Expect another solid year for corporate bonds

Corporate bonds are emerging from the pandemic in good shape and set to outperform government bonds again this year, a CIBC fixed-income expert says.

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Over the year that ended May 31, corporate bonds returned 2.6%, compared to negative 4.4% for Government of Canada bonds and negative 3.5% for provincial bonds, said Patrick O’Toole, vice-president, global fixed income with CIBC Asset Management.

While that outperformance may not be quite as significant over the coming year, strong economic growth and a low default risk should again propel corporates to stronger returns than sovereigns.

Many corporations have taken advantage of low interest rates to refinance debt, O’Toole said, extending their average term to maturity and reducing default risk. Government assistance has boosted balance sheets, and credit market debt to equity for non-financial corporations in the U.S. is at record lows, he said.

“The backdrop remains good for corporate Canada and corporate America, and that means demand should remain solid for corporate bonds — meaning the average credit spread can decline somewhat,” O’Toole said. “And the result is better returns from corporate bonds versus government bonds over the next year.”

While there is more risk for investors looking beyond investment-grade corporates, O’Toole sees “a green light for the high-yield sector as well” over the coming year.

“That doesn’t mean you can be complacent in high yield, so you have to be very well diversified and know the company,” he said. “And we’ll be looking at the maturity wall for high-yield companies, avoiding those companies where refinancing could be a risk or where the sector risks are increasing.”

He said he’s overweight in the basic industry sector with high-yield names, for example, but underweight U.S. REITs given uncertainty when it comes to office space and retail.

The energy sector poses another potential risk. A strong economic rebound supports oil prices, and energy companies have been stronger performers in the high-yield bond sector, but the outlook can change quickly if the price of oil drops, O’Toole said.

There’s also the chance of a policy mistake as the U.S. Federal Reserve reduces its bond purchases, as in 2013’s taper tantrum, he said.

But the biggest risk is inflation, O’Toole said. If the higher reading over the last few months isn’t temporary, bond yields and credit spreads could rise and stocks could plummet.

“If the inflation genie gets out of the bottle, we’re not talking something like the 1970s, where you have double-digit inflation necessarily, but it could be tough to get it back in the bottle,” O’Toole said.

But he said he expects inflation to be back at 2% in a year, proving the Fed right.

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