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Patrick O’Toole, vice president fixed income, CIBC Asset Management.
Last year we had said that corporate bonds were flashing a healthy signal for investors, and they were given the expected strength in the economy and some inflation that was evident last year. And the economy did do great, making it easier for companies to remain profitable and easier for them to finance their operations in the bond market. And corporate bonds did outperform government bonds last year, although all sectors of the market posted negative returns. But corporate bonds still did better.
But the rising government bond yields that we’ve seen of late has really derailed the returns on corporate bonds. And that’s because high-quality corporate bonds, they really take their cues from the government bond market. So if government bond yields rise like they did late last year and this year due to rising concerns about inflation and the expected rate hikes from the central banks to try and combat it, the corporate bond yields generally rise in sympathy, and we’ve seen that.
However, sometimes their yields rise less as investors see a good economic backdrop, meaning less risk for corporate debt. But that hasn’t happened and corporate bonds have suffered this year. And the good news for investors is that the higher yields and increased credit spreads mean that the high-quality corporate bond sector is the most attractive it’s been in years. For example, the yield on corporate bonds and the benchmark in Canada, that’s all investment-grade, high-quality corporate bonds, it’s almost 5%, and that’s the highest yield we’ve seen since 2009.
Now, it’s also constructive given our indicators remain healthy for investing in corporate bonds, but we could continue to see higher yields. Risk is never gone. Risk never totally vanishes. And we could see inflation remain more persistent, meaning central banks go further than we think in raising rates, or we could see them go too far and potentially cause a recession. But regardless, it’s still a good time to look at increasing exposures to bonds and high-quality corporate bonds as well. The yield on them has more than tripled since the beginning of 2021. That’s both on corporate bonds and on the benchmark in Canada. So they offer more protection now to investors given the yields are so much higher. In effect, bonds have gone on sale and investors should be looking to increase their exposure to bonds now.
So we looked at the rise in yields and the rise in credit spreads, just to give you an example. We look at the highest-quality Canadian bank paper. So the big five banks, they all offer yields around the same level when they issue bonds. The extra yield they offer on Government of Canada bonds, what we call the credit spread, that was down to almost 70 basis points or 0.7% in Q4 of 2021. Looking today, those credit spreads are over 1.5% above Government of Canada bond yields. So if you look at a five-year Government of Canada yield today around mid-June, they’re around 3.5. You could add in another 1.6%. So you’re getting above 5% now on the highest-quality corporate debt in the Canadian marketplace. So it’s become fairly attractive.
Now, that does reflect higher risk. Of course, the people are more worried about a recession coming, et cetera, or the housing market moving down. And those, of course, would have negative implications for bank profitability. But banks are still much healthier today than where they were in years past. So we don’t think the risks are really as severe. We find these levels very, very attractive for investors in today’s marketplace.
Another thing that’s attractive at the present time is even provincial debt. So usually, we focus on corporate bonds because they offer higher yields than provincial bonds even, but we’re to the point today in mid-June where a long-term Province of Ontario bond offers a full percent yield above a long-term Government of Canada bond. And that’s getting increasingly attractive as well. So we’re starting to become more receptive towards looking at adding provincial bonds to our clients’ portfolios alongside potentially increasing our corporate exposure as well.