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Adam Ditkofsky, portfolio manager of fixed income, CIBC Asset Management.
So, in terms of what’s transpired in the corporate bond market so far this year, we’ve seen credit spread, which represents the excess yield paid on a corporate bond over government bond, move materially wider. And this is a reflection of inflation being elevated and interest rates continuing to rise sharply. Last year, we started seeing corporate bond spreads rise in November, as markets became increasingly concerned that central banks had let inflation run too high, and that both the Fed and the Bank of Canada would aggressively need to raise their policy rate and taper their balance sheet. This means reducing stimulus and increasing the risk of a policy error, which means that the central bank actions would inadvertently cause a recession. Now, by early March of this year, credit spreads had already widened by 40 to 50 basis points, with the FTSE Canada Universe Corporate Bond Index reaching a wide of 150 basis points on March 8th, compared to 105 basis points in November and 112 basis points at the beginning of 2022.
Now, what’s interesting is the weakness has mainly been a reflection of reduced market risk appetite and not a deterioration of credit fundamentals. In fact, corporate earnings still remain very strong and balance sheets have actually improved since the start of the pandemic. Another interesting aspect has been the fact that the large part of the weakness has been happening in short term financial corporate bonds, which are some of the highest quality corporate bonds in the Canadian market. Recently, a five year senior bank bond has traded as high as 150 basis points wider than a Government of Canada bond, which is about double where they were at the beginning of the fourth quarter of last year. This is normal to see, as investors look to sell their most liquid corporate bonds when the market becomes stressed.
Liquidity has also been a challenge for most of this year in both the primary and secondary market, with new bonds needing large concessions to attract buyers. Still, new issuance levels are tracking higher than last year, so we’re not seeing a situation remotely close to what we saw in March 2020, when the Fed and the Bank of Canada needed to step in and buy corporate bonds, it’s simply more a brief pricing phase. For most of Q1 of this year, we saw any new bond come to the market with a large 10 to 15 basis points plus concession. But rather than perform well once they went live and started trading, they simply repriced all of the existing bonds of those issuers to wider levels, so they were simply repricing existing bonds to higher yields.
Now, this also hurt liquidity in the secondary market, as any issuer, or any corporate bond issuer that was rumored to be bringing a new deal to the market, was seen as being untouchable. And I’d say this pattern transpired, really, until mid-March, until after several large deals came to the market. One being the highly anticipated 13 billion dollar deal from Rogers Communications, their funded acquisition of Shaw Communications. And only after several of these went okay, and we saw similar performance on new deals as in the U.S. market, did we see spreads start to modestly perform.
U.S. bond yields are back above stock giving yield, so valuations definitely look more attractive. Given the recent increase in corporate spread, we tend to see them as more attractive now, but we’re still somewhat cautious that we could see more spread widening, given there are a lot of risks in the market. High inflation, the war in Ukraine, potential COVID variants, and the risk of a policy error from the Fed or the Bank of Canada all could cause spreads to widen, so we’re being careful with where we add.
Particularly, we like shorter dated corporate bonds right now, as they are less sensitive to rising interest rates. And we like the financial sector, they’ve already experienced material widening and spreads over the last six months, and generally, they’re the most liquid part of the Canadian corporate bond market. Right now, they offer a lot of excess yield relative to government bonds. So with a five-year Canada bond trading between 2-2.5%, you can get an extra 1-1.5% By investing in a high quality senior bank bond. That looks attractive, as you’re getting close to 4% on some of the highest quality corporate bonds available in Canada.
In terms of sectors we like, we like energy, particularly companies like Suncor, Cenovus and CNQ, all of which are benefiting from higher commodity prices, and have limited bond issuance needs this year. We also participated in the most recent Rogers deal, which came at a discount to their existing bond, and looked cheap, on a relative basis, to other domestic telecom issuers. So, overall, we think that the corporate bond market will continue to outperform, given the economic backdrop remains okay, and companies still have pricing power. Again, it’s not without risk, but we think a lot of the credit spread widening has already happened.
In terms of implications for the high yield market, it’s not the same case. We haven’t seen high yield spreads move out as materially as investor grade credit spread, so the sector hasn’t cheapened up as much. Right now, the average spread for the ICE BofA US Cash Pay High Yield Index is in the 350 basis points range, which is really only 50 basis points wider from their lows from last year. High yield doesn’t look as attractive. Now, there are some advantages to holding this sector. High yield still has a low correlation with the broad bond market, especially government bonds, they do all provide a diversification benefit, but the focus should be on bottom up analysis, and buying high yield bond issuers that you understand and where you’re comfortable with the risk rewards for the investment. So, fundamental analysis is key for each high yield investment.
- CIBC Canadian Bond Fund