Bond Risks and Opportunities

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Editor’s note: This podcast was recorded on March 11.

Text transcript

Adam Ditkofsky. I’m a portfolio manager and vice-president with CIBC Asset Management in the fixed income group.

The impact of coronavirus on bond yields in Canada has been significant. We’ve seen Canadian bond yields fall to record low levels, with both the 10-year bonds and 30-year bonds in Canada moving below 1%, and credit spreads widening to levels not seen since early 2018—which at the time we saw as a decent buying opportunity. So far this year, overall bond returns have far exceeded expectations of even the largest bear forecasters, which demonstrates their ongoing importance in a balanced portfolio, given the weakness we’re seeing right now in equity markets. But it’s really a global situation that is impacting the market. While China and South Korea seem to have contained the spread within its borders, it’s the ongoing spread across the globe, which continues to impact markets. Ultimately, the real issue is that the impact of the virus on global GDP is difficult to model, so markets are pricing in significant downsides and assuming the worst.

While economic recovery is still not known as the virus continues to spread and the death toll rises, the question is whether we’ll have a V-shaped recovery or a U-shaped recovery over time. We’re of the view that the U-shaped recovery is ultimately more likely. While stocks may at some point recover fairly quickly, given therapid decline we’ve seen, bonds will likely only see a modest backup in yields, as the full impact of the virus on global GDP unfolds over time. The impact on GDP is already being felt. We’re seeing events being cancelled, people are reducing travel and hoarding of goods and medications is definitely happening in people’s homes.

Corporate bond spreads have also materially widened from their recent lows, with the primary market requiring significant concessions to remain open. Still, deals continue to be done with decent investor appetite, although at this time it’s really on a day-by-day basis. One example was on March 10. We saw Bank of Nova Scotia reopen a three-year deposit note 50 basis points wider than where it had been priced in the market a month earlier. At the time, the deal came with a 10-basis-point concession. Now, granted the deal went well. The market required a very large concession to absorb the issue. But we still need to keep in mind that despite spreads being materially wider, overall funding costs were very low, so it’s still beneficial to the issuer to come in this market.

Now, despite the increased risk in the market, this spread widening does prompt us to see opportunities to add credit, especially you see some credit spreads widening by 25 to 40 basis points in a day. We definitely have capacity to add opportunistically, but we’re being careful, given the volatility right now. High yield also offers attractive opportunities, especially with spreads above 600 basis points. We’ve been modestly adding to our high yield weight, but at this stage we’re being cautious given the uncertainty in the market.

The potential impact on bonds will largely depend on the spread of the virus. Specifically, its speed and breadth. At this point, fears of uncontrollable containment are significant and bond yields are continuing to move lower. We’ve already seen a significant stimulus in both the U.S. and Canada, and further actions are expected, and already being priced into the market. Corporate bond spreads will likely continue to remain elevated until competence returns. I also think it’s definitely safe to say that 0% interest rates from the Fed and the Bank of Canada are real possibility and could be reached fairly quickly if conditions continue to deteriorate. I’d also note that U.S. has already been there from 2008 to 2015 and Canada has seen its overnight rate as low as 50 basis points, which I think is important to remember as central banks have been at these levels before. Ultimately, we have already seen actions by central banks to help stimulate the market by cutting rates, but it brings up the questions: do lower rates really provide stimulus when people are afraid to leave their home?

I would argue it does as we’ve already seen a massive increase in mortgage applications and refinancings in the U.S. as rates move lower. And with lower rates, it definitely reduces the increased finance burden for corporate borrowers as their results slow down. But the market is clearly indicating that it wants something more, be it through fiscal spending or even personal tax cuts. We’d also argue that other forms of monetary stimulus are available, such as quantitative easing, additional overnight liquidity, yield targeting for specific parts of the yield curve, and even corporate bond buying, which we’ve seen been done both in Europe and Japan. So, really there are a lot of tools left for governments to take actions and rejuvenate the confidence in the market.