After an unusually punishing year, bond investors are tentatively coming out of hiding and wondering if they can once again trust the “safe” part of their portfolio.
“Prior to the fall, we were talking most clients off the ledge,” said Mark Wisniewski, partner and portfolio manager with Ninepoint Partners LP in Toronto.
Some were ready to throw in the towel, talking about taking capital losses on fixed income with broad bond indexes down double digits for the year. Wisniewski advised against such action.
“Now, conversations have shifted and more people want to talk to us about the opportunities,” he said. “The dialogue has changed significantly in the last month.”
Surging inflation and monetary tightening have visited simultaneous pain on equities and bonds this year, robbing investors of the ballast they’ve come to expect from the fixed income portion of their portfolios.
“I feel for the people who thought they were in 100% safety,” said Rob Pollard, senior vice-president and portfolio manager with The Wyndham Group, Raymond James Ltd., in Toronto.
“This isn’t what they signed up for. It’s one thing when an equity portfolio goes down.”
But after reaching 40-year highs this summer, inflation — which led to this year’s coordinated declines in stocks and bonds — has shown signs of slowing in Canada and the U.S. This has led to a growing “bonds are back” crowd.
With inflation less scary, a pause from central banks more likely and a recession on most forecasts for 2023, bonds could once again provide the yield and protection investors seek.
“The reset in fixed income this year has been brutal, but it was necessary,” JPMorgan’s 2023 outlook report said. “After the pain of 2022, the ability for investors to build diversified portfolios is now the strongest in over a decade. Fixed income deserves its place in the multi-asset toolkit once again.”
Kunal Mehta, head of fixed income for Vanguard Europe, said inflationary risk is largely priced into markets now, but a growth shock is still possible. For that reason, he thinks investment-grade corporate bonds are well placed to benefit in a recession.
“If there’s a flight to quality, investment grade is likely to benefit from a technical standpoint,” he said.
Phil Mesman, portfolio manager and head of fixed income with Picton Mahoney Asset Management in Toronto, agreed that investment-grade corporates yielding around 5% provide a good entry point for bond investors. Many companies refinanced at low rates during the pandemic and balance sheets are strong, he said.
With many high-quality corporates now offering a higher yield than dividend stocks, Wisniewski said the case for bonds is “quite compelling.” Canadian banks, with basically no default risk, are a “no-brainer,” he said.
“The real sweet spot right now is around the five-year area,” he said, as an inverted yield curve means investors aren’t being paid enough for longer-dated bonds.
Mesman said there’s still too much uncertainty around interest rates and a recession to go further out than five years.
“It’s such an important question for advisors: When do you step back in and buy duration?” he said. “It doesn’t feel like at least for the next several months we’re going to have any clarity on the direction from central banks. There’s still a lot of uncertainty and we’re very data-dependent.”
Mehta, however, said his team is beginning to move into durations of six to eight years. The benefits of shorter duration have been largely priced in, he said, and longer-dated bonds “offer much more of a buffer against a growth shock.”
With a potential recession posing risks for high-yield bonds, Mesman and Wisniewski prefer hedging investment-grade for investors seeking additional yield.
“The beauty of the environment we’re in right now is, because credit has become so cheap, I can now use that leverage to buy more cheap securities and generate more yield,” Wisniewski said.
Mesman said hedging can protect against the risk from a recession and interest rates, but also provide alpha. Central banks have removed liquidity, creating a “credit picker’s market.”
“Given the growth of passive investing in fixed income, people don’t read covenants and financial statements like they used to,” he said. “There’s a bit of an alpha opportunity in digging into the weeds.”
Still, some investors will be happy to take the yield that the safest and simplest fixed income investments are once again offering. Ten-year U.S. Treasuries, which began the year yielding 1.6%, are now around 3.7%; the yield on 10-year Government of Canada bonds is close to 3%.
Pollard said it’s a great environment for clients not looking for risk, with three-year GICs yielding 5%.
“We’re building those ladders like crazy right now for clients,” he said.
And after years of searching for yield and shifting allocations toward dividend-paying equities because bonds weren’t offering anything, he said he’s gradually increasing some clients’ fixed income holdings.