process. For a pension plan, particularly one that doesn't use leverage, there's only a certain amount of dollars that you have available in the plan to invest, specifically to invest in bonds that give you exposure to interest rates, so that when interest rates rise, you might have capital losses on your bonds, but your liabilities will also go down. That's why you're essentially using these bonds.

If the return expectations on those bonds are lower, particularly relative to other asset classes, then by inference, the cost of insulating the plan changes, to changes in interest rates. That cost has risen with a low return environment. We're not suggesting that immunizing is wrong, or you should be throwing the towel in with regards to immunizing portfolios. We still think it makes a lot of sense for minimizing risk, but we just wanted to highlight that consideration when thinking about immunization.

Catherine (13:28): Thanks, Ben. One area of concern and one question I get a lot from my clients is, what happens when inflation ultimately rises and pushing interest rates higher? What's your outlook for interest rates and inflation in the current environment?

Ryan: Thanks, Catherine. This is a great one. I've traded inflation bonds my entire career, and for my whole career, inflation was just around the corner. It's never really managed to rear its head. This chart shows the two components of a bond yield. The top of that blue line will show our [nominal] bond yield we usually talk about.

The blue component is the real yield, and the black component is the inflation expectation. The real yield can be thought of as your purchasing power you get above inflation. As you can see, for the last 20 years, yields have declined massively, but inflation expectations have stayed relatively stable.

This kind of goes in the face of the theory that lower bond yields mean lower inflation. On the flip side, we can get rising inflation and not have rising bond yields. Those two things move independently. It's not given that we're going to get higher yields, if we do get higher inflation.

Now, in terms of the inflation outlook, we don't see a big spike in inflation coming here. First off, what underpins inflation is wages, consistent rising wages. Workers that know they're going to get 2%, 3%, 4% a year increases. They're willing to go out and spend that much more. Right now, we've got a lot of people out of work.

We call that a big labor output gap. There's just a lot of people that need to go back to work, before we start getting pressure higher on wages. Then we still have the three Ds of disinflation. These have been with us for quite a while now. Let's take a quick look at them.

The first one is demographics, that arguably hasn't changed really through COVID at all. Our population looks the same, and it's got a downward pressure on prices.

Debt is the next D of disinflation. We're actually more indebted now, as post-COVID. Level of debt really matters, because the more indebted you are, the higher sensitivity you have to higher interest rates. Canadians are one of the highest indebted consumers in the developed world. We're very sensitive to rises in interest rates, which means they simply can't go too high, without putting a break on the economy.

Finally, disruption. Disruption has been a big force in keeping prices down. When you think of disruption through COVID, we've had billions and billions of dollars from around the world, pumped into rebuilding the economies. The “build back better” theme. This is going into new technologies, new disruptive technologies that we're going to look back at in 10 years, and see they've done the same thing that we've had disruptive technologies doing today: they kept the pressure on prices. What are the three Ds? Two of them are actually pushing a bit lower on prices and the other one's unchanged.

Ben: Yeah, I just would add to Ryan's comments here. I look back over the last six or seven years, and particularly to around the period in 2014, where a lot of clients were asking the same question, "Why own bonds, interest rates are a lot lower? We've just had an oil shock. I want to shorten duration in my portfolio, or I want to reduce my allocation to bonds." The problem with this – and I'm sure many of you are having the same thought process right now – is that this is ultimately a decision around trying to time the market.

Those who made that decision to reduce their allocation to fixed income back in 2014 unfortunately missed out on arguably – particularly the last couple of years – some really spectacular returns from fixed income. That's even more the case when you think about those returns on a risk-adjusted basis. The last two years, we've had almost 8% returns in universe bonds each year. Our view really is, don't try to time the market necessarily. Be aware that with fixed income, it's a maturing asset class.

That means that, you're going to have the opportunity each year as bonds mature, to reinvest them at higher rates, if interest rates have risen. Although there may be some capital in the near term, over the longer term, by staying fully invested those fluctuations in rates really shouldn't matter too much, to the longer-term return profile that you get from fixed income. Really, the message here is that, it's very difficult to time the market like this, even with the current low level of rates.

Catherine (18:23): Ryan and Ben, I hear you. There's little sign of wage inflation, with unemployment around 8% or 9%. Surely, given the large expansion in fiscal spending in Canada and around world, it must lead to inflation at some point… what's your view on inflation being driven by statistical policy?

Ryan: This is a great one. This is where I'm going to get a little excited about this chart, and I'll take some time to explain it here. We already have inflation, and I'm going to walk you through that.

