Ben Jones - Welcome to Better conversations. Better outcomes, presented by BMO Global Asset Management. I'm Ben Jones.

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1 Transcript Better conversations. Better outcomes. Episode 1.7 Fixed income: the way forward Scott Kimball - The natural question is how defensive am I still by owning fixed income? Well, we've had that question answered largely by our friends overseas where we see rates have gone negative. We don't have an outlook that US interest rates will go negative, but as has been proved in Japan and Europe, both developed economies, interest rates can go negative. Therefore, the downside to yields remains higher than we may have originally thought, even looking at the historical averages. Ben Jones - Welcome to Better conversations. Better outcomes, presented by BMO Global Asset Management. I'm Ben Jones. Matt Smith - And I'm Matt Smith. In each episode, we'll explore topics relevant to today's trusted advisors, interviewing experts and investing the world of wealth advising from every angle. We'll also provide actionable ideas designed to improve outcomes for advisors and their clients. Ben Jones - To learn more, visit us at bmogam.com/betterconversations. Thanks for joining us. Disclosures - The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates, or subsidiaries. Matt Smith - Today, we're exploring fixed income. We'll discuss the challenges that this sector has faced in recent years, ideas about different approaches to satisfy your portfolio's need for yield, and given that we're at currently historic low interest rates, where we might go from here. We're talking with Scott Kimball, senior portfolio manager at TCH, a subsidiary of BMO Asset Management Corp. Ben Jones - The current landscape of the bond market is experiencing lower interest rates than ever before. With that being said, there's still a lot that's unchanged about the market. Scott argues that there's a lot of defensiveness still left in bonds. Scott Kimball - I'm a senior portfolio manager at TCH, which is a subsidiary of BMO. We manage the BMO TCH Core Plus Bond Fund and Corporate Income Fund. Matt Smith - So, Scott, at the low rates that we're seeing right now for US 10-year treasury, you talk about the defensive nature of bonds. Is there much defensiveness left at these low rates? Scott Kimball - Recognizing that over the course of history interest rates have historically been a lot higher and at higher interest rate points, there is no question that you have more defensiveness than you do at low interest rates. But, when we look at the long-term average for rates with rates being as low as they've been, we've seen those long-term averages come down because we've spent more time at low rates now than at high rates over the recent -- in the

2 recent history. I would say the past 10 or 15 years. So, as that's happened, a natural question is how defensive am I still by owning fixed income? Well, we've had that question answered largely by our friends overseas where we see rates have gone negative. Even at 2.25% for a 30-year treasury, if that security were to fall in yield to let's say 1.5%, you're looking at a double digit return for the 30-year treasury in terms of total return because the price would rise by about 12 points. So, you'd have a 12% return of the treasury just from price appreciation with yields falling from a 2.25% to roughly a 1.25% to 1.5% type yield. So, yes there is a lot of defensiveness left in fixed income. Matt Smith - I think our listeners would be interested in your perspective of what is the same and what has changed in the bond market recently? Scott Kimball - To set the current landscape for what has changed in the fixed income market, we have to take a little bit of a look at the past and see what's, not only changed, but what's also still the same. So, if we look at what is changed, we've seen a tremendous amount of interference by central banks on the behalf of their economies purchasing fixed income securities. We've seen it start with the US Federal Reserve purchasing treasuries and mortgage backed securities. We've also seen that expand overseas. The Bank of Japan has been purchasing corporate bonds and even things including closed-end funds and stocks. And now most recently, the European Central Bank has undergone a bond buying program where they've not only purchased sovereign bonds, but they've begun to purchase corporate bonds. So, what that has done to the interest rate landscape is it has pushed yields low across a number of different asset classes. So, the first thing that's changed in this unusually low interest rate environment is that investors' ability to invest in something that is low risk. Meaning, let's take the United States Treasury, and earn a modest return of, let's just say, a small premium plus the rate of inflation. So, if inflation was 2% and you bought a treasury at 2.5%, you're making 1.5% above inflation for a very low risk. But, with this bond buying that's gone on around the world from central banks, we see interest rates are so low that we now have what's considered, or what we call, negative real yield. So, negative real yield results when you can't buy a low risk investment such as US Treasury or