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Opportunities in Fixed Income

September 25, 2023 9 min 13 sec
Adam Ditkofsky, CFA
CIBC Asset Management
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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.

Adam Ditkofsky, senior fixed income portfolio manager, CIBC Asset Management.

Following the Bank of Canada’s decision last week not to increase the policy rate above 5%, not much has changed in terms of our outlook, which leans towards an economic slowdown and a moderate recession.

First, the market was not expecting the bank to hike rates, as recent economic data has been materially softer than expectations, but specifically second quarter GDP came in at minus 0.2% for Q2, well below market expectations, which we’re looking for plus 1.2, and well below the bank’s most recent forecast, which was looking for 1.5%.

A big part of this has been driven by Canadians appearing to be pulling back on spending with retail sales coming in weaker than expected and recent housing activity being softer. So really the question remains, has the bank hiked enough to cool the market, and will inflation, which has been easing this year, continue to come down and normalize around the 2% that both the Bank of Canada and the Fed are hoping to achieve?

Now, if we look at the bank’s most recent comments, they remain somewhat cautious, especially since inflation is still elevated above 2%. So they haven’t ruled out further hikes, but given our outlook, we see them as being close to the end, if not done. A big part of our view in Canada reflects really on the nature of our mortgage system, where most mortgages here renew every five years, leaving Canadians more vulnerable than our U.S. neighbours to higher rates in the near term.

We’re already seeing Canadians pull back. In fact, if you look at GDP on a per capita basis, it’s been negative for four of the past five quarters, with the bank not expecting an improvement until later next year. Canada’s aggressive immigration policy has helped really drive GDP, but at the individual level, Canadians are seeing their net worth actually get worse or deteriorate. To be clear, we’re not saying immigration is bad. We’re simply highlighting that it’s growing faster than our country can accommodate.

Now, I think we have to take into the strong job growth we’ve been seeing, for example, so Canada has added this year more than 300,000 jobs, but unemployment this year has also risen by more than half a percent to five and a half percent. The question we have to ask ourselves, if jobs become less plentiful or start shrinking, will that rate quickly rise if our immigration policies don’t slow? So we argue that the risks of a recession are very real.

Now, in terms of the U.S., the economy has been more resilient, especially since Americans don’t need to refinance their mortgage every five years. They get to lock in rates for the entire life of their mortgage, so they’re less sensitive to changes in interest rates. Still, there are areas of concerns in the U.S. One, pent-up savings from the pandemic are almost used up, and two, credit card debt is rapidly rising, meaning people are borrowing more, with many noting they’re using credit cards to pay their daily expenses. So consumers are running out of steam. But how quickly this plays out will all be dependent on what happens with the job market.

Now, one concern we have is inflation. Now supply chains have normalized and in many regions, rents are coming down, and this is for Canada, but we have been seeing evidence of food prices and energy prices moving modestly higher. So there are dangers that inflation could emerge or stay sticky. We do think inflation will continue to come down over time, but the rapid deceleration we’ve been seeing this year seems to be over. So we think it’s going to stay elevated above 3% for some time.

So while the central banks are close to the end of their hiking cycle, we expect that they will leave rates elevated at current levels for some time, and we aren’t expecting any rate cuts at least until mid 2024.

So from our perspective, we actually see the outlook for fixed income being very favourable. One, recession risks are rising, inflation has come down and should continue to come down over time, albeit at a slower pace. And central banks are close to the end of their hiking cycle. Plus yields are at the highest level they’ve been in more than a decade, offering very competitive rates to GICs. But not only that, you also get the added benefit of more efficient tax returns versus GICs, as most bonds today are trading at a discount and benefit from the potential of price appreciation as they move closer to maturity.

Also, on top of that, there’s also the potential for further price appreciation should the economy slow further and yields fall. So bond investors could get returns in the range of five to seven percent without even taking any significant duration risk.

Aside from rates, of course we’re watching what happens with inflation, and yes, we are paying attention to food and energy prices. But in our view, we think core CPI is more relevant and it reflects what central banks can control, as really food and energy are more driven by supply and demand factors.

Now, I’d argue in Canada we should also exclude shelter costs, which have also benefited from a lack of residential supply and are impacted by rising mortgage costs, which are up more than 30% year over year. So core CPI at shelter has returned, in fact, to more normalized levels. In fact, most recent data print was seeing an increase of 2.5% year over year, and over the past three months, it’s been trending below 2%.

Now, I think it’s also important that we watch labour data, which yes, is a lagging indicator, but it’s resilience partially explains why consumers, especially in the U.S., continue to be confident with their spending patterns. Ultimately, consumers can continue to pay their mortgage and pay down credit card bills so long as they have a job. Now, from our perspective, though we are seeing some cracks, one, the number of job vacancies are coming down in the U.S. and in Canada. In the U.S. the number of jobs available to the number of people who are unemployed has fallen from a high level of above two times to now most recently one and a half times. And salaries for new hires are coming down year over year as well, according to major recruiting firms. And probably the most important, corporate profits are continuing to fall with the S&P 500 seeing the largest decline in Q2 since 2020. If profits don’t improve, it should cause layoffs as companies look to support their stock prices.

In terms of bonds that look the most attractive, we particularly like bonds in the shorter end of the yield curve, as again, the yield curve is inverted, meaning investors getting higher yields in bonds with shorter maturities that are less sensitive to changes in interest rates.

Now, given our view of a slowing economy, we believe over time shorter dated rates will return to more normalized levels, meaning yields will be lower. So investors in short bonds, call it one to five years, five to 10 year bonds will benefit. Now, we also like short-dated investment grade corporate bonds, with some of the banks and the most liquid investment grade securities offering yields north of 6% for some of these bonds. Now, of course, bottom-up analysis is key to ensure credit fundamentals are sound, so having a strong credit team doing the work with you is necessary.

In terms of other opportunities, we also like private debt securities and emerging market debt in some cases as well, depending on the specific countries. As well as some alternatives as well, because generally in those situations we are seeing spreads being materially wider than some investment grade bonds, and those maturities actually tend to be actually shorter in nature. Specifically if we look at private debt, some of those that we are looking at are involved in infrastructure for energy infrastructure, as well as data centres and the movement of data across the internet across various different internet protocols. So there’s a lot of opportunities in that space that we see being high quality counterparties and offering quite attractive spreads relative to government bond yields and offering increased yield enhancements for our portfolios.

In some cases, even for portfolios that allow derivatives, we also see some opportunities as well because they allow us to focus our carry and shorter dated government bonds, meaning that we can actually go out and buy short-dated, call it one-year bonds, at yields north of 5%. But, we can still get that duration exposure by using derivatives in the portfolio so that we aren’t potentially reducing that hedge against the potential for increased recession risks. So there are a lot of opportunities right now in our purview to really increase the yield within our portfolios, and that’s what we’re trying to do, because ultimately that’s what investors are looking for today.

In terms of bonds that may not provide much yield, we are cautious on high yield as spreads are sub 400 basis points. In times of stress, high yield spreads have been materially higher, meaning they could materially sell off if we see a material slowdown. And given our economic outlook, we are more cautious and have reduced our exposure to the sector.

Now, we’re also cautious on longer dated corporate bonds, not just because the yield curve is inverted, but credit spreads also can move wider and push bond prices lower if recession risks rise. So we’re maintaining an underweight in longer dated corporate bonds.

Ultimately, our view is to focus on shorter dated, higher quality risk assets, which in today’s environment with the yield curve being inverted, the bond market is paying you to do.