Martin Lefebvre
Hi, everyone. Thank you for tuning in to our NBI Podcast. Today's topic is ultra short-fixed income. To help me navigate the subject, I'm joined by Nicolas Normandeau, Portfolio Manager at Fiera Capital Corporation. Hello, Nicolas.
Nicolas Normandeau
Hi Martin.
Martin Lefebvre
Maybe before we jump into the subject, we need to set the table. What do you see in terms of the environment we're in: inflation, economic growth, and the impact it should have on central banks?
Nicolas Normandeau
Let's start with Canada. Canada's growth should be around 1% to 1.5% over the next, let's say, 12 months, which is still below potential. There is no reason to hike in this type of environment. As for inflation, headline inflation is at 3%. But when you look at the core measures, which I think are what is important for the Bank [of Canada], we're already at 2%, which is right on target. There is no problem at all with inflation. Even if the market is pricing in three hikes in Canada for the next year, for us, when you look at employment, the housing market, and all the negotiations around USMCA and all this, we see no reason to hike.
Martin Lefebvre
There's no urgency for them to move.
Nicolas Normandeau
Exactly. As for the U.S., it is a different animal. In the U.S., you have much stronger growth than in Canada. Growth is still around 2% to 3%, and it's also expected to be around 4% for the next quarter, in Q3. So, really strong growth driven by AI maybe, but still good growth. But inflation is still an issue. Inflation, when you look at the core measures there as well, is around 2.5% for core CPI [Consumer Price Index]. But when you look at core PCE [Core Personal Consumption Expenditures Price Index], which I think is still the measure the Fed [U.S. Federal Reserve] is looking at, it's still above 3%. And it's been like that for a while. At some point they will be forced to hike if the economy stays as strong as it is right now. That will be interesting to follow.
Martin Lefebvre
Even though there seems to be a little bit of leeway for the Fed, with employment a little bit softer than expected and inflation coming down a little bit. I guess time will tell. What does that mean for bondholders and for the market in general? We see that yields in the U.S. are close to that 5% threshold in terms of benchmarks. Where do you see the market heading?
Nicolas Normandeau
There is a lot going on with rates. Let's start with Canada. Like I was saying, we like the front end. We like the fact that the market is pricing some hikes. We don't think the Bank of Canada will be forced to hike at least this year, next year, we'll see. We like the curve; we like the full curve. And when you look at, let's say, 10s [10-year bonds] and long bonds in Canada, they are being impacted or influenced by what is going on globally, what is going on in Japan. Japan has a huge deficit, and its interest burden is higher. They have a lot of funding to do. Same thing with the U.S. So, rates are increasing a lot in 10s and long bonds these days. Even if Canada does not have the same fiscal problems, it is a global market. If rates are moving up in the U.S. or Japan, we should also see increases in Canadian 10s and long bonds. So, that's important. But what we've seen lately, at least in the U.S., is that they are using some strategies to maybe prevent those long rates—around 5.30% in the long end and 4.70% in the 10-year—from increasing too much. For example, through these Treasury operations, buying back bonds a little more than they were supposed to. We'll see.
Martin Lefebvre
It remains to be seen whether it will work, because following the announcement, it didn't take long for yields to go back up to where they were. Okay, you talked about the short end of the curve. Tell us a little bit about this asset class and whom it is suitable for.
Nicolas Normandeau
What we like about the front end is, as I said, the curve is steep. You can generate a really good return versus cash with that type of strategy.
Martin Lefebvre
Is cash your benchmark when you manage that type of strategy?
Nicolas Normandeau
Yeah, cash is the benchmark. The goal is to beat cash by 100 to 150 basis points, and right now, even without taking too much risk in terms of credit selection, we're able to build a portfolio with a carry of 140 basis points as we speak. That's pretty interesting. Then you're approaching yields of 3.60% as we speak, better than cash, which is doing a quarter. As we don't think the Bank will be forced to move, it's interesting. And the performance carry is interesting versus the benchmark, plus it's liquid if ever you want to sell it to buy something else.
Martin Lefebvre
You talked about your interest rate forecast for the Bank of Canada. Is it a good time to be ultra short in terms of duration?
Nicolas Normandeau
We like the full curve, as I was saying. You're just taking different risks. If you stay within the front end, and if rates continue to move up in 10s and long bonds because of what is going on fiscally in the U.S. and all the things we are hearing. If you want to avoid that, the front end is the place to be. Then with this asset class, you can beat cash, as I was saying, and you don't take on a lot of risk. That being said, if you think that there is value in 10s and longs, it's not a bad moment also to go into higher duration…
Martin Lefebvre
And capture higher yields.
Nicolas Normandeau
Exactly. And if, for whatever reason, the market starts reducing what is priced in Canada from three hikes to two hikes, that's 25 bps. That's an important kicker, let's say, on total performance, you could have 5% to 7%, depending on which strategies you're looking at.
Martin Lefebvre
In terms of active management, what can you tell us about your daily job and how you position such a portfolio, not only in terms of duration but also credit?
Nicolas Normandeau
This strategy is really active. It's active in terms of duration and where we want to be on the curve as well. We're not forced to be entirely in the zero-to-one-year range. We can have duration in the three-year and five-year range, and usually not more than seven. But after that, what we do also is credit selection. Within this type of strategy, what we are mostly buying is investment-grade corporate bonds, so 94% or BBB and better. It includes all sectors and all the names you can think of, really. And there's more and more supply in Canada. It's in fact it's a global phenomenon. It's easy to find names. I could say like that. And after that, it's also the credit rating—what type of rating you want to select. These days, BBBs are a little expensive in the five-year area. You may want more banks or insurance companies. And then, after that, it's where we are in the capital structure. Yes, we buy a lot of senior debt. But we can go a bit lower in the capital structure, toward sub debt for banks, or even junior sub debt for what we call hybrid rates or LRCNs [Limited Recourse Capital Notes]. Those are the types of names we can buy. And in this strategy, we can also have a position in the preferred shares. The retail $25 preferred shares, which we do own. But the goal is to beat cash. We're not trying to be heroes and select the low-reset preferred shares. That's not the goal. When we buy preferred shares, we'll select good names, but also good resets.
Martin Lefebvre
With the objective of generating 150 basis points above cash.
Nicolas Normandeau
Exactly.
Martin Lefebvre
In terms of asset allocation or portfolio diversification, would you position ultra short bonds as an alternative to cash?
Nicolas Normandeau
Yes, I think you should have some of that type of strategy within your cash allocation. For us, we see it as a way to get extra yield, and it's not really volatile. The average duration of our credit portfolio is two years. It's really short and high quality like I was saying. Or it could simply be that you have a little exposure to medium- or long-term bonds and want to reduce that duration because you think 10-year and long rates could continue to increase. Then this strategy could be added to help reduce the overall duration of the portfolio.
Martin Lefebvre
Nicolas, those are all the questions I had for you this morning. Thank you very much for participating. And to everyone watching, our next NBI podcast will be in a month's time. Thank you for watching.
Nicolas Normandeau
Thank you.
Martin Lefebvre