any sovereign debt, and earn at least the rate of inflation. So, the negative real interest rate for those types of investments is negative. Furthermore, what's changed, and it's really been more in the last six months, is we're seeing negative yields not only in the real sense over inflation, but also in the nominal sense. Which means that we don't factor inflation at all. We just buy a bond. What's the interest rate? If it's 2%, it's 2%. But in some cases we're seeing that these bonds have been purchased with such vigor by central banks, that their yields are now negative. So, we have negative real and negative nominal yields. So, if you were to buy a bond today with a negative interest rate of 0.2%, or what we call 20 basis points, negative 20 basis points, that's how much money you would lose over the holding period. So, what's happened is in order to earn a rate of return that's acceptable to an investor whereby they earn, let's say, the rate of inflation plus some premium, we're having to look at different areas of the bond market. Primary those that have what we call credit risk. When we leave treasuries and we start looking at things like corporate bonds, or high-yield, or emerging market debt, as you move out that spectrum we're taking more credit risk. And that's in a response, and that's the investors response, the yield-seeking behavior is in response to what we're seeing across the landscape about what's the same. And that's that interest rates remain low and for most individual investors relative to our futures and our savings, they're too low. It's a miss-match. If you want to purchase a treasury security at 1% and inflation is running at 1.6%, that's a negative 0.6% real yield. That's a miss-match for your objective. So, what you have to do is look at maybe a corporate bond that's paying 3% and seeing if that matches that 1.4% above the 1.6% inflation is enough rate of return for you to accept a corporate bond, and if it's not, you keep moving out the spectrum until you find that

3 sweet spot where you're earning a relative amount of return relative to your objectives that's consistent with your long-term strategy. Matt Smith - So, you need to invest in bonds that will likely give you a yield that's consistent with your investment objectives. For some, this means bonds with negative real yield, maybe a miss-match for their portfolio. Ben Jones - Some of the news about the current bond market might have some investors and their advisors looking for something else to replace fixed income in their portfolios. But as you heard from Scott at the top of the episode, there's still a lot of defensiveness left in bonds. The danger of yields going negative means that bonds remain defensive even at their current lower rates. Let's take a step back now and provide a little context in reviewing the definition of an interest rate. Ben Jones - What an interest rate projects -- in other words, what an interest rate is -- is a reflection of what the market expects growth and inflation to be for a given economy. So, let's use an example of a US Treasury security. If the US economy is expecting to grow at around 2% and inflation is running around somewhere about 1.6%, then those two numbers, looking at them together, what a treasury at 2% is representing is an outlook that the US economy is likely to grow somewhere in the neighborhood of around 0.4% real. Which means that 2% growth in nominal GDP, less the 1.5% or 1.6% as a current inflation expectation. It's about 0.4% real growth. So, the overall yield of 2% represents the real growth in the economy plus whatever inflation is. So, when we think about what an interest rate is and what it represents, it's the consensus view of the fixed income market participants all over the world about what US growth is going to look like over some intermediate time period. Matt Smith - Scott, let's talk about alternatives to bonds for income. One approach that's popular is to invest in equities that pay healthy dividends. Can you explain the pros and cons of this approach? Scott Kimball - Certainly. So, the efficacy of using dividends as a surrogate for fixed income has been around for a long time. It's coming to much more prominence of late because interest rates, as many people continue to point out, are quite low. However, when we compare the yield of a dividend to that of, let's say, a corporate bond from the same company, we have to take a step back and analyze what these two securities really represent. Equity is an ownership stake in the company, so you are going to be subject to the ebbs and flows, and the earnings cycle of the company. So, you may receive a -- $2 or let's say you receive a $2 dividend on a $20 stock and that represents a 10% yield. So, the opportunity there, which may be a little more complicated than the way I'm going to present it -- but the basic idea is you're receiving the $2 dividend, but because your share price is subject to the earnings cycle of the company, if earnings fall 10% or 15%, that stock may fall 10% or 15%, and the total return of the equity becomes negative even with a high-yield of 10%. That's why I chose a 10% yield in this example because it's probably an extreme and very difficult to find, but even if you do find one with 10%, if the stock falls 15% because earnings fell 15%, that could result in a capital loss that most people looking for a fixed income surrogate may not want. Now, let's take the same company and we look at what their debt represents. Let's say they have a long-term 30-year corporate bond that's paying 5%, half as much as the equity. It's not subject to the earnings of the company. It has a contractual obligation with the company as a bond holder. We have contractual obligations with the company whereby they have to pay us our 5% interest or else they're in default. So, our 5% is not subject to the ebbs and flows of the company. We are higher in the capital structure, meaning we are a senior security holder. We're an actual

