Hello and welcome to The Download. I'm your host, Dave Richardson, and I’m very excited today because we sent out a little poll across the floor on how we would title this segment. And we have a very special segment today, another edition of In the Pitts with Steve Pitts.

Ah, I see what you did there.

Like what, the millionth time somebody's done that? They show up at your house and they say, hey, I'm in the pits.

This is the pits.

Yeah. It's also Dans le pits, as our friend Laurence Bensafi, regular guest on the podcast, would refer to it. She's got that good accent and it sounds a lot better that way. But in the pits. The last couple of weeks has meant the bond market has been a bit in the pits. It's been a little bit better the last couple of days, but it's still been an interesting ride. We've talked about it a lot on some of the episodes that we've taped over the last couple of weeks, but I wanted to get you in as, very seriously, our bond expert. That's why you needed a special segment name for your appearances, because you have become our bond expert on the podcast. Whenever it hits the front page of the newspaper, when I'm walking along and someone— I use my wife as the standard, quite frankly— someone who's generally not watching these things goes, hmm, what's going on with interest rates and bonds? And that's when it crosses from being just inside the industry or within our friends who are worried about this— and you're obviously worried about it every minute of every day— to something that more broadly people are going, hmm, what's going on here? And that's why we love to get you on for these discussions.

Like the proverbial taxi driver bringing it up, or Uber driver.

Exactly. I've got a lot of good stories on that one. But yeah, you’re exactly there. So Steve, we've had a couple of people explain it, but from your perspective, what's the way that you would explain it to that taxi driver if they said, hey, what's going on in the bond market?

What's captured the market's attention is the 30-year bond. This is what's hit the headlines, and particularly in the US. I would say there's been a focus on the US, but it actually has been a global phenomenon. 30-year bonds in Canada are as high as they've been. Similar in Japan and elsewhere. I think it was last week, the 30-year bond hit 5.3%, the highest since 2007. So that's what hit the headlines and probably got the attention of some of the people that might not normally follow the bond market. And I would say also it's fairly specific to the 30-year as well, because if you look at the 5-year bond, 10-year bond, they're not at those highs. They peaked 3 years ago and are still below those levels. So it does seem to be very specific to the 30-year level. And the interesting part is there hasn't been a notable, obvious market trigger or economic event that prompted it. So trying to figure out what caused it, if you look at the components of that yield, there's 2 main components. There's the compensation for inflation, the inflation expectations. And then, the real interest rate. The inflation piece hasn't really moved that much. So inflation expectations, if you look at other measures that look at that, it hasn't been worries about inflation rising over the period of that 30-year. What's priced in is something like 2.25 in the market. And that hasn't changed too much. So it's really the other piece, that real interest rate. And there's a lot of components that go into that. But certainly one of the things is the term premium. And that's certainly what has gone up. And what's built into that is just really the risk, the compensation that investors are demanding to lend money to the government for 30 years, essentially. If I'm lending you money for 30 days, I'm okay with that. If I'm lending you money for 10 years, well, I don't know what you're going to do with it. There's more chance of you doing something crazy with it and not paying me back in 10 years.

Forget about 30 years.

Yeah, forget about 30 years. We're both gone by then.

I'm surprised you went there.

I know. I was going to do 30, but I thought that was crazy.

You're saying the old guy's not going to be around in 30 years.

Neither of us might not make it to that time.

He probably doesn't have it in his will to pay you back. So that's okay.

So yeah, you've had headlines like the debt level in the US hitting $40 trillion. The deficit is something like 6.3% of GDP. So I think there's this overall concern about the sustainability of debt globally. It tends to be a little worse in the US than elsewhere. And overall, a declining trust in US policy, if you will. So concern that there's a greater risk that you might not get your money back or just that the overall sustainability of that debt really over the 30 years.

Let's put that in perspective, Steve. The GDP of Canada. Every single thing, the value of everything, every Canadian working throughout an entire year, we produce around $3 trillion. All of Canada, everyone, everyone listening, everything you produce in an entire year, $3 trillion. The debt in the US is $40 trillion. That just puts into perspective how big that number is. Not just from a US perspective, but just thinking— I don't know, if you stack loonies to the moon, how many times you go back and forth. But it's probably 100 or 200 times to get to $40 trillion. Somebody probably knows that who’s listening. So as these numbers roll off, I think people just go, oh, yeah, $40 trillion, whatever. So government's run up debt. Who cares? But $40 trillion is an astounding number. And that's doubled really since Mr. Trump arrived on the scene.

