How to Invest for the Bond Rebound

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Pablo Martinez

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Pablo Martinez, portfolio manager, CIBC Asset Management.

We’re looking at the outlook for bonds in 2023. The outlook for bonds, obviously, will be impacted by the global economy. In order to better understand what we should be expecting in 2023, we have to go back to what bonds have done in the past year. When we look at the bond yields from June until, basically up to now, what we have seen have been rates that have moved in a range of around 360 to 275. So that can be explained by the fact that a lot of market participants believe that the main threat to the economy is recession, and that took rates down. But there’s also a sizable amount of market participants and central bankers that believe that the main threat to the economy is inflation. So that’s why we have seen rates moving into this range of 360 to 275, and we’re seeing the same thing happening right now.

That being said, when we look at central banks, they are obviously in the camp of those that believe that inflation is the main threat to the economy. So the same way, if we look back at the onset of the pandemic, the narrative from central banks was that they would do everything in their power to make sure that the economy gets back on track, and it didn’t matter the cost. And the cost obviously was higher inflation.

Now, back to 2023, the narrative has changed now, now central banks are telling us that they will do everything it takes, anything in their power, to quell inflation, even if it means lower economic growth, even if it means higher unemployment, even if it means global recession. So we are heading into a slower growth environment. We are heading into a profit recession, and that obviously is putting risky asset in a difficult situation.

The good news though, for 2023, is that we had positive relationship between stock and bond returns in 2022, and that’s something that really rarely happens. If we look back a 100 years back, we only have very little occurrences of positive correlation between stocks and bonds, where both bonds and stocks have negative returns, and we’ve seen that in 2022.

The good news is that chances, for this to happen, are very, very low. We believe that this negative correlation between bonds and stock returns will return, they will get back to more of a normal situation. So the situation where we had no alternative to stocks, and we used the acronym TINA to describe the situation, TINA meaning, there is no alternative. Up to this, last year, there was not a whole lot of alternative to stocks. Bond yields were at record low, we had 10-year Canada bond at 0.5%. We had corporate bond spreads very tight, so there was not, really, an alternative to stocks. But now, with yields where they are now, and corporate spreads where they are now, we believe that there is a good alternative to stocks, and they are bonds.

What will be the impact of slower economic growth on corporate bonds? So obviously, the first reflex we have when we hear, “recession,” well, it’s lower stock markets, we’re seeing a correlation between corporate bond returns and stocks. And the first reflex is to shy away from corporate bonds, but I think that what’s very important to stress here is the fact that the market already has anticipated weakness in the corporate bond markets. And the best example of this is just to have a look at the average mid-corporate spread for the past year. That spread has doubled in 2022, so that slowdown is already being priced into the market.

Now that being said, there is some slowdown and that’s being priced. I don’t believe that a very hard landing or a very hard recession is being priced in it, but I believe that most of the slowdown is being priced into the corporate spread market. So we believe that there are opportunities in corporate bonds.

What we have a lot of confidence is in the short end of the corporate bond markets. We’re talking corporate bonds of two, three, four-year maturity. And there are two reasons why we believe that those are attractive investment opportunities. The first one is that spreads are already wide in that sector. That’s the first reason. And basically, if we look at overall corporate bonds, that sector, if really things get worse, it’s not our base case scenario, but it’s something we have to look at, obviously. If the economic landing of the recession is harsher than what we are expecting, well, obviously you don’t want to be in long corporate bonds because the impact is much stronger, whereas the impact of wider spreads will be much shallower in short-term securities.

So your breakeven is much wider, you have much more protection. And the second reason is the overall curve, the yield curve in Canada’s inverted, as you know. So right now, corporate bonds are being priced off a Canada curve, so two-year Canada bonds right now, are returning 360 compared to a 10-year that’s returning 285. So if you buy a two-year corporate bond, single A, for example, good quality corporate bond, you are having the Canada yield of 360 and you add a spread of, let’s say, a 140, 150 for a nice good triple BBB or single A corporate bond. So you end up with a two-year corporate security that yields close to 5%. Had I told you before, or last year, that we’re able to get a 5% yield on a two-year corporate bond, people would have been all over it.

So we still believe that there’s good opportunity in that short end of the corporate bond curve. There are some good names to be purchased and those provide first, very good yield, and they also provide security in case the economy goes into a deeper recession than what’s being expected. We believe that, as we’re heading into harsher economic times, we need to play a bit defensive. So when we look at the investment grade versus high yield allocation, playing defensive means two things. First, in the mandates where both of the sectors are allowed, we tend right now to decrease the allocation from high yield and go into more secure investment grade bonds. And even within our high-yield allocation, we are right now improving the quality of those names. So we are maybe shying a bit away from the riskier CCC and CC names, going into BBs and single Bs.

Again, they provide very high yield and we’re very happy to hold those names. That being said, if we are heading into tougher economic times, being a bit more on the secure side, I think, is the good strategy. And as for duration, well, really, when we go into the high yield and corporate bonds, normally, the duration is already shorter than the overall index. And we believe that, considering the yield that you have, again, on the shorter end of the yield curve, being in shorter term securities for corporate bonds, again, will protect you rates and Feds move out. And also, you will have gain yield just from the inversion of the Canada yield curve.

How can we protect our investors from the volatility of those? What we have seen in 2022, is a lot of investors have just moved to the sidelines, so they basically decided to remove their investments from more risky asset allocation in stocks and bonds and go and buy GICs. And it’s quite understandable because there was a lot of nervousness in the market, and also GICs had been providing yields that we hadn’t seen in years. Now, as we move forward, no, we have to understand that GICs are a temporary remedy to this situation. And if investors keep holding GICs, well, it basically means that they are trying to time the market. And historically, timing the market is never a good strategy.

Now that being said, we want investors to get back into the market. How can we go back into these market and protect ourselves? As I said before, we believe that the negative correlation of returns between stocks and bonds will return in 2023. We also believe that in harsher economic times, bonds tend to do better.

So one way to protect ourself would be to increase the allocation into fixed income. And that being said, within that allocation of fixed income, we believe that there’s good opportunity to increase the yield over your overall portfolio by buying corporate bonds. Let it be high yield, let it be investment grade. And also, another good way to protect yourself is to go into that sweet spot of corporate bonds within two and three, four years maturity, where we’re having very interesting yield and also good spread protection in case the spreads are backing up.