Is it Time to Buy Corporate Bonds?

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Ebad Saif, fixed income client portfolio manager for CIBC Asset Management.

Rising interest rates are generally detrimental to bond value, and this year we’ve experienced a rapid increase in interest rates, which has negatively impacted corporate bond performance. To put this into perspective and capture the magnitude of changing rates, let’s look at a 10-year Government of Canada Bond yield, which was 1.6% at the start of the year and is now in the mid-threes. That’s nearly a 200 basis point move in interest rate.

Corporate bonds in particular have a lower duration in the Canadian bond universe. So in other words, their sensitivity to changes in rate is lower, which has helped them outperform the broader Canadian fixed income universe. With that being said, absolute performance year to date is closer to minus 11%. If the year ended today, that would easily make 2022 the worst performing year for corporate bonds in over 20 years, with the only other negative year being 2021 at minus 1.34% return.

Looking strictly at historical performance, it has been a rare period of weakness for corporate bonds and large parts of the broader fixed income universe. Looking ahead, recent market volatility and the decline in bond prices year to date does provide an incredible opportunity for investors. Not too long ago, the market was concerned about the limited income and return potential of corporate bonds. This has now changed. Corporate bonds today offer significantly higher return potential than they did at the start of the year. The ultimate maturity for investment grade corporate bonds is about 5%, which is rather attractive for high-quality corporate bonds, especially considering the securities were yielding less than 2.5% at the start of this year.

A great investment option for investors looking to allocate to corporate bonds through a well-diversified portfolio can be a mix of investment grade corporate bonds and high yield corporate bonds. The advantage for those kinds of strategies is that you get to take advantage of elevated market yield that’s been available in the marketplace today and really take advantage of different valuations that are available in both the investment grade and the high yield space. Tactical asset location between investment grade and high yield bonds is also a great advantage for investors looking to really harness the additional yields that the securities provide over a market cycle. For investors that are a bit more risk averse and want to stay from the high yield space because those companies have a bit more leverage, they can choose to invest in strictly the investment grade corporate bond space. And here you’re investing only in higher quality companies, and today the investment grade corporate bond space is yielding well above 5%.

Some risks to consider when investing in the current market environment is interest rate risk and credit risk. Expanding on interest rate risk, the market’s currently pricing in 100 to 125 base points in rate hikes from the Bank of Canada through the middle of 2023. And if inflation remains elevated, there’s a risk we get more rate hikes than what’s currently priced in. In that case, we’ll experience a further decline in bond values. The second risk to consider is credit risk. In the event central banks tighten financial conditions too much, this could tip the economy into a recession.

In that scenario, corporate bonds would be expected to underperform safe haven assets like Government of Canada Bond.