Yeah. And the effect of that is like, the interest payment to support that, I think has just recently passed $1 trillion now. Each year basically, and that's a combination of the debt going up, but also bond yields going up. And as some of the debt matures at lower coupons and is refinanced at higher coupons today, that has gone up. So that's ultimately a big part of that equation in terms of the concern of the market in that whole sustainability issue.

Now, I think the other challenge is going to be, Steve, that no one's really doing a whole lot. In the US anyways— you could argue that across a number of different governments around the world— but in the US in particular, there doesn't seem to be any political will to address the things you need to start to work on that debt. I think the forecast for this year was a 6.4% budget deficit. You generally would see deficits that large in wartime. And when I'm talking wartime, World War II, a large-scale war, or during something like COVID, where was the start of these deficits running. So the bond market has to be worried about getting that repayment, or as you say, wanting to be paid more for taking the risk of lending money to the US government, which is what you do when you buy a bond.

Yeah, that's an important part of it. You have that very large deficit at a time when the economy is actually pretty strong. So if you go back to the Keynesian economics element of it, when your economy is strong, you're supposed to be running surpluses so that when it does weaken, because your deficits are going to get bigger in a recession or time of weakness. And so it is that combination, not only just the magnitude of the deficit, but also the fact that it's coming at a time when the economy is actually doing fairly good. That's not necessarily what you want to see. It is during those good times that you want to be able to try to pay some of that back.

We seem to be doing a better job in Canada. We look at our government sometimes and we wish they were doing a better job on debt, but of course, we've just been through a global pandemic and the things you needed to do there would make a lot of sense. We seem to have managed that better. We're not running anywhere near that size of deficits. That gives us what some would argue is space to spend, but it also puts us in a better position from a debt perspective relative to the US. Our trouble has been getting economic growth to the same level that they've had in the US.

Yeah, that's fair to say. And it's interesting because the Canadian bond market's actually been amongst the developed markets one of the better performing bond markets over the last year. And part of that is the fiscal situation here isn't quite as dire as in other countries. I think our deficit is something to the tune of 2% of GDP versus their 6.5%. So, yeah, more manageable. And also inflation. The last inflation number core was close to 2%. In the US, the core PCE was at 3.3%. So the inflation picture is better here. But to your point, the other part of it is we haven't had the same growth. Certainly, we haven't benefited to the same extent from the AI buildout as the US has, for example. So we haven't had that economic tailwind to the same extent. Then more recently, the potential drag from heightened tariffs from the US is something that has the potential— I think Eric has said it could slow growth by maybe 0.3% or something like that, and the reciprocal tariffs might increase inflation by 0.3%. In a big picture, it's not huge. Of course, if you're in the industries affected, it's very significant, and so you don't want to downplay it, but it's another factor there that's affecting that. That's a bit of a drag on things too.

So then what starts to creep out— and I used to creep out as one on October 31st every year when I was a child— dressing up as a bond vigilante was one of my favorite costumes. No one knew what I was dressed up as. I would tell them, and then even when I told them, they didn't know what a bond vigilante was. Why don't you tell them what my silly costume represented and why you might hear that term around a bond market that has been behaving the way it has been recently, and when you get announcements like $40 trillion of debt level?

Yeah, well, that term in the past has been referenced where the bond market is in some ways forcing the hand of central banks or governments to do something, usually to cut their fiscal spending and bring their house in order. And so you could arguably see that play out today. And that's part of the story. It's not to the same extent that you saw in 2022 in the UK, for example, when they came out with a budget that was a lot of debt-type spending, you saw a very strong response from the bond market. We haven't seen that to the same extent, but there has been this element, following Warsh's last press conference, where arguably the market wasn't overly impressed with his lack of guidance, unclear messaging around inflation, and really messaging around the Fed reaction function in terms of how they would respond to inflation and address it. And you saw that was the start of this, where you did see this steepening of the curve where the long-end yields went up. And that's, again, related to what we've seen probably since then. That was about the last month. So yeah, there is an element of that happening to some extent, but it's not to the same extent as what we've seen. But that's always the risk here, at some point the bond market takes things into their hands. And in some ways that term premium spikes higher, goes up, and it does force the governments to respond and do something about it in terms of being able to continue to access the bond market at reasonable yields.

