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Adam Ditkofsky, Senior Portfolio Manager at CIBC asset management on the fixed income side.
As an update on corporate bonds and how this area has been impacted as a result of rising inflation and interest rates. I don’t think this comes as a surprise to anyone but as the world continues to wrestle with high inflation and rising rates, investment grade corporate bonds have modestly underperformed government bonds as credit spreads, which are the extra yield paid on corporate bonds versus government bonds, have continued to rise. And this has been especially true for short term financial issuers, such as banks and insurance companies, which are generally seen as the highest quality, most liquid corporate bonds. But this year financial corporate bonds have made up more than 80% of total new corporate bonds supply. And you take this in a rising rate environment and you saw deal after deal come to the market with larger spreads as investors demanded higher and higher yield to take on more supply.
Now again, some of these were Canadian bank bonds, which are some of the highest quality corporate issuers in the Canadian corporate bond market. And they were being priced with substantially larger corporate spreads than where they had been 12 months earlier. Well, this environment lasted for a while, but come midsummer, that tone had somewhat changed as the market was starting to wrestle with the theme that all these rate hikes by The Fed and global central banks were already starting to take a bite and near term recession risks were rising fast. So much so that we started seeing the yield curve, which is the difference in yield between the 30 year bond and the two year bond, invert. And what this means is shorter dated bonds had higher yields than longer dated bonds. And it’s also a signal that over the medium term, bond yields are expected to fall, or at least that’s what the market expectation is.
But what we also saw was that the futures market was pricing in a peak in the Fed’s funds rate over the next year. And what this means is that the market has started to price in an end to The Fed’s rate hike cycle. With the expectation that over 12 months, we would start to actually start to see cuts. While risk markets such as stocks, corporate bonds, and high yield bonds saw this as somewhat as a light at the end of the tunnel. Meaning that central banks were close to the end of their rate hiking cycle, and again, these assets start to perform. And what we saw in Canada was corporate bonds actually seeing positive performance in June and July with midterm corporate bonds returning more than 4% in July. And this has also been supportive for new issues in the market as non-financial issuers were able to come to the market again, which was also met by solid demand by bond investors looking to achieve higher than government bond yields.
So, what’s the long term outlook? Well, in terms of our outlook, we believe the bond market will continue to wrestle with two key themes. One, have rates risen enough to cool inflation? And two, rates too high that monetary tightening will cause a recession. So, over the next 12 months, our expectations are for GDP to materially slow to less than 1% for both Canada and the US. And this reflects pandemic stimulus of course, being pulled away and consumer demand materially weakening thanks to higher rates and of course, elevated inflation. Now with inflation, we do see it peaking if it hasn’t already, but we still expect it to remain elevated above the central bank’s target of 2% and above historical norms. Within the next 12 months, we see it remaining actually above 5% for both Canada and the US. So, the good news is we do see the bulk of the move in interest rates higher has already happened, especially in short term rates.
Now, in terms of corporate bonds, obviously a recession would apply wider credit spreads, but what we’ve already seen are large moves in some of the highest-quality, shorter-dated financial bonds, such as bank bail-ins securities. In fact, on a yield basis, many of these securities are trading at their highest level since The Great Financial Crisis in 2008, 2009. So, we actually do see shorter dated higher quality credits as being attractive, especially since investors are generating yields between 4% and 5%. Overall, I’d say I’m a lot more optimistic about the bond market today than at the beginning of the year.
Over the near term, we could see corporate bond spreads widen further, especially if we go into a deep recession, but over a longer horizon return opportunities in high quality, short date corporate bonds, I think, look attractive and these bonds are less sensitive to movements in yields and credit spreads than their longer dated counterparts.
- CIBC Canadian Bond Fund