Don’t overlook bonds ahead of a recession

With economic indicators still pointing to a downturn, bonds can once again offer diversification benefits as well as attractive yields, says a CIBC portfolio manager.

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“Bonds look like a very compelling investment offering to investors today with some of the most attractive return opportunities we’ve seen in a long time,” said Adam Ditkofsky, portfolio manager and vice-president at CIBC Asset Management. 

Since the Fed’s decision to implement another rate hike on May 3, bond markets have exhibited surprising stability, Ditkofsky said. Short-dated bonds, which experienced significant volatility earlier this year as investors attempted to anticipate the actions of the Fed and the Bank of Canada, have now settled. 

Despite initial rallies in bond yields immediately following the Fed’s announcement, rates have remained relatively steady since the central bank adopted a conditional pause.

“As long as inflation continues to come down or move in the right direction, we can expect no more rate hikes from either the Federal Reserve or the Bank of Canada,” said Ditkofsky.

The bond market’s resilience can be attributed to the fact that it had already priced in the possibility of a pause by the central banks, Ditkofsky said, given the recent collapses of Silicon Valley Bank, Signature Bank and Credit Suisse. These events prompted the futures market to anticipate rate cuts within the next six months. Consequently, investors had already factored in the likelihood of one more hike followed by a pause before the May Fed meeting.

Corporate bonds have also been stable since the Fed announcement. In Canada, Ditkofsky said, spreads between government and corporate bonds are around 160 basis points, which he considers “stress levels.” Whether credit spreads improve or worsen from this point depends on the economic outlook and inflation trajectory, he said. 

Market sentiment suggests that many investors are now pricing in rate cuts later this year, with futures markets indicating rate cuts from both the Fed and the Bank of Canada within the next six months. That makes sense, Ditkofsky said, as historical trends indicate the Fed typically cuts rates six months after its last hike.

“Unfortunately, we think the market is getting a little ahead of itself this time,” he said. 

Central banks are determined to bring inflation back to its 2% target, and although inflation has come down from its peak last summer, it currently hovers between 4% and 5%, still well above the target. To regain credibility, Ditkofsky said the Fed and the Bank of Canada likely require strong data and confidence that a sustained decline in inflation is coming before considering rate cuts, unless a significant market disruption occurs.

Looking ahead to the next 12 months, Ditkofsky forecasts a recession for both Canada and the United States, as consumer spending shows signs of contracting and the business outlook deteriorates. The U.S. regional banking system is facing challenges, with deposits flowing into higher-yielding money market funds. This exodus may impede future lending by regional banks, which play a significant role in the U.S. banking system.

While labour data has remained strong, early indicators are also showing cracks, he said. Weekly jobless claims have been increasing steadily throughout the year, and average weekly hours worked have declined, which typically precedes layoffs as companies attempt to retain workers by reducing hours.

Although inflation is expected to continue its downward trend, Ditkofsky said it’s likely to remain above the 2% target for the rest of the year. Positive signs of cooling include the normalization of supply chain pressures, the easing of food and shelter prices, and improvements in the service sector, particularly in staffing issues. 

“We do see inflation normalizing overall, just not fast enough to warrant a rate cut this year,” he said.  

Given this uncertainty, Ditkofsky said bonds are a compelling investment option. In Canada, five-year Government of Canada bonds yield approximately 3%, the highest level since the 2008 financial crisis.

Corporate yields are higher but Ditkofsky advised caution due to the recession outlook, as much of the credit spread widening has already been priced into the investment-grade market. He said bottom-up analysis is crucial to ensure companies’ credit metrics remain strong and profitability is sound. Promising sectors include energy, pipelines, infrastructure, and certain segments of commercial real estate, such as well-anchored retail properties with long-term tenants and properties related to seniors’ living, which have experienced a robust recovery from the pandemic.

Ditkofsky said government bonds, in particular, have reestablished their status as strong portfolio diversifiers, as demonstrated by the rush to invest in them during periods of market uncertainty, such as after Silicon Valley Bank’s collapse.

Overall, Ditkofsky said while a cautious and defensive approach is warranted, bonds offer diversification benefits during risk-off periods and currently provide attractive yields.

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.