Yeah, and for those of you who are regular listeners, I think I've told this before. By the way, if you're not a regular listener, great chance for you to follow us wherever you're listening to podcasts. You can just click the «add» button and get the podcast sent to you in your podcast file whenever we tape a new one, when we get in the pits or something like that. Obviously, we're on YouTube as well if you subscribe to the channel and we love to get reviews and get feedback and comments on what we're talking about. But Steve, we've really come down to you being the only bond person on the podcast. We like to have a lot more equity people. And this, I guess, in some ways could be in life, but particularly in the investment industry. Equity people are optimistic, they're happy, they're cheerful, they're always looking for the next opportunity. Something good has got to be around the corner. All the profits are going to be up, everything, stocks are going to go up. Bond people are miserable. What's the next risk? When's the next rainstorm coming? We're going to have a party? That's going to be a bad party, no one's going to show. That's the way bond people are. Steve, by the way, is a little bit of an exception, not 100%. But you all know people who are happy in life, people who are not that happy. And so, the bond folks are always like that, and the bond vigilantes are in particular, and they really get to come out when the government really gets off track in terms of the way that they're managing their budgets and managing their debt. Exactly as the word says, «vigilante», they're watching. If they sense that there's an opportunity to attack and to put pressure on you because you're not taking this seriously enough— and pretty clearly, there's a lot of governments around the world that have let things get out of hand— that's when they creep out. As you said, which was a great explanation, better than my silly explanation, but what's key is that the government, when this happens, the pressure takes some of the power out of the hands of the Treasury Department of whatever government we're talking about— be it the US, Canada, somewhere in Europe, Japan— and puts pressures that you don't want to have. It's like if I have a credit card payment to make and I don't make it, pressure comes for me to make that payment. Whoever releases the card might let it go for a month or two and charge that high rate of interest. And it is a high rate of interest. But if I stop making those payments, that's when things get really tough. Debt at a personal level and a country level is not that dissimilar. There's ways that it is, but it's not that dissimilar. So when you get in over your head, there are forces that come into play that start to say, hey Steve, you got to get your house in order.

And you've seen in some ways recently Scott Bessent trying to deal with that to some extent. So recently they went in and essentially increased their existing buying. They have an existing program that essentially buys less liquid off-the-run bonds typically, but they've expanded that now to essentially double the size of it to be buying more long bonds and essentially funding that through the shorter end, through T-bills essentially. And so part of the reason I think for doing that was to send a message to the bond vigilantes that the government is willing to step in, that this isn't a one-way trade. And to put the fear of God in them that the government might turn this the other way on them if they're, for example, short a bond and expecting yields to continue to go higher. They can step in. And so there is that element. Now, it worked for a day, but those are very much temporary measures. The yields have come up a bit since then. Using your analogy, it's a bit like borrowing or taking money from your home equity line of credit, using it to pay off your car loan or something like that. Your overall debt is still a problem. You've just shuffled things around a little bit to try to address it in the near term. Really, ultimately, what needs to happen here is that the government needs to come up with a fiscal plan that makes sense. And to your point, neither party in the government seems interested in that, certainly in the US. And the positioning of the US has forced other countries like Germany, even in Canada, to spend more on defense and things that they might not have had to before. It's almost forced other countries as well to increase their own deficits and borrow to fund some of these other infrastructure and military-type projects that they might not have done otherwise. So there's been this flow-through to the rest of the world as well. And so, yeah, Bessent seems to have some of those bond vigilantes in mind when taking some of these steps to offset that.

Is there any level in terms of the term premium or the actual levels of that 30-year yield or 10-year yield when the alarm goes off, not just in the bond market, but where it spreads out into the broader economy and into the stock market as well in terms of the way the stock market trades?

It's a good question. I don't know if there is anything specific. Debt isn't a problem until it becomes a problem. Even looking at when debt levels become a problem, it's hard to answer that because you have some emerging market countries where even getting to 15% of GDP is a problem and you have Japan that's been at 250% of GDP and still doing well. In terms of when debt becomes a problem, you don't really know, and it's different for each country. Then when it flows through to the economy, I think is less clear. Because this has been very concentrated in that long end, it has been less of a current concern because institutions buying bonds at the long end are pension plans, life insurance companies. The hyperscalers are borrowing in the long end. We didn't mention that, but that's coming into play too. Because if you look here in Canada, for example, we had Amazon and Alphabet come to Canada, issue Maple bonds, and I think about a third of that issue was 30-year. It's a similar number for the issues in the US. So they're issuing a lot of longer-term debt as well because their projects are longer-term in nature, these data centers that they're looking to fund. But what happens is if you're an investor and there's $15 billion, if you're going to buy that bond, you'll probably sell a long government bond in order to do that. And so I think it's certainly a factor that has caused some additional dislocation in that longer end of the market. where there's probably fewer players. Not a lot of typical retail investors would own in their portfolios necessarily a 30-year bond, but it'd be funds, pension plans, and life insurance companies.

