Bonds to offer modest returns in year ahead

Investors should expect modest returns for government and corporate bonds in the next 12 months, as both the Bank of Canada and the Federal Reserve intend to keep short-term interest rates low for some time.

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“We don’t see rates moving aggressively higher in the near term. That would counter what the central banks and the governments have been trying to achieve,” says Adam Ditkofsky, vice-president and portfolio manager at CIBC Asset Management.

Long-term rates could “move marginally higher as the recovery continues,” he said, in which case both central banks are likely to step up and provide yield curve control.

That means targetting particular maturities and capping any “aggressive upward pressure” on rates, Ditkofsky said during an early September interview.

As such, he predicts 0% to 1.5% returns for Canadian government bonds, adding that those instruments are best-suited to “provide diversification support in risk-off periods.”

Corporate bonds are a little more attractive, and they’re likely to “modestly outperform government bonds in the next 12 months,” Ditkofsky said.

However, he cautions that returns for corporates won’t be as strong as in the past six months, when central bank bond-buying propped up the market.

Spreads between government and corporate bonds rose from lows of just under 1% in late January to 2.56% in late March, Ditkofsky said.

Spreads have since “retraced about 75% of their widening through the end of August.”

“Portfolios that have been overweight credit since the widening have seen solid performance, and they benefited from material spread tightening and excess carry relative to government bonds,” he said, but the picture isn’t as rosy going forward.

High-yield bonds are most attractive, though spreads have also tightened in that area, said Ditkofsky, who co-manages the CIBC Canadian Bond Fund.

“Spreads have come in significantly from their highs of more than 10% in March, and they’ve retraced about 78% of the widening as of the end of August,” he said. “But we still think the sector offers attractive spread of approximately […] 500 basis points.”

What’s important in that space is company-level analysis.

“Many of these companies in the high-yield sector are heavily exposed to industries such as energy, services and hospitality,” Ditkofsky said. “So understanding the companies and doing the credit work is key.”

As central banks and governments pull back on stimulus, Ditkofsky is monitoring how the re-opening of the economy affects labour conditions, mobility and spending. Improvements in any or all of these metrics is “favourable for credit,” he said.

While spread of Covid-19 remains a risk, “the government has had our back,” which “should keep bond yields low and remain supportive for corporate bonds” as the search for a vaccine continues.

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