Bond markets improve thanks to credit crisis

By Steven Lamb | July 31, 2008 | Last updated on July 31, 2008
6 min read

(August 2008) The fixed-income portion of any portfolio is supposed to provide stability, guarding capital against short-term volatility. But what happens when that volatility originates in the credit markets?

That’s what happened in the summer of 2007, when America’s sub-prime mortgage problems first blew up, and quickly graduated to full-blown credit crisis. Corporate bond valuations plummeted as investors fled to the safety of government issues.

According to some money managers, the move was overdue.

“We’d been reducing our corporate bond exposure last summer prior to the breakout of this credit crisis in early August,” says Steve Locke, senior portfolio manager, fixed income, at Howson Tattersall, and manager of the Saxon Bond Fund. “We look at this right now as actually affording a great opportunity to add significantly more yield to portfolios via corporate bonds relative to government bond exposure.”

He points out that Canadian banks and insurers have far healthier balance sheets than their American counterparts, and yet their bonds have still been sold off; perhaps excessively so.

He explains that the advent of the Maple bond, which allows foreign corporations to raise capital on the Canadian debt market, brought more of a global outlook to debt valuation. When U.S. and European financials got into trouble, their bonds were sold off and the contagion spread to Canada.

The stampede from corporate bonds into government debt drove up the price on sovereign issues, forcing the yield rates lower. With yields on risk-free government bonds at all-time lows, the spreads between them and corporate bonds is grossly exaggerated, according to Ben Cheng, president of Aston Hill Financial, and lead manager on the IA Clarington Tactical Income Fund.

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“At today’s yields, you’re looking at the Government of Canada five-year bond yielding less than 3.5%; there’s not a tremendous amount of value there for clients,” he says. “You’re getting about 1% above the inflation rate, which in our view is not enough to even keep our investors’ heads above water after taxes.”

Cheng’s mandate does not restrict him to bonds, allowing him to seek out additional returns through preferred shares. He describes his investment strategy as “balance sheet arbitrage,” where he examines the entire company and invests in either the debt or the equity, depending on the state of the company’s finances.

“Even bank-preferred shares are trading at some 250 basis points (bps) on a yield-adjusted basis over the Government of Canada risk-free bond yield,” Cheng says. “Those are yield spreads we used to see on junk bonds not too long ago, so to get that kind of yield spread on a bank-preferred share, there has to quite a lot of fear in the market.”

He says much of that fear is valid, but agrees that this is a buying opportunity for investors with a longer investment horizon. Cheng likes the higher yields offered on corporate bonds right now, as much of the market seems to have flown to the safety of government issues.

“The bonds that you hold today over the next couple of years are going to give you some good returns,” says Cheng. “One, they’ll give you attractive yields. Two, in the next 18 to 24 months, we expect to see considerable credit spread tightening.”

Cheng is not alone in seeking out higher yield.

Michael Crofts, director, Mawer Investment Management, is also the manager of the Mawer Canadian Bond Fund, a largely high-quality portfolio of investment grade bonds, which may occasionally dip into the BBB-rated pool.

Lately, he’s been bargain hunting among oversold corporate issues, especially among banks and insurers. Prior to the onset of the credit crisis in July 2007, these issues were offering a premium of only 20 or 30 basis points over risk-free government issues, but the spread has since opened up to about 150 basis points.

“We’re a conservative shop and our risk appetite has gone up a little bit because we think we’re being compensated for it,” he says. “We were neutral to underweight corporates until about March, versus the benchmark and probably most of our peer group. We thought that spreads were at a point that we were getting reasonably compensated, so we increased our weights.”

But his return to corporate debt remains in the safe end of the pool, picking up issues from the same oversold financial sector as Locke, who says there is still more downside risk on the macroeconomic level, especially south of the border. He’s steering clear of the high-yield market, because the stumbling economy is likely to drive default rates higher.

“What is different in this cycle is that we’ve seen a much more exaggerated re-pricing of corporate credit risk. This is a much bigger financial market event than we’ve seen at any time in North America since the Great Depression,” Locke says. “It’s not yet the time to be reaching down the credit ratings spectrum to be buying those lower-quality issuers.”

No one is predicting a return to the Great Depression, but many economists have been predicting higher inflation, which, in periods of healthy economic growth, would force central banks to raise their interest rates.

“Certainly inflation is always the number-one nemesis of a fixed-income investment, because it erodes the purchasing power of those dollars that are being earned over the life of the investment,” says Locke.

But this time around, sluggish economies in North America and Europe could forestall such a move. Locke points out top-line consumer price index readings mask the truth.

“We actually have roughly half of the CPI deflating right now,” he says.

“We’ve had pockets of very high inflation in pricing, but we have not seen a pass-through of that commodity-linked inflation into the wider arena of products,” he continues. “With growth prospects in North America slowing, we think there is limited ability to pass that amount of inflation through into final goods.”

Cheng agrees that while inflation risks are real, the threat of skyrocketing prices has been overblown. He expects the U.S. Federal Reserve to maintain its 2% lending rate for at least the next six months, and points out that with the Canadian dollar hovering around parity, the Bank of Canada has the leeway to even cut rates.

“I think the market has been incorrectly concentrating on inflation risk,” he says. “I think it’s real, but the slowing U.S. economy, plus the tremendous amount of deflation in asset values, hard asset values — these continue to depreciate and that is going to prove to be a tremendous offset to the inflationary risk.”

Even if central bankers do raise rates, all three managers say they should be able to adjust their portfolios accordingly without too much damage. The real problem that a rate hike would cause lies outside the bond managers’ purview.

“I think a lot of people think we are a long way through the credit crisis, and I’ve been skeptical that we’re more than two-thirds of the way through,” says Crofts. “I’m a little bit more worried about equities than I am about fixed income.”

He explains that if the central banks are forced into fighting inflation with rate hikes, companies with maturing debt may struggle to make higher payments on new issuance. In that scenario, he would move out of corporate issues again, and park the cash in federal and provincial debt.

“Central banks would love to move rates up to make sure they control the expectation of inflation,” he says. “But I’m not convinced they have the strength of the economy to do it yet.”

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Steven Lamb