We've actually got a lot of inflation. We just don't have CPI, which is Consumer Price Inflation. We have API, which is Asset Price Inflation. Let me walk you through what's happened here, and how this chart's depicting it.

First, let's look at the green bars. Those green bars are the balance sheets of the largest central banks in the world. You can see post-Great Financial Crisis. They started doing [Quantitative Easing] (QE) and buying bonds in order to stimulate the economy. Then you can see the recent move, higher here in QE, through the COVID crisis.

They've added a lot of money to their reserves. Now, reserves are inflation potential. Reserves in and of themselves, just sit in the Central Bank. They don't actually do anything, but create the potential for consumers to go out, get a loan from a bank, invest that. For companies to go out and get a loan from a bank, invest that in a new factory, hire more workers and pay more wages.

Now the blue line, the blue line is the velocity. The blue line is showing us how much the economy is able to use that potential. Now, all of our textbooks tell us that blue line doesn't move. That's just the assumption in our textbooks. The assumption is that if that blue line doesn't move, the more money that the central banks create, must flow into inflation. It must go into the real economy, but look what's happening: that blue line is drifting down. The more potential central banks have created for borrowing, it hasn't been used. The potential is there, but there's no demand for the credit.

Now, enter the black line and this is where it gets interesting. Financial markets, they love money when it's sitting around. They're happy to take that money and say, "Hey, real economy, you're not using this. The central banks have provided it, we're going to step in and use it." That black line is actually showing velocity in the financial sector – financial assets. As you can see, all of that extra money created by central banks on their balance sheet, that's not being used by the real economy, is going into asset prices. We do have inflation. It's here – it's in asset prices. We don't need to worry about a big spike.

Ideally, what happens is, the higher those asset prices go, companies eventually invest and flow that black line down into that blue line. We get a slow type of inflation, but we're not worried about a big spike in inflation. It's that slow drive, that whole demand of credit by consumers and companies that are going to drive that inflation, and turn that blue line back up again.

Catherine (21:36): Outside of inflation, what other factors could cause interest rates to rise? What impact could that have on returns for fixed income portfolios?

Ryan: Sure, the big thing we're worried about for rising rates in Canada is that Canada has been a great destination. Labor and capital love coming to Canada. We've got the greatest immigration policy in the developed world; the best and brightest from around the world come here. They bring their capital and their labor. They invest it, and we get a lot of benefit from that. As long as we treat labour and capital well in Canada, we make it an inviting home, and we continue to attract global capital, we're not going to get that rise in interest rates.

What our concern would be, is capital flight causing inflation, not deficit spending. Right now, if you look at the present situation where our rates are relatively low, much lower than the US, we're doing okay. Even though we've got 20% GDP spending on deficits this year, we're going to watch where the money is spent. If it's spent in the right places, and productive projects that are going to generate perpetual sources of taxable profits and revenue, then it is sustainable.

The key here is watching the policies and the spending initiatives that come out over the next several quarters. One of the big things we're going to watch is the Canadian Infrastructure Bank to see if they're able to get projects off the ground. That are going to change our economy, create jobs and create that wage growth that we really need.

Ben: I'll just add, Ryan, to that point that: if there was a barometer to look at this risk, probably one of the best ones would be the currency market. In terms of the currency market, watch for when capital stops believing in the outlook for Canada as a good safe haven for investments. Then we'd expect this to show up in the value of the Canadian dollar. It's really for two reasons. First of all, the Bank of Canada's approach to monetary policy is to set interest rates, which they can basically set whatever they want. Ultimately, they can hold rates there. Not just the overnight rate, but they can, if they wanted to influence a longer-term rates, as well. When it comes to other policy measures, they have opted to maintain an open economy in terms of capital flows and also a floating currency.

Therefore, what the currency market's telling us – with the Canadian dollar sitting at two, two and a half year highs... in fact, it's actually strengthened – is that despite some of these fiscal announcements from Canada, the market isn't suggesting that the stimulus measures in Canada are causing any significant problems, despite them being the highest in the developed world.

The second point I would make around the inflation risk to Canada, is that the same risk applies to many other countries as well. It isn't like Canada is going it alone here in terms of their fiscal spending and their deficits, trying to stimulate their economy. This has been a global pandemic, and the policy response has been equally global. Canada might be doing a little bit more than other countries, but what matters more in terms of the size of these fiscal deficits, is their relative size when thinking in terms of capital flow. When we look at Canada in the context of what's going on in the rest of the world, quite frankly, the differences between Canada and other countries just aren't that large.

