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Patrick O’Toole, vice-president, global fixed income, CIBC Asset Management.
Back in April, we had recommended increasing exposure to both investment-grade and high-yield corporate bonds, and it’s worked out even better than we thought. It was helped, really, by the Federal Reserve in the U.S. initiating quantitative easing of corporate bonds. So, recall quantitative easing they’ve done in the past for government bonds; they buy government bonds. Now they’re doing it for corporate bonds. They announced that in late March. The Bank of Canada got on that bandwagon as well a couple of weeks later, but it actually hasn’t had to do much. The Fed’s actions really sparked a resurgence in interest in the corporate bond market. The second quarter saw investment-grade corporate bonds in Canada return 8.1%. And in the U.S. high-yield market, they returned about 9.5%.
Now, those are fantastic numbers. But note that while investment grade is still up 5.4% year to date after that disastrous first quarter, the high-yield bond market was still down about 5.7% year to date at the end of the second quarter. So people might ask the question, “Has the opportunity passed regarding the potential for good returns in corporate bonds?” Well, the best opportunity is very likely behind us. The credit spreads, for the extra yield that they offer over the top of government bonds remains much wider than where we began in 2020. Investment-grade corporate bonds ended last year at 101 basis points, or just over 1%, and ended the second quarter at about 1.58%, or 158 basis points, so still 50% higher. And the high-yield market, it ended 2019 at 358 basis points and ended the second quarter at 644 basis points, so 180 basis points higher than where it ended last year. So, there’s still room for those spreads or the extra yield they offer to compress further if the economy does better.
What are we seeing going forward? Well, we’re more optimistic on GDP over the next 12 months than consensus. And that’s actually rare for us. We’ve actually, for the last 10 years in the last cycle, been below consensus on growth for that entire 10-year period. And where we were wrong, we were generally even a little too optimistic, growth came in even softer than we thought. But why are we more optimistic now? There’s several reasons. The Fed and the Bank of Canada acted way faster and with way more force. And this response provided a cushion. Second, the banks are much healthier and better capitalized now. And I always argue that like a house needs a solid foundation, an economy needs a solid banking system. When the banks are healthy, they’re more apt to lend, and that lending provides the grease on the economy’s wheels.
Third non-financial corporations — so non-banks — they have ample access to liquidity, averting a funding crisis. And we saw them really tap the corporate bond market quite strongly in the second quarter to bolster their liquidity level. And fourth, you have governments, too, doing their part, and they’re doing a heck of a lot of heavy lifting. In the U.S., government transfers, things like the paycheck protection program, they tallied about $3.1 trillion. That’s way more than the $1.3 trillion hit to compensation that people estimate from the Covid shutdown. Contrast that with the last recession: compensation from income and unemployment went negative and stayed negative for two years when that recession hit. Not now — compensation is already at new highs, so there’s very powerful ammunition for recovery going forward. And in total, U.S. monetary fiscal stimulus totals about $10 trillion. So it’s an incredible amount of firepower and that swamps the estimated sort of $2 trillion hit from Covid.
And it’s not just the U.S. and Canada that’s been priming the pumps. China’s been pulling out all the stops. Europe just took its first steps toward a fully integrated fiscal union. And that’s very helpful for GDP going forward as well. So in that backdrop, we see corporate bonds doing better in the next 12 months as the economy does better. Government bonds should lag as that economic recovery does happen, and it happens better than what the consensus is currently expecting.
So what does it mean for interest rates? Well, it means a small rise in longer-term government bond yields as you see the economy recover a little better, and investment-grade spreads for corporate bonds move lower and high-yield credit spreads move lower as well. So both handily outperformed government bonds, with high-yield actually winning the day.
But government bonds still have a role to play despite low yields in investor’s portfolios. There’s a lot of uncertainties out there. We could have another wave of infections. You’re seeing some of the resurgence in of some of the U.S. states that could derail the recovery. We’ve been expecting to see some of these flareups, so it’s not really coming as a surprise. But it would mean, if it’s more substantial than we think, bond yields could fall further. The Fed and the Bank of Canada, they could engage in something called yield curve control— it’s being done in Japan for the last several years; the Reserve Bank of Australia started to this year — and that’s the targeting of bond yields at low levels. That would mean they don’t allow yields to go above a certain level. So I would argue, keep some insurance in government bonds against the poor economy. Their role really hasn’t changed. And remember that yields in most of the developed world are still negative, and not here, not in the U.S. So we could see our yields still drag even lower despite the current low levels we see now. But we don’t think yields are going to go negative here for a host of reasons. So looking for diversification of fixed income, look to global bonds. That may provide you some currency exposure and not just U.S. dollar exposure; private debt funds, other things to broaden the set of opportunities and perhaps lower overall volatility from your fixed income returns.