Bond spreads and the pandemic

Since the coronavirus pandemic hit, fixed income investors have had to deal with everything from fears of a financial crisis to wild swings in credit spreads.

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Massive central bank interventions have eased fears for the investment-grade sector, said Patrick O’Toole, vice-president and senior portfolio manager, core and core plus, at CIBC Asset Management. But he still has concerns about high yield.

U.S. investment-grade spreads hit a low below 1% earlier this year before rising above 370 basis points at the height of the panic, O’Toole said in an April 16 interview. They’ve since moved backed down to around 200 basis points, which he attributed to the Federal Reserve’s bond buyback programs.

“That really helped put a ceiling on spreads as investors now perceived that there’s a large buyer, the Federal Reserve, [that] will soon become engaged in the marketplace and be purchasing investment-grade corporate bonds,” he said.

The swings in Canada were less dramatic, with a high above 270 basis points and back down to around 200 basis points. The Fed’s moves helped here, too, but so did the Bank of Canada’s surprise decision to buy back $10 billion worth of investment grade corporate bonds, he said.

The best buying opportunity for investment grade has probably passed, but he still sees opportunities.

“Those yield spreads or corporate spreads are still about double what the spread was earlier in 2020, so they’re still very attractive,” said O’Toole, who manages the Renaissance Optimal Income Portfolio.

He’s less convinced that the high-yield sector is in the clear. The central banks aren’t buying back most high-yield bonds, though the Fed’s program includes “fallen angels,” or companies that were investment grade but have been downgraded since March 22. (This includes companies such as Ford and Macy’s.)

Fallen angels aside, the high-yield market is “more susceptible to stock market gyrations than investment grade is now in our view,” O’Toole said.

Stocks have recovered from their lows a few weeks ago, but he said this could be due to investors applying a buy-the-dip strategy that worked over the previous decade.

“That may not work in a bear market,” he said. “[In] bear markets, you generally see a retesting of the lows, or even deeper lows after a strong rebound. And so far, what we’ve seen is just a strong rebound.”

O’Toole expects more stock market volatility as companies report earnings for the pandemic period, which creates the risk that high-yield spreads will revisit recent peaks.

He also isn’t ruling out another wave of infection causing more prolonged damage with businesses re-shuttered. But that’s not the scenario he expects.

O’Toole’s outlook for high-yield bonds is constructive, though investors need to be cautious. While defaults will spike in the coming months, those risks are already priced into the most exposed companies, he said.

“You have to really do a lot of good bottom-up analysis and be very comfortable with the companies you’re buying that they can survive, make their coupon payments, and be able to refinance debt,” he said.

If high-yield spreads can stay in the low 700s, the sector could provide high single-digit or even low double-digit returns over the next 12 months, he said.

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