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Adam Ditkofsky, I’m vice president and portfolio manager with CIBC Asset Management.
Earlier in the year, right around the time that Covid-19 was becoming a real threat here in Canada, I talked about how significant volatility can pose material risks and opportunities in the bond market. Since the beginning of March, we’ve seen interest rates materially fall, not just in the short end of the curve, where we saw the Bank of Canada and the Fed aggressively cut their overnight rates to essentially zero (Canada now sitting at a quarter of a percent), but also for the longer-dated government bonds. But both the Canadian and U.S. 10-year yields falling by more than 70 basis points, to roughly 0.4% and 0.5% respectably in early August.
So with the drop in yield, the bond market has so far been able to generate another strong year of returns with the FTSE Canada Universe Index being up year-to-date, ending August 31st, 7.7%, which compares to just under 7% for all 2019.
If we look back to the beginning of the year using the average corporate spread for the FTSE Canada Universe Corporate Bond Index, which represents the difference in yield between the Government of Canada bonds and corporate bonds, we can see the spreads rose from their lows of just under 1% in late January to more than two-and-a-half times that, or 2.56%, in late March. And [they] have since retraced about 75% of their widening through the end of August.
So portfolios that have been overweight credit since the widening have seen solid performance, and they benefited from material spread tightening and excess carry relative to government bonds.
Well, obviously a lot has happened in our world to get there. Both the Federal Reserve and the Bank of Canada brought their overnight lending rates to essentially zero. We saw the implementation of quantitative easing in both countries. And, for the first time, the implementation of a corporate bond-buying program — both in the U.S. and Canada — to help reinstill competence in the market, which in early days of the pandemic saw periods where liquidity was close to nothing.
Now, one of the things worth noting: the Bank of Canada put in place it’s $10-billion corporate bond-buying program several weeks after the Fed announced theirs. And since then, it’s barely been used. So then we have to ask the question, was it really needed? Well we’d argue yes. Well, first off it was really the announcement by the U.S. and their program that brought confidence back to the market, but it was also the Canadian program that further drove this confidence [and] continues to support this confidence in our market as well.
Well, if we step forward six months later, to where we are today, we’ve seen a significant amount of stimulus programs put in place in Canada and the U.S., both on the monetary side and on the fiscal side. And gradual re-openings of our economy, leading to improvements in labor conditions, mobility, and spending all being favorable for credit.
Of course, the risks to further spread of Covid-19 remain, especially as we move into the fall and colder months, but it’s important to recognize that through this period, the government has had our back and has demonstrated that they will continue to do what it takes to help Canadians through this uncertain period, which ultimately should keep bond yields low and remain supportive for corporate bonds. Of course, there’s also the other side of the coin. Should we get a successful vaccine, a treatment, or rapid testing solution, all of which are in final testing phases right now, this would also be positive for credit and risk market.
In terms of our outlook over the next 12 months, we have modest return expectation for government of Canada bonds: 0% to 1.5%. Interest rates are already low and, while the Fed and the Bank of Canada has communicated intentions to keep short term interest rates low for some time for the next few years — which is good — there is the possibility that long-term rates could move marginally higher as the recovery continues. But, we have to keep in mind, should interest rates spike meaningfully, it raises the likelihood that the Federal Reserve or the Bank of Canada would step in with potential yield curve control.
So yield curve control essentially means putting a target on long-term yields, which the Fed did in the late 1940s, and Japan has had in place since 2016 on its 10-year yield, which they target zero. So this would cap really any aggressive upward pressure on where rates could go. So we don’t see rates moving aggressively higher in the near term, that would counter what the central banks and the governments have been trying to achieve.
Now, still, even though we’re only expecting modest returns for government bonds, we do believe they continue to have a place in a well-balanced portfolio, as they provide diversification support in risk-off periods. But we do maintain the view that corporate bonds will modestly outperform government bonds in the next 12 months. But we should keep in mind that it likely won’t be as strong as what we’ve seen over the past six months, ending in the end of August, as a lot of the easy money has already been made this year.
In terms of high yield, we believe it does offer good opportunity for investors, however like investment-grade, a lot of easy money has already been made. Spreads have come in significantly from their highs of more than 10% in March, and they’ve retraced about 78% of the widening as of the end of August. But we still think the sector offers attractive spread of approximately, roughly 500 basis points and we believe this sector will outperform Government of Canada bonds and investment-grade credit over the next 12 months. Of course with high yield, fundamental analysis is crucial as many of these companies in the high-yield sector are heavily exposed to industries such as energy, services, and hospitality. So understanding the companies and doing the credit work is key when making these type of investments.
- CIBC Canadian Bond Fund