4 claimant or an actual debt owner of the corporation. So, the reality is to accept equity as a surrogate for fixed income; you have to be earning a significant yield premium. Many fixed income professionals such as myself would argue that in most cases historically, an equity dividend relative to the fixed income should be paying you a significant premium. Maybe twice as much as you're receiving for the debt. Because so many people have been purchasing anything related to income, particularly dividend paying stocks in this case, we've found the premium between the debt and the equity is quite narrow, if not the same. And if you're looking at the same amount of interest or income whether it's between dividend yield and corporate bond yield, we would be a strong advocate for purchasing the corporate bond because you are higher in the capital structure and your exposure to total return losses is much lower. The other aspect to consider is what role fixed income plays in the portfolio. Fixed income can be very defensive, such that if interest rates decline because stock market volatility increases and earnings slow up, we find fixed income holds up significantly well - In some cases, has positive returns. If you're using dividend paying stocks as a surrogate for your fixed income, you're likely to realize negative total returns because what you're correlated with is the equity market, not the bond market. So, you're also giving up a lot of defensiveness in your portfolio by using stocks as a surrogate for your bonds. Matt Smith - At some point in the future, we are going to have more positive outlook on future growth, whether it's US or globally. Scott Kimball - Mm-hmm. Matt Smith - Could you address the concern that maybe some investors have when owning fixed income that when interest rates go up, they're holding an asset that is exposed to interest rate risk and that might be a concern for them. So, can you talk about the scenarios that would happen with fixed income investments as interest rates go up, whether it's quickly or in a more gradual way? Scott Kimball - Sure. So, when interest rates rise, let's just take the US Treasury for example and stick with that as an idea, let's say we're looking at a 10-year US Treasury at 2%. What does that tell us over the long-term? It's telling us that right now that the long-term growth expectation for the US is around 2%. So, inflation of, let's say, 1.5 and real growth potential of 50 basis points or 0.5%. If interest rates are to rise gradually, in this environment that can happen for two things -- two ways. One is that the overseas outlook for growth, we can say in Europe, which has experienced zero or negative growth, let's say those growth expectations start to rise. We see less central bank purchasing of assets in Europe, meaning European Central Bank starts buying less of their sovereign corporate debt. That means that the investors over there now have a greater supply of securities. Maybe they buy less US Treasuries. So, that effect -- that substitution effect -- of people from overseas buying US Treasuries as a surrogate for their own, maybe that starts to dissipate. That's one example that would reflect overseas buyers having a view that their own growth potential, their own growth prospects, are increasing. The other more powerful one is that the US growth expectations start to rise, and the focus is really on that real growth component. So, if we have a 10-year treasury at 2% and 0.5% of that is real economic growth, if that number starts to rise and we start expecting 0.75% or 1% real US growth that would have two effects. The first order of effect is that the expected treasury yield would rise from, let's say, 2% to 2.5% or 2.75% to reflect the increase in US growth. But there's also a margin above that because with growth comes inflation. So, it's not just what happens on the growth side, it's what happens to inflation expectations. So, in that environment, let's say that 1.5% inflation expectation that we have today, that increases to 2% on top of a 1% real growth expectation. You're now at a 3% expected treasury year

