Opportunities in Corporate Bonds

Text transcript

Welcome to Advisor ToGo, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Pablo Martinez, vice-president and portfolio manager, CIBC Asset Management. 

The outlook for bonds in 2024 is quite appealing. What we are telling our investors right now is that bonds are in vogue; bonds are in style and appealing. After years of financial repression where central banks kept rates very low to stimulate growth, bond yields are finally attractive. 

And when we compare them to dividend yields, and compare dividend yields with bond yields, bond yields are trading at multiple what the dividend yields on stock market is giving you. So, yes, bond yields are appealing on an overall yield basis, but also they are appealing because of our outlook on the market. 

Basically, we’re not expecting the bond market to trade elsewhere than in a range for the year 2024. So, basically we’re not expecting yields to move up significantly higher, nor do we expect yields to move down significantly lower. So, the main reason why we don’t believe rates will move significantly higher is that we don’t expect the U.S. economy and the Canadian economy to provide the good performance that we saw last year. 

Last year, we were quite surprised by the economic growth in the U.S. And that growth has been spurred by a very strong consumer in the U.S., and we’re expecting this year that the impacts of the cumulative interest rate increases by the Federal Reserve will be felt by consumers. So, if we look back at 2023, the very strong consumers can be explained mostly by the fact that consumers dug in to their savings to finance their purchases, and also consumers use revolving credit to finance their purchases. 

So, when you look at this, this is not something that’s sustainable long term. So, we’re not expecting a significant drop in economic activity. We’re just expecting things to slow down in the U.S. mostly because rates are affecting the consumer’s propensity to consume. The same thing can be said about the Canadian consumer, and actually the Canadian consumer is suffering even more from higher rates because when we look at the mortgage rate in Canada, it’s directly affected by the overnight rate from the central banks. 

So, the central bank in Canada has been on a hiking cycle, and it is affecting the mortgage rates for Canadians that do have a mortgage. So, those consumers have less income to spend on discretionary spending.  

So, that’s why we’re expecting growth, yes, to be positive, but not as much as it was last year, which will keep rates from moving significantly higher. 

On the downside, we’re not really expecting rates to move down quite quickly, mainly because inflation remains sticky. So, we have seen at the end of last year, the market’s starting to expect very dramatic drops in interest rates from central banks. And what we are realizing now is that we are in an environment where rates will remain higher than what the market earlier expected, mostly because inflation is sticky. It’s sticky mostly because wages remain high. The wage rate in the U.S. and the wage rate in Canada are too high to attain that 2% target right now. 

So, we are expecting rates, yes, to move slowly down, but not in a dramatic fashion as what the market was expecting at the end of last year. So, that’s why we’re expecting rates to trade in a range. And that range right now is quite appealing to consumers, because the yield that’s provided by bonds right now compared to what we’re getting from riskier assets is quite interesting. So, you can invest in bonds right now, which will get you the security you need in an environment of where risk assets are very pricey and also get a very attractive yield. 

Very interesting to see how inflation and interest rates are impacting corporate bonds. So, we know that, and we have seen this in 2022, when inflation spikes higher, interest rates also spike higher and that is affecting bonds negatively. And we believe that this is something that has banged us. Now we have to look at the future. So what we see now is that inflation right now can be advantageous for corporations in the sense that normally higher inflation is associated with increasing revenue, and increasing revenue means better ability to service debt. So, an increasing inflation, or inflation that’s relatively high, is normally good for corporate bonds.  

And also, when corporations are issuing debt, every month that passes with the passage of time and inflation, each coupon payment is being paid by nominal dollars, which are affected by inflation. So, in real terms, every time that a corporation pays coupon, they’re paying less in real dollars. 

So, inflation is affecting corporate bonds positively in that sense.  

Mind you, higher interest rates will have an effect on the bottom line of corporations that are issuing new debt, because they are issuing debt at this new higher level. That being said, a lot of corporations have borrowed during the time where rates were very low. So, when central banks dropped rates very low during the pandemic, a lot of corporations went in and turned out their debt. So, they don’t really need to issue as much right now that rates are higher, because they already issued longer-term bonds when rates were low. So, that is providing the flexibility that corporations need to be able to increase profits and also service debt. 

