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Themes and opportunities in the high-yield bond market in 2018.
(Runtime: 4 min, 22 sec; size: 4.39 MB)
Nicholas Leach, vice-president, CIBC asset management
So as we look forward to 2019, I think it’s important to review how we got to where we are now.
2018 saw several themes impacting both fixed income and equity investors. We saw rising interest rates, a flattening yield curve, global trade war tensions, Brexit uncertainty, falling oil prices. All of these contributed to higher levels of volatility in the equity markets, a spike in the volatility index and wider credit spreads.
But let’s first look at the impact of rising rates that we saw in the first three-quarters of the year. The 10-year Treasury yield rose from 2.4% to 3.2% by October. That’s a huge move. The Canada 10-year bond also moved much higher, but by not as much. That kind of move is obviously bad for bondholders, so for the first three-quarters of the year, the broad U.S. bond market was down about 3.7% for the 10-year Treasury bond, and down 2.1% for investment-grade corporates.
But the high-yield market was actually up 2.5%, and it was similar in Canada. Canadian broad market was down 50 basis points, but Canadian investment-grade corporates managed to just tweak out a 14-basis-points positive return. And keep in mind, corporate credit always outperforms in a rising interest rate environment, and 2018 was no exception. The higher coupon carry and the spread compression provides cushion against rising rates as it always does.
Then market sentiment turned in the fourth quarter. U.S. equities fell by almost 10%. Again, we saw a spike in the volatility index, and oil prices fell. Credit spreads always widen in this type of risk-off environment, both for high yield and investment grade. Market volatility in the final quarter appears to be driven by those things I mentioned: trade wars, Brexit fears, falling oil prices.
But there was also technicals.
So the technicals that we’re seeing in the bond market are playing an important role today. In September and October, we saw billions and billions of dollars of outflows in retail mutual funds, and we’re seeing that there are billions and billions of dollars of inflows into the money market funds. So the money market funds are looking very attractive because of the flat yield curve. So investors can pick up extra yield and not take on as much interest rate risk.
So as investors sell the corporate bonds, that is actually causing some of the spread widening. So a lot of the technicals that we’re seeing is causing the spreads on the corporate bonds to rise, and we’re really not seeing a fundamental deterioration in credit quality. So we think it’s more of just a transitional phase, as there is a shift in the asset mix from longer-term corporate bonds into money market funds.
And there was also some idiosyncratic risk among some of the large bellwether U.S. investment-grade issuers. When we look at, for example, Ford, General Electric—all those investment-grade issuers really sold off. Pacific Gas and Electric, because of forest fires in California, that also was a negative for investor sentiment on the investment-grade side, and it did spill over into high yield.
So the volatility in the broader credit markets actually did provide some pretty good opportunities. For example, Ford, due to the fears of a ratings downgrade, the credit spreads on the Ford senior unsecured bonds spiked into high-yield territory. Spreads were actually 50 basis points wider than its competitor, Ally Financial. And those were subordinated bonds, so it was really overdone. So that’s one of the opportunities we took advantage of, was to buy some of the Ford credit bonds.
And we also did reduce some of our exposure in some of the higher beta energy companies. We noticed that credit spreads were somewhat lagging the drop in oil prices, so it was actually good timing because the credit spread on some of those energy companies did catch up to the falling oil prices.