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Patrick O’Toole, vice-president, global fixed income, CIBC Asset Management.
Last year, we said a recovering economy should help corporate bonds. And in the last year to May 31st of this year, corporate bonds have returned a positive 2.6%, while Government of Canada bonds have returned negative 4.4%, and provincial bonds returned a negative 3.5%. So corporate bonds were the big winner. And that happened because the economy was strong, leading to solid corporate profits, making it easier for companies to finance and pay debt.
Today, our starting point isn’t quite as good for corporate bonds to outperform government bonds to such an extent as we saw in the last year. In other words, the extra yield that corporate bonds offer over and above government bonds isn’t as attractive as it was a year ago. However, we still expect with great growth in the next 12 months, growth is still going to be above the long-run trend of 2% and nominal GDP will likely be in the double-digit zone for the next couple of quarters or longer. We haven’t really seen that since the high inflation years of the 1980s. So the backdrop remains good for corporate Canada and corporate America, and that means demand should remain solid for corporate bonds, meaning the average credit spread can decline somewhat. And the result then is better returns from corporate bonds versus government bonds over the next year. There is a risk of default on corporate bonds outside of what you see. There really is no risk for default on government bonds. But for corporate bonds, default risk is not really an issue for investment grade debt. It can be in the high yield corporate bond market. However, we just saw last week that JP Morgan dropped its forecast and expected defaults from 2% down to 0.6% for this year, so that’s good news. And the long-term average is 3.6%. And for 2022, they still see a low default rate of only 1.25%. So really not much to worry about there. And that’s really not that surprising given how strong GDP is expected to be, given that many corporations have taken advantage of low yields to call and refinance debt. And that extends their average term to maturity, thereby reducing default risk.
But it’s also not surprising it’s forecasts are falling given that the government support provided to companies and individuals since the pandemic hit is quite extensive. The challenges for the corporate bond market or the high yield corporate bond market in particular to be in 2022 and 2023 if growth slows sharply and companies have bonds to refinance. We also see that credit market debt to equity for non-financial corporations in the U.S. is at record lows, and that’s data going back 65 years. And looking at how flush corporations are, their cash holdings among S&P500 companies are at record highs. So they’re more flush than they’ve ever been.
So for the next year, we see a green light for the high yield-sector as well. That doesn’t mean you can be complacent in high yield so you have to be very well diversified and know the company. And we’ll be looking at the maturity wall for high-yield companies, avoiding those companies where refinancing could be a risk or where the sector risks are increasing. While we’re overweight in things like the basic industry sector in the high yield market, we’re watching to ensure the recovery is not going to falter. We still think it’s prudent to remain underweight U.S. REITs given the shifting consumer and office space dynamics.
Regarding other risks out there for investors, there are always several risks. Number one, the economy could slow sharply and that’s more possible in the later 2022. We we expect nominal GDP to be double digits the next several quarters. We expect it to be less than half what it is now in one year, less than a quarter of what we’re seeing in the second quarter this year, or the middle of 2023.
The second risk is there could be a more material retreat and commodity prices. Corporate bonds in the energy sector in particular have been doing great for high yield corporate bond sector. That can change quickly if oil price retreats. But a strong economy is actually supportive for oil for now.
A third risk is that the Fed taper program could cause some problems. The Fed is expected to let us know something this year regarding the timing of when they start reducing quantitative easing. We think they’ll start next year and cut the current $120 billion per month of buying of treasuries and mortgage-backed securities about half that by the end of 2022. When they announced in 2013 that they were going to taper their bond purchases, the bond market took it hard. But we think they’re setting the stage better this time. Notwithstanding that there still could be a negative reaction.
The fourth risk is, and probably the biggest risk, is that inflation doesn’t prove to be transitory. That should result in bond yields and credit spreads going higher and stocks going down. And why would that happen? Well it would happen because the Fed would have it wrong. If the fed is wrong, that’s only not good for the bulk of financial assets. I mean, if the inflation genie gets out of the bottle, we’re not talking something like the 1970s, where you have double-digit inflation necessarily, but it could be tough to get it back in the bottle. But we’ve been hearing that inflation is coming back for 30 years. It’s here now. We expect it back at 2% in a year. So we think the fed will be right in their guidance that inflation will prove to be transitory. And the Fed gets a lot wrong, but we think they have it right this time.