Now, what does that mean for investors? 

So obviously, inflation has led to higher rates, and those rates have been damaging on the way up to bond investors, let it be in government debt and also in corporate debt. 

But now that rates are higher, we have to stress the fact that corporate debt is trading at a spread to government debt, which means that it’s increasing the overall yield that we’re getting out of those products. 

What opportunities exist out there? 

We have seen a dramatic shift in the fixed-income market in the past two, two and a half years. We have seen interest rates increase quite a lot, and also we have seen an inverted yield curve, which does create a good opportunity, especially at the short end of the corporate bond market. So, this shift in yield and this change in curve is providing us with three opportunities from the market. 

First, the inverted yield curve means that short-term securities trade at a higher yield than long-term securities. So that short end of the corporate bond yield curve is quite appealing. Second, corporate bonds at this part of the curve offer an attractive spread, so it enhances the all-in yield of these securities. 

And thirdly, and that’s something that I find very interesting, is that those bonds in this part of the curve have been issued maybe two, three, four years ago, when rates were lower. So as rates moved up, those bonds right now are trading at a discount, so they’re not trading at $100, they’re trading at $92, $93, $94. And as those bonds, short-term bonds, move closer to par, that price movement between the discount and the par price is fiscally advantageous. 

And that’s why at the bank we came out with target date funds. So, we have three sleeves of short-term corporate bond funds, 2025, 2026 and 2027, in which we invest in very short corporate bonds that are trading at a discount. As the yield curve is inverted, short-term securities provide a higher yield than longer-term securities and also are less risky in the event of a downturn. 

We have to remember that the duration on the longer-term security is much higher, which means that the downside is quite elevated in the case of adverse conditions. So, we believe that the relative value of those longer-term corporate bonds are not worth really the risk. We’re not really being compensated enough to hold longer-term corporate securities compared to shorter-term securities. 

We often compare the longer-term security yield on corporate bonds with provincial bonds, and right now that spread is very tight, so tight that really it doesn’t pay that much to be holding those bonds compared to provincial bonds. So that’s why we prefer that shorter end of the corporate bond yield curve. 

When we look at sectors right now, at this point in the cycle, we tend to prefer slightly more conservative sectors that would provide security for our investors in very uncertain times. 

We are at an all-time high in a lot of equity markets, and we are looking at this and we’re seeing the economy somewhat slowing down, higher rates starting to pinch consumers and corporations. So, we tend to prefer more conservative sectors that are offering an appealing yield. We’re looking at energy, for example, telecom and infrastructure. 

We are a bit more negative and we’re reducing sectors that will be more vulnerable to downturns in this post-Covid economy. We’re talking here about retail and especially office REITS. We have to realize that a lot of things have changed in this post-Covid environment, and office REITS provide a lot of risk compared to the returns that are being provided right now. 

In this very uncertain and exciting environment in the bond market, how do investors protect themselves? Well, obviously, I’m pretty sure that all of my colleagues would say the same thing, that we need to diversify the risk here. We need to allocate part of our portfolios, obviously, to fixed-income securities. 

It used to be very painful to buy fixed-income securities when rates were very low. The opportunity cost was very high because we were moving away from asset classes that were providing good yield and good potential return into a market — way back when — when yields were very low. This is not the case anymore. Financial repression is now a thing of the past. Investors are now properly compensated by investing in bonds. So, we can get into this bond market, which offers more security and also an attractive yield compared to much riskier assets that are right now very close if not at the top of the recent cycle. 

As well another way to protect ourselves, obviously, is to stay away from the parts of the market that are expensive. We are looking, obviously, at longer-term corporate bonds in Canada. As well, we need to take care at the sectors in which we are invested in. Some parts of the REIT market, for example, office REITs, will be under pressure in this new post-Covid normal, and as interest rates are staying higher for longer, well, those markets are showing some risk.