Fixed Income Solutions Negative Interest Rates: Are they Coming to Canada? June 11, 2017 Harold Scheer
CENTRAL BANKS HAVE INFLATED THEIR BALANCE SHEET AT RAPID PACE IN RECENT YEARS First round of QE significantly helped to inject liquidity into seized banking system and lower overall risk premium in capital markets. Impact much reduced with each subsequent round of QE. USD (B$) 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 07 08 09 10 11 12 13 14 15 16 17 Fed BoE ECB BoJ Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 1
GLOBAL POLICY RATES After faltering impact of QE, the ECB and BoJ push policy rates negative. Of note, the reason Sweden and Switzerland first cut rates below zero was to slow their currency appreciation versus the faltering Euro. INTEREST RATE(%) 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0-1.5 06 07 08 09 10 11 12 13 14 15 16 17 Canada US Eurozone Japan Sweden Switzerland Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 2
GERMAN YIELD CURVE 1995/2005/2017 Combination of QE and NIRP pull bund yield curve below zero. YIELD (%) 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0-1.5 Source: Bloomberg, Baker Gilmore. Year end 1995 Year end 2005 April 30, 2017 Sept. 30, 2016 6M 5Y 10Y 15Y 20Y 25Y 30Y BAKER GILMORE & ASSOCIATES Fixed Income Solutions 3
JAPAN YIELD CURVE 1995/2005/2017 Also in Japan and YIELD (%) 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Year Year end 1995 end 1995 Year end 2005 Year end 2005 April 30, 2017 Sept. 30, 2016-0.5 6M 5Y 10Y 15Y 20Y 25Y 30Y Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 4
SWITZERLAND YIELD CURVE 1995/2005/2017 numerous other countries. YIELD (%) 5.0 Year end 1995 Year end 1995 4.5 4.0 3.5 3.0 Year end 2005 2.5 Year end 2005 2.0 1.5 1.0 April 30, 2017 0.5 Sept. 30, 2016 0.0-0.5-1.0-1.5 6M 5Y 10Y 15Y 20Y 25Y 30Y 35Y 40Y 45Y 50Y Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 5
10 YR TREASURY TERM PREMIUM Although negative nominal yields are presently a European and Japanese phenomenon, 10 year US Treasury term premium has also been pulled below zero. TERM STRUCTURE PREMIUM (%) 6 5 4 3 2 1 0-1 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 6
YIELD VS DURATION : 2005 -> 2016 Not only have yields moved to or below zero, but risk has also increased. 6% 5% 4% YIELD 3% 2% 1% 0% -1% 2 4 6 8 10 12 DURATION (YRS) UST UK Gilt Japan Govt TIPS EUR Govt Canada Govt US IG EUR IG Canada IG Source: : Bank of America Merrill Lynch Indices BAKER GILMORE & ASSOCIATES Fixed Income Solutions 7
CANADA YIELD CURVE 1995/2005/2017 Government of Canada bond yields follow global trends moving every closer to zero. YIELD (%) 8.0 7.5 7.0 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Year end 1995 Year end 2005 April. 30, 2017 6M 5Y 10Y 15Y 20Y 25Y 30Y Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 8
NET FOREIGN PURCHASE OF CANADIAN BONDS BY TYPE Foreign investors buy large volumes of Canadian and US bonds in search for yield. 140 120 100 C$BN 80 60 40 20 0-20 -40 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 Source: Statistics Canada, CIBC Capital Markets BAKER GILMORE & ASSOCIATES Fixed Income Solutions 9
JGBS & HEDGED 10 YR CANADA YIELDS Yield hungry Japanese investors buy Canadian bonds when currencyhedged yields are attractive. 4.0 3.5 3.0 2.5 YIELD (%) 2.0 1.5 1.0 0.5 0.0-0.5-1.0 10 11 12 13 14 15 16 17 10Yr JGB 10yr CDA Hedged to JPY with 3mo Fwd Source: Bloomberg, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 10
BUNDS & HEDGED 10 YR UST YIELDS Yield hungry German investors buy US bonds when currency-hedged yields are attractive. 5.0 4.5 4.0 3.5 YIELD (%) 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5 10 11 12 13 14 15 16 17 10yr Bund 10yr UST Hedged to EUR with 3mo Fwd Source: Bloomberg BAKER GILMORE & ASSOCIATES Fixed Income Solutions 11
GOVERNMENT OF CANADA - REAL 10 YEAR YIELDS* Real yields pulled far below zero by global forces. 7 6 % 5 4 3 2 1 0-1 -2 97 99 01 03 05 07 09 11 13 15 17 Source: Bloomberg, Statistics Canada * Real Policy Rate = Rate CPI Core 2 years 10 years BAKER GILMORE & ASSOCIATES Fixed Income Solutions 12
RISK/RETURN CANADIAN GOVERNMENT BOND YIELDS Government of Canada bond yields offer little compensation for duration risk 140 120 YIELD/ EFFECTIVE DURATION (bps) 100 80 60 40 20 0 97 99 01 03 05 07 09 11 13 15 17 Source: BofA Merrill Lynch Canada Government Index, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 13
RISK/RETURN CANADIAN PROVINCIAL BOND SPREADS while other sectors of the market more than adequately compensate for spread risks, although 120 100 SPREAD vs. CANADA (bps) 80 60 40 20 0 99 01 03 05 07 09 11 13 15 17 Source: BofA Merrill Lynch Canada Corporate Index, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 14
RISK/RETURN CANADIAN CORPORATE BOND SPREADS corporate spreads are getting close to fair value. 400 350 SPREAD vs. CANADA (bps) 300 250 200 150 100 50 0 99 01 03 05 07 09 11 13 15 17 Source: BofA Merrill Lynch Canada Corporate Index, Baker Gilmore. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 15
INITIAL YIELD AND SUBSEQUENT 10-YEAR RETURN Future bond returns likely to be low. YIELD (%) 18 16 14 12 10 8 6 4 2 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 Annualized 10 year return FTSE TSX Canada Long Term Index / Annualized return over the next 10 years Yield at year-end Source: The Wall Street Journal. BAKER GILMORE & ASSOCIATES Fixed Income Solutions 16
FED MODEL S&P 500 earnings yield 10 YR US Treasury yield Search for yield and returns pulls investors into riskier assets, especially those with attractive valuations. 8 6 4 Stocks are attractive RATIO 2 0-2 -4-6 Source: : Bloomberg Bonds are attractive 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08 11 14 17 BAKER GILMORE & ASSOCIATES Fixed Income Solutions 17
ASSET ALLOCATION TO ACHIEVE 7.5% EXPECTED RETURN Investors will have to take more risk, which also requires more expertise and patience. Regulators have been moving in other direction demanding less risk taking. ASSET CLASS WEIGHT 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 6.0% 100% Bonds Source: : Callan Associates, Wall Street Journal 8.9% 4% 5% 14% 5% 20% 52% 17.2% 12% 13% 22% 8% 33% 12% 1995 Bonds 2005 2015 U.S. Large Cap U.S. Small Cap Non-U.S. Equity Real Estate Private Equity 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% PORTFOLIO STANDARD DEVIATION BAKER GILMORE & ASSOCIATES Fixed Income Solutions 18
CONCLUSION Expect lower returns (i.e. cost of hedging liabilities has increased) Expect increased volatility Expand into other investment classes Carefully manage risks given many unknown BAKER GILMORE & ASSOCIATES Fixed Income Solutions 19