Bond risks and opportunities

In a surprise move last week, the Bank of Canada cut its benchmark interest rate by 50 basis points to 0.75% in response to the spread of Covid-19. The Federal Reserve followed with a rate cut on Sunday to effectively zero.

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But will Canada cut rates again to match the Fed? According to Adam Ditkofsky, vice-president and portfolio manager at CIBC Asset Management, it’s a “real possibility.”

“[That rate] could be reached fairly quickly if conditions continue to deteriorate,” he said, in a March 11 interview.

“I’d also note the U.S. has already been there from 2008 to 2015, and Canada has seen its overnight rate as low as 50 basis points, which I think is important to remember: central banks have been at these levels before.”

Like many others, Ditkofsky questioned whether low rates provide stimulus when people are afraid to leave their homes. Many governments have declared states of emergency, closing schools, daycares, bars, restaurants and other gathering places, and forcing many to work from home.

But he said there’s evidence that monetary policy can stimulate the economy.

“We’ve already seen a massive increase in mortgage applications and refinancing in the U.S. as rates move lower,” he said.

“And with lower rates, it definitely reduces the increased finance burden for corporate borrowers as their results slow down. But the market is clearly indicating that it wants something more, be it through fiscal spending or personal tax cuts.”

President Donald Trump has proposed an economic package worth $1 trillion that would see Americans receive cheques within a few weeks. Prime Minister Justin Trudeau unveiled a package worth up to $82 billion Wednesday in direct payments and tax deferrals for Canadians.

Central banks have also been buying back government bonds to maintain liquidity. Still, more forms of monetary stimulus are available to rejuvenate confidence in the market, Ditkofsky said. This includes “additional overnight liquidity, yield-targeting for specific parts of the yield curve, and even corporate-bond buying, which we’ve seen been done both in Europe and Japan.”

Meanwhile, the impact on bond yields will depend on how quickly and widely Covid-19 continues to spread.

“At this point, fears of uncontrollable containment are significant and bond yields are continuing to move lower,” said Ditkofsky, who co-manages the CIBC Canadian Bond Fund, among others.

He noted Canadian bond yields have already fallen to record lows, with 10-year bonds below 1%, and 30-year bonds at around 1%. Further, credit spreads have widened to levels that haven’t been seen since early 2018.

Corporate bond spreads have also widened, he said. “One example was on March 10. We saw Bank of Nova Scotia reopen a three-year deposit note 50 basis points wider than where they’d been priced in the market a month earlier. At the time, the deal came with a 10-basis-point concession.”

While the deal went well, “the market required a very large concession to absorb the issue,” he said. “Despite spreads being materially wider, overall funding costs were very low. So it’s still beneficial to the issuer to come in this market.”

The breakdown of OPEC, which sent oil prices into “freefall,” has impacted credit spreads in the energy sector. “This is a more complicated situation as oil prices are well below where most producers generate profits,” Ditkofsky said.

This means due diligence and credit analysis are key when assessing energy companies. Ditkofsky is shifting to “more stable names” that “aren’t as reliant on the spot price of oil.” Suncor is one example of a company he likes. Its breakeven on oil is in the mid-$20 range, he noted.

Despite the increased volatility and risk, the widening spread also means there are opportunities to add credit, Ditkofsky said, especially as some spreads are widening by 25 to 40 basis points a day.

“High yield also offers attractive opportunities, especially with spreads above 600 basis points,” he said. “We’ve been modestly adding to our high-yield weight.”

Ditkofsky said it’s still important to be cautious when adding credit or high yield due to market uncertainty.

The real issue with Covid-19 is that it’s difficult to model its impact on global GDP, he said.

“Markets are pricing in significant downsides and assuming the worst. While economic recovery is still not known as the virus continues to spread and the death toll rises, the question is whether we’ll have a v-shaped recovery, or a u-shaped recovery over time.”

Ditkofsky expects a u-shaped recovery is “more likely.” Stocks may recover more quickly given their rapid decline, while bonds will only see a modest rise in yields, he said.

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.