An improving economy should provide a good backdrop for corporate bonds in the coming year, but lagging government bonds will remain a valuable part of portfolios, says CIBC’s Patrick O’Toole.
Central banks’ response to the Covid-19 pandemic “sparked a resurgence in interest” in corporate bonds, said O’Toole, vice-president, global fixed income at CIBC Asset Management.
Investment-grade corporate bonds in Canada returned 8.1% in the second quarter, he said in a late-July interview, while U.S. high yield returned about 9.5% in the same period. The question now, however, is whether the moment for strong returns in corporate bonds has passed.
“The best opportunity is very likely behind us,” said O’Toole, who manages the CIBC Canadian Bond Fund and the Renaissance Corporate Bond Fund.
Credit spreads for investment-grade corporate bonds ended the second quarter at around 158 basis points, or 50% higher than at the start of the year, he said. High-yield spreads were 180 basis points higher on June 30 than at the start of the year.
“There’s still room for those spreads, or the extra yield they offer, to compress further if the economy does better,” O’Toole said.
And he’s betting on a stronger economy. In addition to the cushion from central banks and “heavy lifting” from government fiscal programs, he said banks are healthy and well-capitalized.
“When the banks are healthy, they’re more apt to lend, and that lending provides the grease on the economy’s wheels,” he explained.
With access to liquidity, companies were able to avert a funding crisis during the Covid-19 lockdowns, he said. “We saw them really tap the corporate bond market quite strongly in the second quarter to bolster their liquidity level.”
O’Toole is more optimistic than consensus on GDP growth in the coming year.
In its latest monetary policy report, the Bank of Canada provided domestic real GDP projections of -7.8% for 2020, 5.1% for 2021 and 3.7% for 2022.
“We see corporate bonds doing better in the next 12 months as the economy does better,” he said. “Government bonds should lag as that economic recovery happens — and it happens better than what the consensus is currently expecting.”
With the recovery, long-term government bond yields will rise slightly, and spreads for investment-grade and high-yield bonds will move lower, O’Toole predicted.
Despite their low yields, government bonds still have a role in portfolios because of the uncertain economic outlook, O’Toole said.
Governments have demonstrated “an incredible amount of firepower” in the fiscal stimulus to dampen the economic impact of Covid-19, he said, but many are concerned about what happens when those programs expire.
The U.S. Congress hasn’t been able to agree on a new stimulus package after the US$600 weekly jobless benefit expired last month. President Donald Trump has issued executive orders that he said will address some of the shortfall.
A more substantial virus resurgence than what’s currently expected could lead bond yields to fall further and force central banks to adopt yield curve control — targeting low bond yields and not allowing them to rise above certain levels, O’Toole cautioned.
While there’s room for yields on North American bonds to move lower, he doesn’t expect them to go into negative territory.
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