If the viral game Wordle were to extend to 9 letters and be bound by a capital markets theme, almost certainly one would be guessing “inflation.” It has become the soup du jour of the asset management community and for good reason. We believe it is time to dig a few layers deeper into the effects of interest rates and duration on portfolios and ways to mitigate that very same risk.
The backdrop for this debate on duration started with the idea that monetary and fiscal policy would need to be normalized as we entered a post-Covid world. Central Bank governors globally started to lay the foundation for this change in policy from very early on in the year as the economic recovery took hold. A further reinforcing point and—in our view—a very important one was the global increase of inflationary forces.
Although we believe these forces were initially mislabeled as “transitory,” in major economies around the world, inflation data began to be reported in high single digits and as demand increased there was not expected to be a drop off in inflation. But the phrase “transitory inflation” ended up being transitory, not inflation itself.
The tragic events in Ukraine added fuel to the inflationary fire and commodity prices spiked globally. In our view, it became increasingly clear that central banks in the developed world were behind the inflation ball. We saw a rise in hawkish narrative to match the inflationary data.
High inflation is poised to persist for longer than was initially expected, especially with the recent geopolitical conflict in Ukraine not yet reflected in the Consumer Price Index (CPI). Given this context, we believe investors are not being adequately compensated for long-duration rate risk.
Historically, investors have generally at least been compensated for the loss of their purchasing power through inflation in the risk-free rate, which pegs fair value for bond yields higher. Traditional fixed income is not discounting this new landscape with the 10-year U.S. Treasury at 2.4% compared with break-even inflation at 3% (inflation rate discounted in inflation-protected Treasuries).
For 2022, a continuation of the lag period where 40% M2 money supply growth in the past two years takes time to make its way into the real economy and historically has a causal effect on higher GDP/Income (real and nominal) and inflation. Given that the money printing we have seen in the past two years is unprecedented in U.S. history, we believe its economic effect could have a longer tail than expected.
Purpose Global Bond Fund
The chart below shows the duration of the Purpose Global Bond Fund measured against the global and Canadian aggregates. These aggregate indices are representative of the types of securities that we buy in the fund. As the chart displays, we have clearly run with a much lower duration than the fund's peers.
At the height of the monetary and fiscal stimulus and leading into the 2020 U.S. presidential election, we ran with a longer duration than usual, although we were still significantly less than comparative indices. When the facts changed in the market as we approached the election and it became clear that there would be pressure on rates, we changed. We quickly brought duration back down from 4.91 in November 2020 to 2.25 as of March 2022.
Purpose Global Bond Fund's duration compared with aggregate indices
Purpose Credit Opportunities Fund
In managing the Purpose Credit Opportunities Fund, we don’t think in terms of underperformance or outperformance. We think in terms of whole cycle risk-adjusted absolute return and absolute yield more than spread. Already, because of the selloff, we could fill a portfolio with high-yield ideas that have strong credit metrics. We can credibly hedge our duration profile through shorting long-dated investment-grade bonds to make duration not a determinant in the security selection process.
The results of managing a low-duration profile in the way we manage our fixed income is quite evident in the chart below with muted drawdowns relative to longer duration, passively managed products. Highlighted is the time period inclusive of where we have recently seen the highest spike in nominal government bond yields, reflecting a period of interest rate hike expectations and greater volatility in the face of persistent inflation.
Just as important as protecting asset values from drawdowns in periods of great volatility is the ability to generate strong returns reflective of the risk undertaken. In the broader context of a multi-asset portfolio, absolute returns are key drivers of clients being able to achieve their investment goals. But long term, and more sustainably, the ability to add value for each unit of risk is incredibly important and reflective of the high-quality management of those very assets.
The table below expresses how our observation and management around duration and focus on quality security selection has generated strong risk-adjusted returns (i.e., the Sharpe Ratio) and minimized drawdowns regardless of underlying volatility or risk.
We continue to believe that we need to keep duration short and managed. We intend to continue to make asset allocation and security selection the twin drivers of return—not duration. Crystal ball absent, we believe the prudent approach is to focus on what we believe is most manageable and respond in challenged environments with our experienced team bringing value in high-quality security selection and forward-thinking allocation views.
—Adam Nowak, Product Manager at Purpose Investments
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