Catherine (25:26): Thanks, Ben. In a nutshell, we're saying that as long as Canada’s fiscal spending is in line with other countries, perhaps a titch more, it shouldn't have an overall impact on our inflation level.

Changing gears a bit, one part of the return from fixed income returns, is the alpha that an active manager can create over and above the market. Does this current low-rate environment impact a manager's ability to generate that alpha? Does it actually enhance the importance of that alpha?

Ben: This is something that's come up, particularly in the current environment. First, maybe just a step back, I want to just talk about alpha, and in the context of outperforming a benchmark. Maybe just spend a moment on benchmarks in their own right.

Fixed income markets and the indices that they're benchmarked against, are typically based on the level of outstanding debt. Really, that probably isn't a great way to start determining how capital gets invested because in effect, what you're doing is, you're directing capital to the more indebted and leveraged parts of the economy. In our minds passive investing isn't a great approach, particularly in fixed income and when you think about how that fixed income capital gets allocated.

But you don't need to take my word for it. I wanted to show this slide, which shows the universe of core bond managers in Canada. Specifically, it's the median manager's performance in each calendar year, over the last decade or so. What you can see when looking at this is that even the median manager has been able to outperform the market by around 35 basis points annually every year, over the last 10 years. They've also outperformed the market in 8 of the 10 years.

I do want to highlight just a couple of points here, about this, without getting too deep into the numbers. The returns that active managers have been able to generate above the benchmark are not correlated to the level of interest rates. We've gone back in a longer history and looked at this. A low-rate environment really shouldn't have a significant impact on an active manager's ability to generate returns in excess of the benchmark. In fact, it's kind of nice that when you think about portfolio construction, active manager returns or their alpha that are in excess of the benchmark, is actually another uncorrelated source of return to add to portfolios. It's actually uncorrelated with the returns of the index itself. In fact, it's slightly negatively correlated. That's really important, because it means that having active management in fixed income, if you achieve median returns which outperform the benchmark, those additional returns that are added are uncorrelated, and therefore lower the volatility. You see the volatility of active strategies, actually being lower than the benchmark itself.

Catherine (28:47): Thanks, Ben. I'd like to add that alpha is particularly important when return expectations are low. When real yields on bonds after inflation are closer to zero, the alpha that an active manager generates can be a significant part of the portfolio returns, especially when the market is volatile, and there's more opportunity to add value. Shifting gears a bit, while we're on the topic of volatility, can you comment on the liquidity in markets in recent years? In particular, the illiquidity we experienced in March of this year, including the effect it has on market volatility and how liquidity matters for clients.

Ryan: Certainly, liquidity is one of those interesting things that, it's never priced right. In Canada, when we think of liquidity from a bond perspective, it's our ability to sell bonds, within the context of the market pricing. Usually, we've got ample liquidity. We can sell our bonds, no problem at all.

Then in times of stress, that liquidity evaporates and we saw that in March. Just the ability to sell bonds and generate cash swings from very easy to very difficult. It's reiterated our view on managing that liquidity. Now, liquidity also means alpha opportunities.

Quite often we deploy strategies that take advantage of this mis-pricing of liquidity. Market volatility provides movement, which we also need within active management. We're also very mindful of our cash. Cash is the ultimate form of liquidity. Within our fixed income portfolio, we don't look at cash as a drag. Cash is an option to buy something in the future. Unfortunately, quite often you need it when it's hardest to get, but we do guard that quite carefully.

Ben: Yeah, I think we all should go back to the drawing board in terms of the definition of liquidity, too. I think it's such an [abstract] concept, and sometimes has more than one meaning to it. I want to touch on this slightly, because we often hear, particularly from longer-term investors and clients including pension plans, that maybe they don't need liquidity, because the plan is open. Contributions are exceeding any redemptions, so they just don't need the cash.

There is some validity to that. One definition of liquidity is, the ability to raise cash to meet benefit payments, for example, but there is another value or definition of liquidity. That really comes from the opportunity cost, which sometimes gets forgotten. That opportunity cost is about being able to deploy capital between different markets when valuations in different markets change. We saw that in spades in March of this year, when we had extreme levels of volatility. That liquidity was incredibly helpful, particularly for many of our balanced clients, to be able to quickly rebalance out of fixed income, which tends to be a more liquid asset class, into other markets like equities, where opportunities and valuations became significantly more attractive.

Catherine (32:17): Maybe just moving on to the next question. Perhaps you could have an abbreviated version of the answer on this one. Outside of active management, what other trends are you noticing in the industry, by clients who are looking to improve investment returns?

