How to invest for the bond rebound

Bonds took a beating in 2022 as interest rates climbed, but it may be time to increase bond allocations in the face of recession warnings, a CIBC portfolio manager says. 

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Pablo Martinez, portfolio manager with CIBC Asset Management, said short-duration investment-grade bonds present opportunities.

Bonds, which typically move in the opposite direction to stocks, fell sharply in 2022 alongside equities after central banks around the world aggressively raised interest rates to curb rising inflation.

However, that positive correlation is rare, Martinez said, and a negative correlation should return in 2023.

Prior to last year, record-low bond yields and tight corporate spreads led investors to believe there was no alternative to equities, but that has changed after last year’s selloff and with higher interest rates leading yields to spike. With corporate spreads wider, Martinez said bonds could once again become an alternative to stocks. 

After reaching 40-year highs last year, inflation has shown signs of slowing in the U.S. and Canada. The Bank of Canada last month said it would take a “conditional” pause in its tightening, while the Federal Reserve slowed the pace of its hikes to a quarter-point last week.

Still, Martinez said central bankers are on intent on crushing inflation, even if that means a recession.

“We are heading into a slower-growth environment,” he said. “We are heading into a profit recession, and that obviously is putting risky assets in a difficult situation.“

What does that mean for corporate bonds? The first reflex for investors may be to shy away from corporates, but Martinez said the weakness is reflected in corporate spreads.

“I don’t believe that a very hard landing or a very hard recession is being priced in, but I believe that most of the slowdown is being priced into the corporate [bond] market,” he said.

However, “as we’re heading into harsher economic times,” he said, “we need to play a bit defensive.”

He said there are opportunities, especially in the “sweet spot” of short-duration corporate bonds with two-, three- and four-year maturities. 

Right now, high-quality short-term corporate bonds are providing very good yield, he said, and they also provide security in case the economy drops into a deeper recession than what’s expected.

“If the economic landing of the recession is harsher than what we are expecting, obviously you don’t want to be in long corporate bonds because the impact is much stronger,” he said. “Whereas the impact of wider spreads will be much shallower in short-term securities.“

As for high-yield corporates, Martinez said he’s shifting a bit more defensively away from C-rated bonds into higher quality BB and B-rated securities, while also sticking to shorter durations.

Regardless, looking to 2023, Martinez said corporate bonds will provide investors with opportunities to increase the yield in their overall portfolio.

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