5 treasury yield. So, the way in which that happens in an orderly fashion, one that is a gradual rise, is that those expectations don't change overnight. In most cases, we don't see growth expectations change by 0.5%, or 0.75%, or 1% almost instantaneously. They move by 0.05%, 0.10%, 0.15% slowly over a number of quarters. Maybe even over the course of a year you'd be lucky to see that type of growth expectation increase. So, what we examine is the background of the US economy and we look at the velocity of money, the velocity of earnings. How much is wage growth accelerating? How much more money are people making? How much more money are our companies making? How much more money is coming into the economy for investment purposes? We've seen at this point in the cycle there's been a bit of a flat line and maybe some of that has started to taper off even. So, our expectation is that there still is a lot of growth potential in the US, but we're realizing that growth potential now and while it might accelerate, it's unlikely that it accelerates in any great way to cause a tangential or a very accelerated shift in the way people are thinking about US growth. So, we think that modest growth expectations will result in modest increases in treasury rates, and getting back to the first point about overseas, we do think that as investors overseas calm down about their own economies and maybe there's less pressure on US Treasuries from them purchasing them and them holding them overseas, that might give us a little bit of a rising interest rate also because we are importing some of the problems from around the world. People buy treasuries for safety no matter where they are on the globe. So, maybe Japan and in Europe we see less purchasing of treasury securities, that might give us a little bit of relief, but the big factor is really growth expectation within the US and the degree to which they rise. Ben Jones - That's a good point. Interest rates could rise as a result of international investors calming their anxieties about their own economies. It doesn't just have to be the US economy showing signs of revitalization. And this would result in less stress on US Treasury bonds. I think it's also important to heed Scott's warning about equity dividends in place of fixed income. Your clients needs to understand that their principal will have greater risk exposure and potentially increased volatility. Now, let's turn our attention to actively managed fixed income versus passively managed fixed income and compare and contrast the two. Scott Kimball - I'll start with passive. What passive fixed income investing has done historically is get you very broad exposure to the fixed income marketplace with a lot of diversification and without having a manager move the sector or the security allocations much different than some benchmark. So, what that broad exposure has really gotten you is fixed income -- the defensiveness of fixed income and the diversification benefits of fixed income at, in most cases, a very low cost. And that is the explicit cost, meaning the expense of the fund. But, what passive does carry is a very large opportunity cost, which is that because the manager doesn't have the ability to reflect any views about the direction of interest rates or the economy, their portfolio is what it is and if interest rates rise and certain areas of the bond market to which a passive portfolio is overexposed, namely US Treasuries, suffers large negative returns those are going to be imported by the investor into their portfolio because the manager doesn't have an opportunity to diversify away or explore any of the instrumentation the bond market has to tackle rising rates. Fixed income investors over the course of the fixed income marketplace, the US fixed income marketplace is almost $14 trillion. We've been doing this a long time and there's a lot of tools we've developed to help combat rising rates, particularly rising rates that occur faster than the market is expecting. Earlier, you and I talked about our view for a rather orderly and slow increase in interest rates and interest rate expectations, but let's say that for example, labor market data comes in strong, wage growth moves faster than expected, consumers spend, real estate takes off, and the US growth expectation increases faster than we're anticipating. There's nothing you can do in a passive fund to combat that. But an active manager can read and react to that, and move to, let's say, floating rate notes. Floating rate

6 notes don't have a fixed rate coupon. Their interest rates increase along with market interest rates, so if we see that we buy a short-term floating rate note that we start off earning 1% and rates rise 1.5% or 2%, that security is now paying 2.5% or 3%. You're earning a significant amount of yield premium that you weren't before and you didn't suffer any principal losses. The volatility is very low. Let's say for example US growth expectations remain rather stable and overseas expectations are increasing. An active manager can purchase securities such as emerging market debt. They can purchase high-yield securities in some amount and they can manage the volatility those securities bring in, but they're also bringing in extra yield on top of that. And by bringing in that extra yield and earning that extra income, that gives you a further cushion in an active portfolio versus a passive portfolio because the yield cushion that a manager can build in gives you some resistance against rising rates because your break even against interest rates is a lot higher. If a portfolio has a pocket that is invested at, let's say 