Short-term bonds are overvalued

Investors should favour high-yield over investment-grade and government bonds.

And, within the high-yield sector, they should consider choosing BB- and B-rated, as well as medium- and longer-term, bonds, says Patrick O’Toole, vice-president of global fixed income at CIBC Asset Management. He co-manages the Renaissance Canadian Bond Fund, an underlying fund in the Renaissance Optimal Income Portfolios.

Long-term bonds are preferable, he adds, because short-term products have become overvalued. “A lot of market participants have been rushing to short-term investments [to] capture yield and avoid the potential for rising yields.”

If your clients prefer investment-grade products, he suggests they consider deposit notes. That’s because “it looks like we’re going to have bail-in deposit notes over the next 12 months, and these won’t stand as high in the capital structure as current deposit notes.”

So, “the current outstanding deposit notes will likely no longer be issued. They’ll be collectors’ items [and] we’re trying to collect some now.”

Read: Outlook for high-yield bonds

As well, he suggests avoiding government bonds since they’re expected to “bring up the rear over the next 12 months as far as returns go.”

Read: Why a 60/40 portfolio is an active bet

Turning to sector analysis, O’Toole says investors should focus on “the consumer sector [as] the U.S. economy bounces back. We’re seeing good job market gains in the U.S., [along with] robust auto sales, a tight supply of homes for sale and a stronger U.S. dollar.”

Read: Consumer debt grows to more than $1.5 trillion

Further, he adds, we’ve seen gas prices falling due to energy market volatility. “So we think consumer stocks [and] consumer bonds are actually going to have better return prospects” going forward.

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What’s more, O’Toole predicts the steadying U.S. economy will have a positive effect on Canada. “It’ll help counter some of the drags we’ve seen, [such as] sluggish employment and stagnant business capital spending, that have been holding our economy back.” He adds lower commodity prices and a weakening Canadian dollar may help domestic consumers.

Read: Economy on track for increased growth

A look at growing economies

Currently, O’Toole favours North America over regions such as Europe.

“In the U.S., we see better employment prospects,” he adds, “and the U.S. does seem to be diverging from the rest of the world. [It] seems to be on better footing than two or three quarters ago.”

Further, “we expect U.S. growth is going to outpace Canada’s over the next 12 months, and that hasn’t happened in a few years.”

Read: World’s most competitive economy is…

As well, growth in the U.S. will spur the Mexican economy, which has improved in the last several years.” In particular, “Mexican peso bonds are at a pickup to Canadian bonds of around 400 basis points,” says O’Toole. “You usually have to move to the high-yield sector to get that [kind of] increase in yield, and these are A-rated bonds.”

Even after accounting for currency volatility, he adds, “we still pick up an extra 2% on a currency hedge basis—that’s adding an extra 50 basis points every quarter for the position we have in Mexican bonds.”

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