Choose corporate bonds to boost yields

Corporate bonds can double or triple the yields available from government bonds, says Patrick O’Toole. That’s why he’s increasing his weighting of corporates.

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“This strategy won’t work every quarter or every year, but over the medium- and long-term, corporate bonds have outperformed government bonds,” adds O’Toole, vice-president of global fixed income at CIBC Asset Management and co-manager of the Renaissance Canadian Bond Fund, an underlying fund in the Renaissance Optimal Income Portfolios.

Read: Look to high yield for diversity

Turning to corporates is key, he notes, because interest rates won’t move dramatically higher over the next few years. “We still have the old headwinds we’ve been [dealing with], but there are also other factors at play.”

Along with persistent global troubles—including China’s slowdown, the oil-price plunge and Greek debt problems—markets are now worried about issues such as the U.K. leaving the European Union, says O’Toole. “All of these things will act as a lid on bond yields because they keep people nervous. When investors are nervous, they rush to the safety of government bonds, thereby pushing prices up and yields lower.”

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Further, central banks in Europe and Japan are in the midst of quantitative easing, which “is making the lid holding down bond yields even heavier.”

Finally, North America is grappling with demographics and continually high debt levels, says O’Toole. “When you’ve got a work force in Canada and the U.S. that’s growing at less than 1% per year, it’s no surprise that the economy is slowing. And, generally, bond yields and interest rates follow the growth rate of the economy; if you have slower growth, that’s met with lower yields on bonds and low interest rates.”

Read: Favour equities over bonds in 2016: Analysts

When it comes to high debt, he adds, “We know that part of the debacle of the U.S. housing market was caused by too much debt as people levered up to buy houses. Households have reduced their debts since the credit crisis, but global debt is higher today than it was back in 2008.”

As a result, the cap on bond yields is unlikely to change in the short term, says O’Toole. “All of this doesn’t mean rates can’t rise, but it does mean there are major forces acting to keep yields lower than most of us have seen over our lifetimes.”

Read: Using short positions to boost liquidity

So, how can you help clients? O’Toole suggests educating clients about both investment-grade and high-yield corporate bonds. “Gone are the days when advisors could look at government and corporate bond yields and say, ‘It’s not that big of a difference, so I’ll stick to government bonds.’”

Instead, “Investors have to recalibrate their expectations [because] slower growth means lower returns,” from bonds as well as stocks and other assets. “To boost returns, [investors] should consider taking a bit more risk with corporate bonds.”

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