Which is really important, particularly in the Canadian situation, that it is in the longer Canadian bond that you saw the most significant move, because it's at the shorter end, which is the Bank of Canada overnight rate, the 1- through 5-year terms, maybe a touch longer, that lead to the pricing of debt for consumers. So that's where your prime rate is established, that's where your mortgage rates are established. We don't do 30-year mortgages here in Canada, so that rate going higher isn't going to affect your cost of borrowing for what most consumers would use it for, which is, like you say, a car payment, a mortgage on a house, etc.

Yeah, that's true. In the US, there's 30-year mortgage. So there's some tie to the 30-year bond there. But here in Canada, you're generally 1 to 5 for the most part. And so it's very to the front end of the curve. To your point, that's largely driven by what the Bank of Canada is doing with policy rates. If you look at that, I think the market's now pricing in maybe 1 or 2 hikes from the Bank of Canada over the coming year. But nothing too significant overall. And so yeah, that's probably why there's been less of a flow-through to the economy in terms of the impact overall. It's not going to really hit consumers to the same extent if it's fairly isolated. We've still seen things like 2 and 5 years increase a little bit, but not necessarily to the same extent. And so I think for it to really pass through to tightened financial conditions move in the shorter end and move in what central bank policy rates are doing has a bigger impact on that.

Sure. I always put this reminder in that the bond market globally is larger than the stock market by several times and if we look at a typical Canadian investment portfolio, it has more bonds and cash than stock. That would be the average positioning of a Canadian investor. When we're talking about the bond market, this is really important, which is again why bond folks take it so seriously. The bond market is not just a government bond market and it's not just developed markets like Canada and the US who have never missed a bond payment and it's a whole wide range of different governments that are issuing debt in different denominations for different terms. And companies, different types of companies, very stable companies, maybe the hyperscalers with all kinds of cash flow, massive businesses, issuing relatively light amounts of debt given their balance sheet, the size of the company, to very risky companies that are using the markets to fund almost the beginnings of their operations. They're high growth, so there's high potential, but there's also quite a bit of risk there. When you look across the bond market, typically those riskier options have a significantly higher yield. Even though we've seen some of the longer-term debt for very stable governments or traditionally very stable governments rise in the face of where debt is, we've seen the broader bond market remain very stable, almost as stable as you would ever see it. You mentioned the growth, but what do you attribute that to?

Well, I think certainly within the credit markets, we haven't really seen a response from the credit markets to this broader concern about fiscal policy and that kind of thing. If you look at where spreads are, where that risk premium that you're getting on credit— the high yield market today, I was just looking at it earlier this week, and the spreads are in the first percentile relative to the last 10 years. So that means 99% of the time spreads are wider than they are today based on the last 10 years. So that's a pretty narrow compensation. Maybe you could make the argument that if that spread is over government, maybe the government risk is going up and narrowing. Normally, spreads narrow from the top part going down, but maybe it's the bottom part going up. Possibly that's part of the story there, but I think it is notable. Then part of that is just the economy has remained strong. If you look at the credit markets in general, say whether it's corporate bonds, high-yield bonds, generally, fundamentals are good, earnings are good. There's not a lot of distress in the market. Defaults are low. And even things like technical. We've seen a lot of issuance, but it's all been well received. Investors have been welcoming a lot of these with open arms. We've seen a bit of spread widening, some indigestion a bit in some of the hyperscalers in some of the markets that they've gone in, but nothing too significant. But outside of that, fundamentals are good and some of the supply-demand factors are good or technicals are good. The biggest concern at this point is just valuations. Valuations, that's that compensation you're getting for taking on that extra risk of investing. Going from a government to a corporate bond, it’s pretty narrow relative to history. Having said that, I think there's thought that you could see spreads stay at these narrow levels for a period of time. And often that's what you do see. In a risk-off period, you get this risk premium or spread widening out and it comes back in and then you spend a few years bumping along at these fairly low levels, the old coupon clipping environment. And that's where we are today. So while things are more expensive, within our portfolios, we're not necessarily jettisoning all our credit out of the portfolios. Probably it is a part of the cycle where you want to be more selective in doing your credit work and understanding the type of companies and the quality of the companies you're investing in. And then maybe, again, being a bit lighter in terms of your weight to credit relative to your range over time and a bit more higher quality. And that's tended to be where a lot of our portfolios have structured themselves from a quality perspective. I think the playbook for this tends to be to look at higher quality, a lower weight than average to credit, and then put yourself in a position where at some point, we know that the next big move in credit will be for spreads to go wider. We just don't know when that's going to be or what's going to prompt that, but you want to have yourself in a decent position to be able to take advantage of that. That's generally where a lot of our portfolio managers are from a credit perspective.

