Corporate Bonds Remain Stable, So Far

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Adam Ditkofsky, CFA

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Adam Ditofsky, portfolio manager and vice-president at CIBC Asset Management.

In terms of an update on credit and how it’s impacted the corporate bond market, corporate bonds have outperformed the broad Canadian bond market year-to-date. As companies have benefited from the very strong economic backdrop, which in turn has given many of the opportunity to increase profitability and improve their balance sheet. So if we look year-to-date for the period ending August 31, corporate spreads, which represent the difference in yield between corporate bonds and government of Canada bonds, have remained fairly stable — ranging from a spread of 110 to 124 basis points and ending the period at 116 basis points. So this has enabled corporate bond investors to benefit from extra yield and corporate bonds to outperform government bonds. Particularly corporate bonds rated triple B, which is the lowest rating for investment grade issuer, they’ve done very well and both in terms of industries, financials and real estate sectors, have seen solid performance largely because of the economic recovery and the reopening we’ve seen this year.

High yield bonds, which are incorporated into many of our mandates, have also benefited from the reopening story and in the first eight months of the year have returned four and a half percent with spreads falling from 380 basis points to 315 basis points. Now, corporate issuance has also been very strong this year, reaching just shy of a $100 billion year-to-date and which has represented an increase year-over-year of 13%. So we’re tracking well above levels seen last year, which was the strongest year on record with more than $118.8 billion in total issuance. So we can easily see 2021 become the highest issuance year on record should levels remain elevated. Now, fortunately, demand from investors has been very strong with many new issues continuing to be oversubscribed with limited concessions in these new deals. So, overall, the corporate bond market remains very active and healthy.

In terms of how the next wave of COVID impacts the corporate bond market, it really depends on how effective the vaccine roll out has been in Canada, especially related to its uptake and ultimately it’s effectiveness against the Delta variant and future mutations. So, really the key metrics to watch are hospitalizations and ICU capacity, which as we saw last year, forced various levels of government to enact lockdowns and restrictions, which ultimately reduced mobility and hurt the economy. Now, hopefully that doesn’t happen again and it shouldn’t, given a large majority of the Canadian population has been vaccinated, but should factors change, we could see credit spreads widen with lower quality subordinate credits or those that are more volatile being the most negatively impacted.

So high yield could materially underperform in this scenario, especially sectors that are more sensitive to the economic re-opening, think of leisure and travel and resources. These would be at the top of the list. And hybrid securities, which have been issued by various energy pipelines and financial companies, including the Canadian banks, which are subordinated to traditional bonds, have both equity and fixed income like characteristics and are more volatile than traditional corporate bonds. These should underperform in this scenario as well. Now I don’t think we should see corporate bond spreads returned to levels seen in the first lockdown towards the end of March 2020, when investment grade corporate spreads reached as high as 256 basis points and this is really a reflection of government support, which would likely be high should additional restrictions be imposed. But again, should economic conditions surprise to the downside because of further COVID restrictions, credit spreads could materially widen.

In terms of opportunities, we continue to believe that corporate bonds will outperform government bonds over the next 12 months but we would highlight that the easy money has already been made as credit spreads have materially come in from their wides seen earlier in the pandemic. So a lot of the recovery has already been priced into the corporate bond market. Now we’re also expecting that over time, GDP growth will return to more normalized levels and peak growth is likely already behind us, so some caution is warranted. But still the fundamental backdrop remains intact with corporate profitability being strong and balance sheets being well capitalized. So ultimately our expectation is that corporate bonds should outperform government bonds over the horizon. And it’s a similar story for high yield. Generally when spreads perform well in high yield and are low, they tend to stay low for multiple years. So we see high yield continuing to outperform governments as well, especially with this backdrop. So we are maintaining our overweight in credit but we’re being constructive on adding additional risks to our position.