Time to Be Picky About Corporate Bonds

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Patrick O’Toole

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Patrick O’Toole, vice-president, Global Fixed Income, CIBC Asset Management.

It was really a great year for corporate bonds in 2020 after a very dismal first quarter when the pandemic hit. The catalyst, of course, for the improvement and strong returns was the stimulus measures that the Federal Reserve took in late March of 2020 to stabilize markets via the resumption of quantitative easing and, I think, very importantly, was the initiation of corporate bond buyback program. Now, the Bank of Canada also announced the corporate bond buyback program a few weeks after the Fed, but really hasn’t had to use it much because I think the Fed program was really the catalyst for real improvement and tone in the marketplace. We’ve seen credit spreads recover about 90% of the widening that we saw in Q1 of 2020. For 2021, we still expect the corporate bond sector to lead the way. That’s really due to the fact that we see stronger GDP expectations in the consensus. We see less supply than last year as well.

Our stronger GDP expectations are really predicated on, because the amount of firepower the consumer has, there’s a lot of pent-up savings, a lot of pent-up demand that was there, given the support programs the government put into place last year, writing direct cheques to consumers, et cetera. We think when that gets unleashed, you’re going to see the economy doing much better than the consensus expects. It’s going to be a very good year, GDP-wise. That’s generally very good and constructive for corporate bond issuers because you’re actually making more money more easily. They’re able to refinance their bonds and collect the maturity. But, the current spread level on corporate bonds is leaving us pretty cautious to start 2021. We’re holding onto some firepower to take advantage of expected volatility. After all, we have these lockdowns to start 2021. They’re spreading and investors may expect that will eventually lead to earnings downgrades, or there could be concerns that we could see spreads increase as that risk-off mindset takes hold.

We continue to see some opportunities in the corporate bond market even today. But this year, we think the theme is it’s going to be more challenging to extract value in the corporate bond sector than it was in 2020. We have to be pickier. That’s not just being selective of which companies that you buy and the corporate bonds that they issue, but also which bonds [of] the companies we like. So, you have to be much more selective this year. So, we still see opportunities in some long-term corporate bonds and we don’t see much value in short-term corporate bonds. But when it comes to those long-term corporate bonds, we don’t really see the value in the 30-year area. We really see better value in the seven to 20-year area in the corporate sector. If government bond yield don’t change that much in the next year, which we don’t think they will, they could move up a little bit, we think those bonds in that seven to 20-year area will post pretty decent returns comparatively.

Sector-wise, we don’t see much value in the highest quality utilities. We like the banks. We like telecom companies. We’re pretty selective on the oil and gas companies. We like renewables, infrastructure bonds, industrial REITs, not so much some of the other REITs. We also liked the autos and some retailers. In the high-yield sector, we’re cautious as well, given the spreads are in about 370 basis points over treasury bonds to start 2021. We think the high-yield sector could see some turbulence if lockdowns do lead to that risk-off mentality. But, if we do see those spreads move back to the 500 basis point area, we’d be more apt to spend some of our firepower that we have. But in the high-yield sector today, we still like basic industries, technology, health care. And we’re OK with some of the higher quality companies in the energy area.

So overall, we expect corporate bonds are going to outperform government bonds in 2021. To sum up, we see a strong economy and somewhat higher inflation as the seeds for moderately higher government bond yields, and continued demand for the higher yields available on corporate bonds —meaning, the corporate sector will win versus government bonds again in 2021.