Yeah, but those folks that are in retirement and looking for income from their bond portfolio or even using it as the traditional offset against equity risk— and there is risk there in the equity market— but higher bond yields make a nice entry point into the bond market because I know I'm going to be generating more income off of that purchase when rates are higher. And so, the bull case story would be: we get a resolution to the war in Iran, inflation continues to fall, continues the trend down, perhaps even accelerated because of AI and the efficiencies and productivity gains we get out of artificial intelligence. Maybe we even get a resolution between Russia and Ukraine. The price of oil and price of energy comes down significantly. So then you've got falling inflation, falling interest rates, and that creates a nice setup for the bond market, particularly if you're entering at these levels.

Yeah, absolutely. And I think that given you're at richer valuations in the equity market, to have some bonds in there to protect you if you do get a bit of a correction in equities. It's kind of, to your point, a good entry point given where yields are today. One of the charts I like that a colleague of mine has maintained over the years is a chart of the 10-year bond yield and goes back to the 1870s. I don't know if you've used it in some of your presentations.

Oh, absolutely. I love that chart.

It's great because you see this basically 100-year period from 1870s to 1970s where the 10-year bond basically traded between 2% and 5% that entire period. And we're just under 5% today. So we're close to the peak of where we traditionally are. It spiked during the '70s when you got the hyperinflation period, and then it went way below that in the post-financial crisis, zero interest rate environment. But now we're back to that normal rate environment today. That 3% to 5%. And so it's something for people to keep in mind. And I think we are at a point where we’re— maybe it doesn't feel like it some days— but probably in a more normal environment, at least from a yield perspective. And if you look at history, buying when the 10-year is at 4.75% actually tends to be a pretty good time to be getting invested in the market.

Yeah. And I highlight that, not just for investors, but people who are borrowing money for a home or for a mortgage. that rate's high right now. And even after this move, as you say, we got close to 4.75% on the 10-year Treasury in the US. And you look at that chart, and you look at an extended history of rates. Give me an environment where economic growth is pretty good, inflation is a little bit elevated, and we've taken on a little bit too much debt, I would think 4.75% is about where you'd be sitting. And so you resolve or start to work on some of those issues and that gives you the potential for it to come down. And of course, when yields go down, the value of bonds goes up and that's when bonds become attractive and you're holding on to that higher yield as rates fall.

Yeah. And the interesting thing about the bond market and financial markets in general is different things drive the price at different times. Earlier in the year, the story was AI and then for a while after the initial part of the Iran War, inflation and oil prices, that was what was driving. So you had bonds and stocks really both driven by inflation. And now we're in a period where it's this fiscal concern, bond vigilante light environment. But it's not going to be like this all the time. You don't know what’s the next thing that's going to drive the market. It could be weakness, disappointment, to your point, which would give you a nice rally in bonds potentially, given that we're at pretty decent yields too.

Well, that's why I'm so glad you brought the chart up, because we've been in the business forever. If you're watching us on YouTube, you can see that. You can see the experience on the top of our heads and in some of the lines on our faces. And I love it when you take a step back and you look back to, as you say, a chart that goes well back into the 1800s. So 150, 180 years, a long period of time. And you start to think of all these almost minute-to-minute, or day-to-day, or week-to-week, or month-to-month trends that start to move markets and make big moves in markets. But when you step back and look at that big picture, again, rates are where you'd expect them to be. I like your point that traditionally, that has not been a bad time to start to look at longer-term government bonds, at least. I know in some of our portfolios, we had made some additions. In general, we're balanced in our portfolios between stocks and bonds. I think that's reflective of a market that there's risks out there, so the answer is staying broadly diversified in your stocks and your bonds. It's a good time to do that. If you do that, it'll provide some protection and then look for a time to really go into battle somewhere down the road.

Yeah, and to your point, we've been taking advantage of those higher yields by adding to bonds in some of our balanced portfolios and adjusting duration in some of our portfolios as well. It is something where you can take advantage of some of the opportunities in those yield movements with professional management.

Well, Steve, I'm really glad we got you on today. We've talked a little bit about bonds in some of the episodes this week, because it's something that's in the news and obviously what happens in the bond market affects everything. Hopefully we've done a good job of highlighting that, but what are we at? Oh, a little over half an hour focused exclusively on the bond market. What's happening? Why? Explained, I think, in terms that pretty much any investor could understand. Great work and thanks for always agreeing to come on. And again, I think really valuable at this time for investors because investors own a lot of bonds. And they got a lot of questions and you answered them.

Great. Thanks, Dave. My pleasure.