Ben: Yeah, I'd say the biggest trend has been just to move to less constrained mandates. Most frequently in the Canadian marketplace, it's been core-plus type strategies, which are really trying to get a little bit more out of a typically universe benchmark strategy.

My main observation on those strategies, we have one obviously as well, is just the diversity across the Canadian market. It's not like choosing a core bond manager, where most of the strategies are relatively homogeneous. Core-plus strategies differ widely. It's just important to make sure that that matches your risk tolerances.

The other couple of things I would just say in terms of the high yield market. In Canada, the high yield market's relatively small. Most managers spend a lot of time outside of Canada. The part of the market that actually doesn't get a lot of attention, or it's just starting to is the bank loan space where these are higher up in the capital structure, senior secured loans that aren't available in Canada, because the banks don't syndicate those loans. They are available in the US, and it's a market we've seen a lot of interest in over the last few years.

Finally, just a quick comment in terms of private asset markets, there's been a lot of movement of money into private assets in fixed income, including mortgages and other forms of private debt. We don't think this is a bad idea. We're not suggesting that those of you who've decided to maybe move capital into that space, that it's wrong. Every asset class has its own merits. Our main observation, and one of the reasons we haven't gone into the space yet, however, is that from the work that we've done, it suggests that any premium that you're receiving on those private assets, it's questionable whether or not you're being sufficiently compensated for the liquidity there. It's kind of a breakeven to be honest, and closer to breakeven from our point. We haven't seen a rush, but we wouldn't exclude the possibility of investing in private fixed income at some point in the future, with valuations more attractive.

Catherine (34:37): Thanks, Ben. Just wrapping it up very briefly, a few key takeaways for our participants:

• Although rates are low, we still believe there is a role for fixed income in a balanced portfolio.
• We expect fixed income returns, and returns for other asset classes to be fairly low going forward.
• It's important to note that we're expecting positive, real returns that are uncorrelated (not necessarily negative correlated) in fixed income to other asset classes.
• We expect inflation to be muted for the medium term.
• We also think that active management is magnified in this low-rate environment, as investors seek additional sources of return.
• Alternatives can be a source of additional return. They're not without risk, and investors have to be fully cognizant of the dynamics of those markets.

With that, we'll move over to Q&A.

Q&A (35:41)

Ben: I'll just jump in, if I may. A couple of questions here are talking about the return series in the chart we showed earlier. They're asking whether that was net or gross of fees, so because different clients have different fees depending on their mandates and the size of the mandate, et cetera, we tend to always show returns gross, which is what we've done here. What we would say is that, the relative performance of just the median manager alone, tends to more than justify the fees. Particularly, what we're talking about here, is the difference between active and passive fees. That tends to apply also, whether you're talking about large institutional clients or individual investors as well.

Ben (36:34): We have another question here, which is from one of my clients. Thank you for this question. In fact, a couple of people have asked this question with different versions of it. The question is, "What kind of returns can I expect from the FTSE Canadian bond index over the next year or two”? Another question that's very similar, "How does that compare perhaps to expectations, particularly what's including fees and with current CPI, at a median CPI at 1.9%?" I'll answer the first part of that question, which is around expected returns. We've done a fair bit of work on this topic recently.

"Forecasts are hard, especially when they're about the future," is one of the older Yogi Berra's sayings. We've taken an approach, when thinking about expected returns, particularly in fixed income, of just imagining that the yield curve stays exactly as it is rather than trying to include predictions for whether interest rates are going up or down. If you do that in a constant duration portfolio, you earn the yield, which is about 1.3% plus you earn “roll down,” which in the Canadian fixed income universe right now... because the yield curve is upward-sloping in longer data maturities, that adds up to an extra 60 basis points. That gets you to about 1.9%.

That's roughly where we think expected returns will be. Not just for next year, but basically if you were a new investor in fixed income, going forward, you should be expecting returns somewhere around 2%. To the point on inflation, the one someone else asked: median and Canadian inflation might be around 1.9%.

We really think that in the context of return expectations, including real return expectations in excessive inflation, the better number to look at is what long-term real return bonds are implying for inflation expectations. That's somewhere closer to around 1.5%. Even with those return expectations of 1.9%, you're still generating a positive, real yield of about 40 basis points.

Ryan (39:17): If I can jump in here, Ben, we've got a couple of questions that are kind of tied together. There's one on higher taxes potentially coming here, and another on infrastructure projects. Our views on that, and they do tie in together.

If I can comment quickly on those. For the first one on the potential for higher taxes: in the near term, there's nothing really meaningful in the recent update. The government's not planning necessarily on hiking taxes on capital immediately. I mean, their priority right now is to get everyone back to work. Now, the government doesn't actually need revenue in order to spend it, not like a household does. The government can happily spend away, and worry about the revenue later.

