A Playbook for Bond Investors

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Adam Ditkofsky, senior portfolio manager for Global Fixed Income at CIBC Asset Management. 

In terms of rate cuts and do we think that they’re going to happen this year, yes, I’m still in the rate cut camp for this year, especially for Canada, which is clearly showing divergence from the U.S., with regards to economic growth and progress with bringing inflation back to target. 

Now, while the U.S. has continued to show strong economic growth, and higher than expected inflation north of 3%, Canada has continued to see weakness, especially at the consumer level. And inflation has continued to come down, and for the first three months of the year remains below expectations, and within the Bank of Canada’s target range of 2 to 3%. And this is headline inflation, which includes energy, food and housing prices, all of which have been problematic components for the inflation pricing basket. 

So yes, in Canada, we have seen some improvement in economic activity in recent months, although I’d argue this continues to be largely driven by our aggressive immigration policy. And as our firm has talked about in the past, GDP per capita continues to be negative, meaning Canadians continue to be worse off. 

Now, in the U.S., I’m still optimistic that we could see one cut this year, but at this point, it’s clear that inflation has not cooled in line with what the Fed has been projecting. So, there are increasing risks that this forecast will not come to fruition, and even for potential for the Fed to be on pause for the entire year.  

Now, a big part of this has come from the strong consumer spending in the U.S., which has led to higher than anticipated GDP. In fact, if we look at the U.S. consumer, historically, the personal savings rate as a percentage of disposable income was closer to 6%; today, it’s close to 3%. And while historically consumption has made up 67% of GDP, today, it’s close to 70%. 

So, spending patterns in the U.S. have clearly changed. And a big part of this, unemployment is very low, consumers are saving less, and they’re spending on both goods and services. And we’re also seeing this in credit card data, with credit card debt now more than 22% higher than pre-pandemic.  

Now, in Canada, the consumers are not spending. Retail sales data have been negative for the first two months of the year, and our savings rate here is close to historical norms at 6%. So, we’re seeing less confidence for consumers here. And many believe it’s because of the structure of our mortgage market, where most mortgage holders see their rates reset every five years. But ultimately, what we are seeing is that strength of the Canadian economy is materially weaker than that of the U.S. 

We also can’t forget jobs. In the U.S., the unemployment rate is less than 4%, while in Canada it’s risen above 6%. And there’s one major difference for both markets, and I think this is very important to mention. In the U.S., there are still more vacant jobs available than people looking for work. And in Canada, there are more people looking for work than jobs available. 

So ultimately, what does this mean? I think we’re seeing a large divergence between both countries that does continue to warrant rate cuts faster in Canada than the U.S. 

In terms of what that means for the bond market, we’ve already seen the bond market sell off this year, as expectations for rate cuts have cooled. And let’s not forget, in January, the futures market was pricing in five to six rate cuts for both the Fed and the Bank of Canada starting, as early as March. Now, the market is only pricing in one to two cuts for Canada this year, and only one cut for the U.S. for Q4 of this year. 

So, I’d argue any modest action by the bank — the Bank of Canada or the Fed — is already priced in. Now, still, the bond market should react favourably to any cuts, but unless expectations for cuts or hikes materially change, modest cuts are already priced in. 

With the stickier inflation that we’ve been seeing, and with the Bank of Canada raising its neutral rate, what should really be the playbook for investors? Now, first off, what does that mean when the Bank of Canada raises its neutral rate? Well, this is where the bank expects its overnight rate to be over the long term, and the bank now believes its neutral rate is between two and a quarter to three and a quarter per cent, as opposed to what they had previously expected of two to 3%. Well, first off, this shouldn’t change too much in terms of expectations over the medium term that the Bank of Canada still expects to cut rates from its current overnight rate of 5%. So, we’re substantially higher than that long-term target still. It just means that they think that their historical target was too low, at least to keep inflation in check.  

It doesn’t change expectations that interest rates should fall over time, which is still positive for the bond market. In fact, it signals that investors should be taking advantage of higher rates in the markets we are seeing now, particularly shorter-dated maturities, as the yield curve is still inverted, meaning that shorter-dated bonds offer higher yields than longer-dated maturities.  

One opportunity that we continue to see are target maturity funds, where all the investments have a target maturity, meaning you can invest in a bond fund where all the bonds mature in either one year, two years, three years, et cetera. If you hold bonds to maturity — this is the important factor — is that you aren’t exposed to the mark-to-market or sensitivity to day-to-day changes in interest rates. 

Rather, you’ll receive the yield to maturity that you get at the time of investment, and you get the principal back at maturity, hence the name fixed income.  

And in today’s market where three-year government bonds of Canada’s are yielding close to 4%, one-year bonds are still close to 5%, investing in high-quality corporate bonds in these terms. And we’re seeing yields between 5 and 6% for these funds.  

Now, on top of this, these funds can even generate returns better than GICs, as many bonds today trade at a discount. So, there’s the benefit of some capital gains treatment from a tax perspective. This is a similar environment to what we actually saw in October of last year when yields had moved much higher, and we actually saw pretty much the entire U.S. yield curve up close to 5%. 

In terms of our outlook for the fixed-income market, while we do anticipate seeing some rate cuts in Canada over the next 12 months, we do see inflation decelerating at a slower pace than consensus, with inflation averaging two and a half to 3% over the next 12 months. Still, we do see rates moving modestly lower, particularly in the short end of the yield curve, meaning bonds with maturities of five years or less. So, this should enable investors to generate returns in line with where yields are today. So, with the yields ranging between three and a half to 5%, investment grade corporate bonds yielding four and a half to 6%, we should see returns of a similar nature, assuming our base case comes into fruition. 

Now, of course, if inflation does reaccelerate, we could see rates move higher. And under this scenario, obviously returns would be lower, but again, focusing on shorter dated bonds, discount bond funds, and target maturity funds with finite maturities, this enables investors to reduce this market volatility risk, and allows investors to collect their yield as they get the yield from these funds, and they get the return of their principal at maturity. 

So, in terms of credit risks, if rates do stay higher for longer, specifically, if we don’t see rate cuts as anticipated this year, particularly in Canada, this should have negative implications for risk assets, including investment grade corporate bonds, high yield and equities. 

But so far this year, risk assets have been resilient, and have continued to outperform. Now, a lot of that strength has been driven by expectations that some rate cuts will happen this year, but we’ve also been seeing solid earnings for corporations, which is also supportive for credit markets. And right now, we’re seeing companies maintain conservative balance sheets, so credit can continue to perform. Now my team has become somewhat defensive in our portfolios, and while I’m overweight credit, the bulk of the overweight is in shorter date credit, which in nature has less volatility, and with the inverted yield curve environment that we continue to see, offers attractive yield opportunities in the five to 6% range. 

Now, in terms of specific regions, our dominant focus remains in North America. We have a global exposure to issuers across the globe, of course. Our key focus for us includes geographic diversification within these names, and solid credit fundamentals. 

In terms of sectors such as banks and real estate, we continue to like both sectors, but bottom-up analysis is key. For banks, making sure lending practices and margins are strong, and of course, monitoring proper loan provisions and capital levels are necessary. Also, banks should continue to see improved performance should we see further normalizing of the yield curve, meaning less inversion. And for real estate, companies again, bottom-up analysis is key here as well. Right now our focus are on key subsectors. We like senior living, industrial space, retail anchored by strong tenants, and data centres — that’s more in the IT space. But we like, of course, a solid customer base, and in many cases, diversified customer bases. Essentially, we like companies where they can continue to generate solid free cash flow, and can continue to increase their rental rates, and maintain strong credit metrics.