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Ebad Saif, fixed-income client portfolio manager, CIBC asset management.
In 2023, the Bank of Canada, since January had been on a pause. More recently, we saw in June and July the Bank of Canada stepped off the sidelines given some inflationary pressures and they’ve delivered two 25 basis point rate hikes, the first one was in June and the second one was in July. Now that brings the overall overnight rate to 5%.
And how’s that impacted fixed-income investors? One, it’s important to remember that fixed-income investors this year are experiencing a positive return, and that’s primarily due to the elevated yield that they get to enjoy given the higher interest rate environment. And that elevated yield does provide a level of protection from higher interest rates.
Looking at the outlook with regards to interest rates both from the Bank of Canada or the Fed in 2022, both central banks were at close to 0% overnight rate, zero for the Fed, 25 basis points for the Bank of Canada. Since then, they’ve been on a very aggressive cycle to bring interest rates higher to bring inflation in check.
Now looking ahead, when you look at Canada, we’ve come a long way in our view when we look at the marketplace. The market’s pricing in anywhere from no additional rate hikes from the Bank of Canada to one. The benefit the Bank of Canada does have is the next interest rate meeting isn’t scheduled till September. So, they are going to have an opportunity to look at more data and make their interest rate decision.
In our view, we do expect the Bank of Canada to be more data dependent. Looking at where inflation rate pressures are today, it is likely that we see them being at the end of their rate hiking cycle and not raise rates further from here. But they have the ability to look at July CPI print, which will come out to influence their decision.
Now when we look at the U.S., they’re also at the end of their rate hiking cycle or close to the end, but the market’s pricing in somewhere between one to two rate hikes by the end of 2023. What’s also important to realize is in middle of 2024 to the latter half of 2024, the markets are actually pricing in rate cuts. So they’re expecting rates to move significantly lower, almost by another hundred to 125 basis points lower by the end of 2024. So although both central banks are expected to possibly raise rates by anywhere from no additional rate hikes to two, whether it’s the Bank of Canada or the Fed, the markets are expecting rates to move lower in the latter half of 2024.
The main risks for fixed-income investors in the current environment, what the central banks have been fighting, is this higher inflationary environment that we’ve experienced. Now today, we’ve seen inflation move significantly lower from its peaks of high single digits, whether it was Canada or the U.S., we’ve seen it move significantly lower. Part of that has been tighter monetary policy. We’ve seen the base effects also have contributed to lower inflation.
Now, the main risk would be if inflation over the next few months is stickier and more elevated than markets are currently expecting. That would result in the central banks, whether it’s the Bank of Canada or the U.S. Federal Reserve, having to be more aggressive with regards to their interest rate policy. They’re quite elevated already, but if they need to be more aggressive, that’s going to be a headwind for fixed-income investors.
The other risk for, I would say fixed-income investors, but also investors in other public markets, would be if there’s an economic downturn. So an environment where you’re in a deep recession, you’re starting to see significant earnings revisions from corporations. That’s going to have an impact on bonds. It’ll be positive for high quality government bonds which will benefit from lower rates, flight to safety. But for investors that are invested in securities with some credit risk, whether it’s the investment-grade corporate bond market, the high-yield market, emerging market debt downturn in the economy, slower economic growth is a risk that we should consider when we’re investing in fixed-income.
With regards to opportunities that exist in the corporate bond world, we like to look at the market in two different components, in particular the investment-grade market and also the high-yield market. So just looking at the high-yield markets, long term spread is around five and half percent. Today in mid-July, when you look at current valuations in the overall broad high-yield market, they are tighter than the historical averages. So for us, there are opportunities, but the way we see, we want to be a bit more defensively positioned within the high-yield market. If there is a market downturn, you’ll be in an environment where those spreads can move wider pretty quickly. So being in more defensive sectors, having more exposure to higher rated high-yield market issuers is attractive.
Also for a Canadian investor, the high-yield market is an attractive place to be because it provides diversification and exposure to sectors that aren’t as readily available in the Canadian fixed-income market.
The other corporate bond market that we do like is the investment-grade market. When you look at the yield curve, it is inverted. You’re getting very attractive yield in high quality investment-grade corporate bonds. You don’t have to take on significant duration risk and interest rate risk and look for corporate issuers or in bonds in the short end of the yield curve and is providing a significant attractive yield.
Kind of looking at certain sectors within the investment- grade space, as we all know, the real estate sectors have experienced some headwinds. We’re starting to see valuations look attractive in that space. And when we look at it as an active manager, we kind of dig a bit deeper, in particular at some of the REITs that are available. Not all REITs are the same. There’s some REITs, of course, that are feeling the pricing pressure because they’re office-based and there’s a lot of office exposure and they’re rightfully feeling that pressure. But then there’s other REITs that are anchored by pharmacies, grocery stores, and even their pricing is experiencing some volatility. And for an active manager, that’s when we can go in, do our due diligence and find opportunities where we think that there’s some mispricing in the marketplace. So there are some of those opportunities that we’re taking advantage of.
One other aspect that we are investing in our corporate bond strategies, given our outlook that we do expect some headwinds in the overall economy, we have tilted towards higher quality corporate issuers. We’re a bit defensive overall, and we do have some exposure to government bonds in our corporate strategies. Essentially, that’s providing us with a lot of liquidity and also attractive yield while we wait for some market volatility to take place, which will allow us to liquidate and use some of the cash that we have or the government exposure and really put that capital to work and take advantage of opportunities that present themselves in the marketplace.
Duration perspective. Currently, as we discussed, the overall yield curve continues to be inverted. So shorter term bonds, whether it’s corporate bonds or government bonds, provide a very attractive yield without taking on significant interest rate risk. So in the current environment, it’s very attractive to have some exposure to shorter dated bonds, but I would remind our investors that there is an advantage of being invested in investment solutions that allow you to be dynamic. So today, it’s attractive to being shorter dated bonds, but as inflationary pressures slow down and you start to see the central banks finish their rate hiking cycle, there’s going to be an opportunity over the medium term to extend duration and be in longer dated bonds as they’re going to benefit from the move-in rates lower, and there’s going to be an opportunity to capture capital gains.
So in summary, shorter dated bonds, in particular short-dated corporate bonds are providing an attractive place to be. But being active and dynamic with your duration positioning is going to be beneficial over the medium to long term.