Opportunities in fixed income

With inflation remaining stubbornly high and interest rates expected to stay higher for longer, a CIBC Asset Management portfolio manager says investors should look for opportunities in fixed income.

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“Not much has changed in terms of our outlook, which leans toward an economic slowdown and a moderate recession,” said Adam Ditkofsky, vice-president and portfolio manager, core and core plus, at CIBC Asset Management, in an interview on Sept. 12.

In this environment, he sees “the outlook for fixed income being very favourable.”

The market was expecting the Bank of Canada to hold given the underwhelming second-quarter GDP, which came in at minus 0.2%, well below both market expectations and the Bank of Canada’s forecast.

He attributed this contraction to a pullback in consumer spending, with retail sales weaker than expected and housing activity showing signs of softening.

The question, according to Ditkofsky, is whether the central bank’s rate hikes will be sufficient to cool down the market and bring inflation down to the central bank’s 2% target. He’s concerned that Canadian households are vulnerable, given that most mortgages renew every five years, making them more sensitive to near-term interest rate increases. 

“We’re already seeing Canadians pull back,” Ditkofsky said, noting that GDP per capita has been negative for four out of the past five quarters.

Ditkofsky also raised concerns about rising unemployment, especially if immigration policies continue to drive population growth faster than the economy can accommodate.

“At the individual level, Canadians are seeing their net worth get worse or deteriorate,” he said. 

South of the border, Ditkofsky said the U.S. economy has been more resilient as homeowners have longer mortgages, reducing sensitivity to interest rate changes. However, he said pent-up savings from the pandemic are nearly depleted and credit card debt is rapidly rising. “Consumers are running out of steam,” he said. 

Regarding inflation, Ditkofsky said that while supply chains have stabilized in many regions, food and energy prices are still moving higher. Therefore, he expects inflation to remain above 3% for some time, despite a general trend of deceleration this year. As a result, he said central banks will likely keep rates elevated for an extended period, with no rate cuts expected until at least mid-2024.

In this landscape, Ditkofsky said the outlook for fixed income is favourable. First, recession risks are rising, and although concerns about inflation persist, Ditkofsky said it is expected to continue declining, albeit gradually. Moreover, central banks have indicated that their interest rate hiking cycles are nearing an end.Yields in the fixed income market are also at their highest in a decade, offering strong competition to GICs but with tax advantages, he said. If the economy slows down and yields drop, there’s a chance for further price appreciation, he said, potentially delivering returns of 5-7% without taking on significant risk.

In light of these factors, Ditkofsky said investors should focus on shorter-dated bonds that offer higher yields and are less sensitive to changes in interest rates, especially given the current inverted yield curve. This includes short-dated investment grade corporate bonds, provided “credit fundamentals are sound,” he said.

There are also opportunities in private debt securities, especially those related to infrastructure and data centres, and select emerging market debt, Ditkofsky said. He said these investments offer attractive spreads relative to government bond yields.

Lastly, he highlighted the potential use of derivatives to enhance yield without increasing duration risk. Conversely, some bonds may not provide much yield, Dikofksy said, and he expressed caution on high-yield bonds due to spreads being below 400 basis points and their vulnerability during times of economic stress.Longer-dated corporate bonds also come with risks given the inverted yield curve and the potential for wider credit spreads during a recession, he said.

“Our view is to focus on shorter-dated, higher-quality risk assets, which in today’s environment — with the yield curve being inverted — the bond market is paying you to do,” he said. 

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