5% to 7% in high-yield securities and another doesn't, and interest rates rise 1%, the break even versus treasuries -- high-yield looks pretty attractive because of the income, that extra carry, that extra amount of yield you've received, the active portfolio receives a bit more of a defensive nature against rising rates in the passive portfolio is perhaps the biggest difference we're talking about with clients, and what we continue to see in this environment when we talk about those two different approaches. Matt Smith - I think Scott's points here really provide a good foundation for advisors who are having conversations with clients about fixed income. Whether discussing concerns they might have about investing in bonds during a rising rate environment or to be able to compare and contrast alternative approaches to generating income such as equities that pay dividends. Speaking of concerns, Scott has some good advice for advisors coming up. But first he warns about the current landscape of the auto loan sector and student loan debt. Scott Kimball - We have noticed that there's been a market change in the composition of, let's say, mortgages since the subprime crisis in that the quality of the mortgage borrower is very high right now. So, mortgages have proven to be very defensive and done very well in an interest rate rally. Where we've seen the subprime start surfacing again has been in the auto loan sector where they call it the SAR, or the seasonally/annually adjusted sales rate for US autos is near an all-time high. So, we're starting to see that consumer credit is being stretched a little bit in order to allow for auto manufacturing to continue and for that growth of the auto industry to remain. It doesn't really have the same scope as the student loans. Student loans right now at roughly four trillion is the same size as the subprime market was in housing. The subprime auto market is not anywhere near that landscape at this point. So, it's not a primary concern. What we are focused on, however, is still the negative real yields we've talked about in the bond market. So, getting back and just looking again at active versus passive discussion. We are looking at TIPS or treasury inflation protective securities. That's another tool an active manager has in their tool kit to put into, let's say, a core plus bond portfolio that wouldn't be available in a traditional or a passive portfolio. It's not a benchmark security, but what it does provide is -- over time as inflation increases, the principal value of the security rises and then your interest is calculated on a higher principal. So, you get -- is an inflation adjustment in your pocket. So you can at least earn your weight of inflation using inflation protected securities because nominal treasuries aren't doing it at this point in time. I think as a -- people who have been immersed in the bond market understand some of the dynamics about what these different areas of the bond market are, whether that's corporate bonds, high-yield, emerging market debt, or frontier debt, and private bank loans, and things like that. A lot of people, rightfully so, have realized that they need a higher rate of interest they can get from their traditional bond choices, so they've moved out the spectrum. They've moved into the core plus, multi-sector, unconstrained, emerging markets, bank loans. And without an understanding of what those

7 instruments really entail other than the fact that they pay the required rate of return that they think they need which is completely understandable. The question is what happens on the volatility side? That's why we've advocated to a lot of our clients and to a lot of people we speak that we like the core plus style, we like the core plus strategy. Because its core bond investing, it has the defensive properties of fixed income, but it has those alpha or those excess return generating capabilities. It has those areas where we can buy little bits and pieces of all those markets into a core bond portfolio to create the core plus and we can do it in a way that's professionally managed and where the risks are a bit more balanced than we think most people perhaps on their own might do. So, we sit back and look at the landscape of fixed income. We look at core plus as being a sweet spot where you have the core fixed income exposure, but you're letting the manager go out and individually evaluate these opportunities rather than just in sort of a blanket way just short of buying them in masse. Matt Smith - So, I'm interested in your opinion as to whether or not -- we talked about buying a core plus fund. And how is that different and what advantages does a portfolio manager who's managing a core plus fund have that maybe an investor or advisor doesn't have if they're just going to buy an allocation of core and then, on their own, put some high-yield or emerging market debt next to that. What does a professional portfolio manager -- what are the advantages they have in managing that core plus as a single portfolio? Scott Kimball - So, the primary advantages come from knowing what's going on on both sides of the equation. So, if you have different managers, one's doing your core, the other is doing emerging markets, one is doing