When we look at the projects that are coming down the pipe, real rates in Canada are negative. The Government of Canada is actually borrowing at a negative rate. Everyone might say that the government's a terrible allocator of capital, and we don't need to get into that debate. But they don't actually have to allocate it very well, in order to cover their financing charges.

So these projects... and one of the comments said that a lot of the projects face environmental hurdles, and could take a long time. Yeah, I agree. When you look at big projects in the past, they've generally run over budget and they've cost much more than everyone would expect. And there were lots of people fretting that there'll be lots of taxes, but let's look at big ambitious projects. The transcontinental rail system in the US, the interstate highway system in the US, Panama Canal. At the time each of these were built, people thought they were a crazy waste of money. They were incredible deficit spending, but no one would argue these days that any of those projects were a waste of money. They're still paying returns. The point is, as long as the government hits some projects that are going to turn into long-term generators of wages and jobs, we can grow ourselves out of the debt. We don't need to tax away capital in order to do it.

Ben (41:38): Thanks, Ryan. I'm reviewing some of the questions now as well, and hopefully we're going to be able to get to most of them, but there certainly are a lot. Thank you everyone for these great questions. One participant was asking if we could share some insights into substituting duration risk for credit risk. How do we manage this tactically, within our core plus strategies?

This is a technical question, but a very good one. It has to do with how we construct portfolios. It applies also not just to our core plus strategy but to essentially all of our universe and long bond strategies as well.

One of the things we spend a bit of time on, is thinking about how we want to express a view, in making sure that when we deploy our clients’ capital to an investment within fixed income that we're deploying that capital into those areas of the market that offer the best risk adjusted returns.

Now, unlike equities, where you might just want to buy the stock that has the highest expected return, in fixed income those expectations for returns might be by allocating to corporate bonds, instead of say federal bonds. It might be by allocating capital to longer duration bonds, versus shorter duration bonds. To different parts of the curve or yield curve. There are many different levers, and they're not also necessarily just about picking individual issuers.

When we make that assessment, what we're really doing is employing a technique, which we've used for many years. That acknowledges we don't have perfect foresight. We can't always predict what's going to happen, but we look at lots of different scenarios and we tend to coalesce them into three to five scenarios. We probability weight those different scenarios, and we think about how the different market positions we have on are going to perform under those different scenarios.

A really good example of this is inflation. We have had an overweight position to real return bonds based on the view that inflation expectations were too low. At one point, they were as low as 0.8 of a percent, for the next 30 years. Which clearly we think is – unless you're a deflationist – really is exceptionally low.

We've had opportunities over the last few years to redeploy capital. One of the interesting things was that, when the market dislocation happened back in March, we had an opportunity to consider where we would deploy that capital. We actually ended up moving some of that capital from inflation to credit. Not because we didn't think that inflation was a good trade, but because we thought the risk-adjusted returns that were being offered now in credit were even better.

We make those same interplays when thinking about, "Do we want to be short duration or long duration, or over or underweight duration? Do we want to position, so that the portfolio benefits from rising interest rates or falling interest rates?" We are contrasting that against the return expectations from credit.

The last thing I'll just say on this is, all of these factors that we consider, they're all also correlated with one another in different ways. We sometimes are trying to... maybe we want to take a view that is positive for risk. We expect markets to perform well. Maybe we'll take that view in credit, or maybe we'll take that view in interest rates, but it really depends on where we think the best risk-adjusted returns are.

Catherine (45:42): Perhaps we have time for one last question, before we wrap up here. There was a question, what is defined as asset inflation? Perhaps, Ryan would be best to cover that off.

Ryan: Inflation in general is money, which is credit in essence, moving faster into a category than that category can absorb it productively. In asset inflation, you'll see it in declining PEs. You will see it in other things like housing prices shooting up beyond GDP levels in the area. Typically, in market assets, we'll see it in things like PEs. We'll also see it in the shape of the yield curve, where the yield curve can get a little... actually a little flatter because there's going to be a little more demand for bonds and limited product essentially. That's the key to remember: it's more credit moving into any asset class.

It’s the same thing with consumer inflation. If you put more money into the real economy than there is an ability for the real economy to use it, you're going to get price inflation for consumers.

Catherine: Thanks, Ryan. With that, I think we'll wrap up here. I'd like to thank everyone for their excellent questions, and thank you very much for attending our webinar today. If we haven't addressed your question, please feel free to reach out either to your portfolio manager.