Fixed Income Looks Promising Again With Recession Worries

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Adam Ditkofsky, CFA

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Adam Ditkofsky, senior portfolio manager at CIBC Asset Management on the fixed income side.

There’s been a lot of talk about a potential recession on the horizon, and the question is really how would this impact bond rates and returns? So really the two key themes this summer for the markets have been excessively high inflation and how aggressive will central banks be in raising rates to bring inflation under control? And the second key theme is, are central bank’s efforts being too aggressive and will they push the economy into a recession? Now, throughout the summer, we’ve seen these two themes battle for dominance, and this has caused significant volatility in the bond market as investors saw signals that inflation was coming down and the economy was slowing. But in terms of a recession, and while not the official definition, the US has already experienced two consecutive quarters of negative real GDP and the yield curve, which is the difference in the yield between two year bonds and 30 year bonds, has inverted. And this means shorter dated bonds have higher yields than longer dated bonds. So it really is possible that the US is already in a recession.

Now, what does this mean for bonds? Well, last year we spent a lot of time talking about the concept of TINA or “there is no alternative.” And this was a reflection of the extremely rich valuations we were seeing in both stocks and bonds. Now, both bonds and stocks looked expensive last year.

Now, keep in mind, since the beginning of the year, bond yields have materially moved higher with 10 year treasury bonds now above 3% compared to low 1% in September of last year. So government bonds have gotten a lot cheaper and are at the highest level they’ve been in 10 years. Now, if we also compare this to the S&P 500 dividend yield, which is just above 1.5%, bond yields look far more attractive today than they did over the past two years. So we’d argue that bonds look a lot more compelling today than where they have been for a long time. And with recession risk rising, which would cause yields to fall, we believe that the 60/40 portfolio, meaning the mix of stocks and bonds in an investor’s portfolio is very alive and well, and investors should not be avoiding bonds, especially now.

Now just for context, the FTSE bond universe index returns 3.9% in July as recession risk throws in the month and yields start to fall.

In terms of which types of bonds would be harder hit, obviously, in a recession environment, corporate bonds would underperform government bonds as credit spreads ,which represent the yield paid on a corporate bond versus a government bond, would be larger and should cause corporate bonds to underperform. That being said, investment grade corporate bonds have already materially widened this year, especially high quality short term financial bonds such as bank bail-in which represents some of the highest quality and most liquid corporate bonds in the Canadian marketplace. In fact, some of these bonds are yielding between 4.5 and 5%, which represents some of the highest yields they’ve seen since the great financial crisis in 2008, 2009.

Also, you can argue that the market may see economic weakness as a sign that central banks hiking may be coming to an end and view this as the light at the end of the tunnel. Which in that case may be supportive for credit spreads. Now in terms of high yield on the other hand, they would likely underperform investment grade corporate bonds in a recession, and this reflects their more volatile nature, but also the fact that spreads remain fairly low, around 450 basis points today. And that can move materially higher in a recession. But again, they could also benefit from government rates falling so they may not perform as poorly as they did in previous recession cycles.

What risk remains for investors and what opportunities are there? Well, the market still remains very volatile as both inflation and recession themes continue to battle for dominance. So it wouldn’t be a surprise for the bond market to remain volatile. Still, our expectations are for economic growth to slow below 1% for both Canada and the US over the next 12 months. And while inflation will still remain elevated, it is expected to come down from its current levels.

Our expectations are for yields to modestly fall over the next 12 months. So we do see opportunities in government bonds and we believe yields are compelling at current levels. We also see opportunities in high quality short term investment grade corporate bonds with some two year and three year corporate bonds yielding 4.5 to 5.5%. We like these and they offer attractive yields and are less sensitive to changes in interest rates as they’re short term in nature. But overall, we’d argue that bonds are more compelling than they’ve been for a very long time.