Impact of rate hikes on fixed-income investors

Bonds have performed well this year but investors have to weigh the competing risks of sticky inflation, higher rates and a recession.

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Ebad Saif, fixed-income client portfolio manager at CIBC Asset Management, said fixed income investors are enjoying positive returns so far this year. 

After sharp rate hikes in 2022, the Bank of Canada had been on pause since January before consecutive 25-basis-point hikes in June and July, bringing the overnight rate to 5%. 

According to Saif, the positive returns that fixed-income investors have experienced so far this year can be attributed mainly to this higher interest rate environment and the resulting elevated yield. In addition, he said, “the elevated yield provides a level of protection from higher interest rates.” 

Market expectations vary from no additional rate hikes to one more by the Bank of Canada. In the U.S., where the Federal Reserve meets this week for its next rate announcement, markets expect one to two more rate hikes before year-end, Saif said. Both central banks are expected to complete their rate-hiking cycle by the end of 2023.

The Bank of Canada holds an advantage given its next meeting is scheduled for September, Saif said, allowing time to assess additional data. He anticipates that the Canadian central bank will adopt a data-dependent approach and likely halt further rate hikes.

“Looking at where inflation rate pressures are today, it is likely that we see them being at the end of their rate hiking cycle and not raise rates further from here,” he said. 

Annual inflation tumbled to 2.8% in June, within the Bank of Canada’s target range for the first time in more than two years.

Saif said the market expects rates to decrease in the latter half of 2024, indicating a potential shift in the investment landscape.

The main risk that fixed-income investors face in this environment is higher inflation, although Saif noted it has moderated from previous peaks. However, if inflation remains stickier and higher than expected, he said central banks may need to take a more aggressive stance.

“They’re quite elevated already, but if they need to be more aggressive, that’s going to be a headwind for fixed-income investors,” he said. 

Another risk, said Saif, is the possibility of an economic downturn, which would have varying effects on different bond sectors.

Saif said that high-quality government bonds would benefit from lower rates and serve as a safe investment, but securities with credit risk, such as investment-grade corporate bonds or high-yield bonds, might face challenges.

“In an environment where you’re in a deep recession, you’re starting to see significant earnings revisions from corporations,” he said. 

The high-yield market provides Canadian investors with diversification and exposure to sectors not commonly available in the Canadian fixed-income market, Saif said, but it also comes with more risk.

“If there is a market downturn, you’ll be in an environment where those spreads can move wider pretty quickly,” he said. “So being in more defensive sectors, having more exposure to higher-rated high-yield market issuers is attractive,” he said. 

The inverted yield curve also means investors can find “very attractive yield in high–quality, investment-grade corporate bonds,” Saif said, without taking on significant duration risk and interest rate risk.

He said investors can look at specific sectors, such as real estate, where valuations have become more attractive and present opportunities for active managers.

Overall, Saif said he’s defensively positioned in his corporate bond strategy, with exposure to higher-quality corporate issuers and even government bonds.

“Essentially, that’s providing us with a lot of liquidity and also attractive yield while we wait for some market volatility to take place,” he said. That will free up cash that can be put to work when opportunities present themselves. 

Lastly, Saif said shorter-term bonds are more attractive due to the inverted yield curve. However, he advises investors to remain dynamic in their duration positioning, as changes in inflation and rate cycles could provide opportunities in longer-dated bonds.

“Being active and dynamic with your duration positioning is going to be beneficial over the medium to long term,” he said.