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Patrick O’Toole, vice president, CIBC Global Asset Management.
When the coronavirus first hit Western countries, there was some concern about corporate bonds triggering a broader financial crisis. Now, that concern has somewhat subsided, but it’s a bit of a yes and no answer. It’s yes really for the investment grade sector. And if you look at investment-grade corporate bonds, let’s start with the U.S.

Investment grade spreads hit a low of 93 basis points earlier this year, so just a little below 1%, and they hit a high of 373 basis points at the height of the panic, and they’ve since moved down to about 209 basis points. So they’ve recovered a lot of lost ground.

And why have we seen this improvement? Well, the Federal Reserve in the U.S. a couple of weeks ago announced a primary and secondary corporate bond buyback program. And that really helped put a ceiling on spreads as investors now perceived that there’s a large buyer, the Federal Reserve, will soon become engaged in the marketplace and be purchasing investment-grade corporate bonds.

What did we see in Canada? Well, we saw a low, similar to the U.S., around 100 basis points, and we saw a high much lower than the U.S. did. We went up to about 274 basis points, so about 100 basis points lower than the U.S. did. But we have moved lower as well, sitting almost the same as the U.S. We’re sitting at 207 basis points today.

So Canada’s market really has been helped by this Federal Reserve doing that corporate bond buyback program, but it’s also been helped by the announcement from the Bank of Canada recently that, and it was a surprise to most investors in the marketplace, that they’re going to do a secondary bond market buyback program of $10 billion worth of investment grade corporate bonds. That’s been a big help, and we’ve been telling the Bank of Canada a couple of weeks ago that this program was needed. The market hadn’t seized up. Now the Federal Reserve, I really think got things going, but it’s good to see the Bank of Canada has responded as well.

So even though there’s been this improvement, we think there’s still opportunities here. Yes, the worst we think is behind us for investment grade, but that unfortunately does mean the best buying opportunity is probably behind us. It doesn’t mean that corporate bonds still aren’t attractive. We think they’re very attractive today. Those yield spreads or corporate spreads are still about double what the spread was earlier in 2020, so they’re still very attractive.

Now when I said yes and no, has this concern subsided, it’s really maybe no for the high-yield sector. Why is that? Well, there’s been no buyback programs of corporate bonds for high-yield bonds in Canada or the U.S. In the U.S., there’s a little bit because there’s the buyback program they implemented includes those what they call fallen angels, and those are companies that were investment grade before March 22nd, but have since been downgraded to the high-yield space. So it includes Ford and Macy’s, so they’ll still be part of that bond buyback program. So a little bit of the high-yield market is open to the Feds’ buyback program, but the high-yield market, it’s more susceptible to stock market gyrations than investment grade is now in our view.

So, yes, we’ve seen the stock market improve, and it’s bounced more than 20% off the lows that we saw for the TSX and the S&P. They both went down around a little over 33-34%. But what we’ve seen this last cycle was that old buy the dip mentality, which really was what everybody was doing during the bull market. That may not work in a bear market. Bear markets, you generally see a retesting of the lows, or even deeper lows after a strong rebound, and so far what we’ve seen is just a strong rebound.

We haven’t really seen earnings estimates revised down sharply yet. It may be that markets are just, or investors are just looking past all of this to 2021 when whatever the new normal is occurs. But we expect that, as the pain that companies experience is reflected in earnings and valuations adjust, you’re going to get more volatility in the stock market, and that should be reflected in the high-yield market as well. So there’s still the risk for high-yield spreads to revisit the peaks that we’ve seen recently.

Well, there is another potential worst-case scenario for corporate bonds, and that would be another wave of infections without having a treatment or a vaccine in our view. So that would result in the reclosing of businesses, assuming we see them reopen here first, and that would mean more prolonged damage to those that actually survived the first wave.

It also means it’s less likely we’ll see a meaningful bounce to GDP. We’d likely see more defaults and more downgrades as corporate bonds results as well. And investors in that environment will rush back to the safety of government bonds. Credit spreads could move to new highs.

Now, having said that, we don’t expect this scenario. We have seen a very strong response from governments and central banks, really stepping in forcefully, and they would likely go even farther to stabilize sentiment should we have a second wave. We’ve said many times in this last expansion, never underestimate the ability of governments and central banks to come up with new programs, to backstop companies and the economy. And that’s what we continue to see.

Our outlook for high-yield bonds is actually constructive. Yes, we do see the potential for a second wave of spread widening. As I talked about earlier, you could see the potential that the stock market could go down and retest the lows, make new lows, and that could result in higher spreads.

But we expect that defaults are going to spike in the coming months as well. But that the risks are largely priced into most of those extremely levered, most exposed high-yield companies. So today’s entry levels are still very attractive, but in a high yield you need to be really careful about which companies’ bonds that you buy. So you have to really do a lot of good bottom-up analysis and be very comfortable with the companies you’re buying that they can survive, make their coupon payments, and be able to refinance debt.
But we forecast that if high-yield spreads … I mean they ended the first quarter of 2020 at 873 basis points. They moved up to about 1,080. They’ve moved down to about in the low 700s. But we think that in the next year or so, if we get those high-yield spreads back to stay in the low 700s, the sector could actually provide very high single-digit, maybe even low double-digit returns, over the 12-month period, to the end of the first quarter of 2021.

Funds:
Renaissance Optimal Income Portfolio
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