high-yield, one is doing bank loans. They don't all know what's in each other's portfolios. So, there's a lot of probably double counting of risks. But furthermore, a little bit of a lack of understanding about how all of this ties together for the investor who's sitting in the middle and owns all these exposures. So, what a core plus manager can do is purchase the core allocation of, let's say, 80% of the fund in traditional core bond style, and with the 20% allocation they're looking for for the plus sectors, they can independently evaluate opportunities on a security level and understand that on the security level if I add this bond to this portfolio it does this to risk. It does this to return expectations. If I add these five, it does this to risk; it does this to return expectations. And by doing so, the outcomes for the individual investor can result in a lot less volatility because there's a better understanding on a security level about what's going on in the total portfolio because you have a manager in the middle who is, on a daily basis, recalibrating their portfolio for all those risk and return expectations. Ben Jones - Throughout our conversation about the bond markets and fixed income instruments, the common theme that runs through all of this is the US economy and its ability to grow and revitalize consumer spending, which in turn will revitalize interest rates and bonds. Scott talks about his vision for the future. Matt Smith - What keeps you up at night, either about the bond market or the economy in general? Scott Kimball - Well, I think for whether you're talking about US treasury rates or you're talking about corporate bonds or high-yield, there's one common link to all of these securities and that's what happens to the US economy. We as bond managers would like to see interest rates move up some. We'd like to see treasuries get back to a positive real yield. We'd like to see corporate bonds perform well and have credit spreads continue to be supported by a strong economy. We like to see high-yield companies matriculate from high-yield to investment rate companies at a lower cost of capital, because with that lower cost of capital comes long-term

8 growth and that's good for everybody. So, the link to that though comes back to US growth and US GDP. 70% of our GDP is consumer driven. We have consumers in this country that have not seen much real wage growth and furthermore, our newest consumers are recent graduates from universities are very encumbered by debt. So, maybe perhaps it's the bond guy DNA in me who doesn't want to see somebody with very low earnings over encumbered by debt, but I do think there are economic implications for that. It's something we at TCH are watching very closely is to what extent these new consumers are able to earn and experience wage growth consistent with the amount of debt they're graduating with. So, student loans has the ability to finance college education, which is certainly something we all advocate, but at the same time, if that consumer is too burdened by debt and they're unable to service their debt and save money, that's not a good long-term outlook for the US economy because we need these consumers to replace people who are retiring. If they're spending less money than the people they were replacing, that's a negative for GDP growth. So, the dynamics of our consumers and the degree to which they're encumbered by debt, particularly our new consumers, is a cause of a lot of concern we're monitoring. Matt Smith - Scott did a great job explaining and simplifying some of the complex issues related to fixed income. I'm confident this podcast will help our listeners make more sense of the bond market and the fixed income landscape. For show notes and links from this episode, visit bmogam.com/betterconversations. That's bmogam.com/betterconversations. Ben Jones - Scott, thanks for joining us on the episode. The episode was produced by Jonah Geil-Neufeld and the Freedom Podcasting team, as well as our team here at BMO Global Asset Management; Pat Bordak, Gayle Gibson, and Matt Perry. Ben Jones - Thanks for listening to Better conversations. Better outcomes. This podcast is presented by BMO Global Asset Management. To learn more about what BMO can do for you, go to bmogam.com/betterconversations. Matt Smith - We hope you found something of value in today's episode and if you did, we encourage you to subscribe to the show, and leave us a rating, and review on itunes. And of course the greatest compliment of all is if you tell your friends and coworkers to tune in. Until next time, I'm Matt Smith. Ben Jones - And I'm Ben Jones. From all of us at BMO Global Asset Management, hoping you have a productive and wonderful week. Disclosure - The views expressed here are those of the participants and not those of BMO Global Asset Management, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment professional about their personal situation. Past performance is not indicative of future results. BMO Asset Management Corp is the investment advisor to the BMO funds. BMO Investment Distributors, LLC is the distributor. Member FINRA SIPC. BMO Asset Management Corp and BMO Investment Distributors are affiliated companies. Further information can be found at C11: