Managing risk in fixed income

In response to the pandemic, central banks injected massive liquidity into the market, boosting risk assets, including bonds, and allowing for new issuance. How central bank action continues to impact the bond market is a growing concern, however.

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“There’s been a flood of debt in the bond market due to Covid, as central banks essentially print the money that governments want to cushion the blow,” said Patrick O’Toole, vice-president of global fixed income at CIBC Asset Management, in a late-July interview.

“Normally, economists would warn us that that money-printing would lead to higher bond yields and higher inflation.”

Greater supply in the bond market typically results in higher yields to attract buyers, while more money circulating in the economy results in higher inflation.

The U.S. M2 money supply, a measure that includes currency in circulation, savings deposits and money market funds, was up 23% year over year in June, surpassing prior records back to 1960, according to National Bank’s August fixed income report.

Yet, higher bond yields and inflation haven’t materialized.

“Yields have fallen, and inflation expectations were maintained,” O’Toole said.

With central banks buying government bonds, less supply is available for private investors’ demand, he said. Inflation hasn’t increased significantly because the pandemic negatively affected demand for goods and services.

“Despite a record amount of supply in the first half of 2020, there’s been no trouble digesting the bonds,” said O’Toole, who manages the CIBC Canadian Bond Fund and the Renaissance Corporate Bond Fund.

This dynamic could continue.

“The data we’ve seen from the U.S. show more money going into fixed income and coming out of stocks,” O’Toole said. Further, inflation expectations aren’t materially higher than at the worst point during the economic shutdown, he said.

“Investors are rationally adjusting to the guidance we’ve seen from the Fed and the Bank of Canada,” O’Toole said.

For example, the Fed’s dot plot projections show no change for the Fed funds rate through 2022. The Bank of Canada has also said it will maintain its key interest rate at the lower limit of 0.25% until inflation gets back into its target range of 2%.

In this environment, investors face the choice of low-yielding government bonds or moving higher up the curve, to investment grade, high yield and global bonds.

O’Toole suggested buying broadly diversified products where the credit risk is managed.

“Look for an experienced fixed income team with […] an in-house credit analyst team that understand the risks of investment-grade and high-yield companies,” he said.

He also suggested investors identify cost-effective investments and avoid high fees.

Still, risk remains.

For example, a second wave of Covid-19 would hurt corporate bonds and benefit government bonds, as in Q1, O’Toole said.

Inflation could also unexpectedly appear.

“After all, the money printing in this episode far outpaces anything we’ve seen since the end of World War II,” O’Toole said.

If inflation rose, government bond yields would likewise rise as investors looked for compensation for the loss of future purchasing power.

The U.S. consumer price index was surprisingly strong in July (the latest reading), rising 0.6% in the month — about double what economists expected. Also, the Fed is expected to detail a new policy approach to inflation on Thursday, which would allow inflation to run higher after periods when it runs low.

Another risk for investors to consider is that stocks could collapse, which would hurt corporate bonds, given that riskier assets tend to take a hit when stocks do, O’Toole said.

At the same time, he warned against being fearful. “Once-in-a-lifetime” shocks have occurred before, including Y2K, 9/11 and the 2008–09 financial crisis.

“Each time, we weathered the storm,” O’Toole said. “It’s time in the market that matters.”

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