Corporate bonds will keep paying off

Five years ago, Patrick O’Toole said he was maintaining overweights in corporate bonds. At that time, he said, “We think that strategy is going to pay off over the next few years.”

It did.

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Over the past five years, O’Toole, vice-president of global fixed income at CIBC Asset Management, saw returns around 4.5%; over the same time frame, Government of Canada bonds returned 2.5%, while all government bonds, including provincial and municipal, saw 3.4% yield.

So, “the strategy has certainly paid off,” says O’Toole, who co-manages the Renaissance Canadian Bond Fund, an underlying fund in the Renaissance Optimal Income Portfolios. “As far as having our outlook being that interest rates could actually fall a little bit or at least hold the line – that also worked out fairly well.”

Read: How asset managers are adapting to fragile bond liquidity

He anticipates corporate bond strength will continue this year. “Investors should continue to be overweight corporate bonds. Sure, they’ve had a good rally versus government bonds the last few years, but they still look fairly attractive.”

In particular, O’Toole likes investment-grade corporate bonds. “When you’re looking at five-year Government of Canada bonds, for instance, yield [are] around 1%. You can pretty much double that on a high-quality investment-grade corporate bond, so that still […] looks like decent value.”

Takeaway: Consider corporate bonds with slightly longer duration.

As for high yield, O’Toole says the cost diminishes its attractiveness this year. “[The sector] enjoyed a fantastic 2016, so the outlook for 2017 just naturally can’t be quite as bright. But we still do expect positive returns there.” After reducing exposure to high-yield last year, “we’re leaving ourselves room if we do see those spreads increase to become a little more attractive—then we could add to that position as well.”

Read: Protect portfolios from bad corporate bonds

Before reducing his overall weighting in corporate high-yield in 2016, he took advantage of the increase in spreads when lower oil prices hit oil bonds. “We did add to some positions early in the year, and we’ve since cut back on some of those.”

Tips for 2017

O’Toole says he is leaving the duration of his portfolio longer than his benchmark. “Interest rates have actually risen meaningfully so we’re keeping our duration just a little bit longer,” he says. “That’s also acts as a hedge against the credit risk in the portfolio, and that has tended to serve us quite well these last many years.”

In addition, O’Toole expects that with the incoming U.S. President promising deregulation, inflation may rise slightly, but it isn’t likely to be sustainable. “Instead what you might see is corporations having to absorb some of the higher costs. That means inflation stays fairly contained, [and] we shouldn’t worry about bond yields rising drastically from current levels.”

Read: Where to look as U.S. rates rise

As a result, he says, “If you’re looking for opportunities today, keep duration a bit long; there are still many risks that could result in a flight-to-quality trade. We’ve seen that happen time and time again over the last five years.”

Indeed, since 2007, there have been seven or eight increases in bond yield, “all followed by rallies. So every year we hear that the bond rally has ended, but you’ve got to keep in mind the bond market has had more premature death notices than Gordon Lightfoot. So we still think it’s an OK place to be, [but] we do expect more muted returns going forward.”