Bonds, and particularly corporate credit, had a painful year in 2022. However, there may be some compelling opportunities for fixed income investors willing to ride out the current volatility. It was quite the journey for financial markets in 2022. Fixed-income markets were extremely challenged, with the historically negative equity/bond relationship breaking down, leaving investors with nowhere to hide. As economies emerged from the pandemic, spending resumed as demand outpaced supply, spurring inflation.
Globally, central banks have been laser-focused on taming persistently high inflation by swiftly transitioning from accommodative to restrictive monetary policies. In North America, this has resulted in one of the most aggressive rate hike campaigns ever. Unfortunately, fixed-income portfolio performance has become collateral damage. However, a turbulent start does not have to spoil the journey ahead. The negative total returns in fixed-income resulting from higher government yields and wider credit spreads are bestowing attractive opportunities for astute investors with an active approach.
Short-Term Pain for Long-Term Gain?
As the year turns over and new year’s resolutions come into effect, we may quickly realize that letting go of habits can be hard to do. Let’s start with the obvious: bond pains endured by investors in 2022 is hard to forget. Globally, central banks have a strong resolve to fight inflation, which has been higher and more persistent than expected. They have also rightfully prioritized taming consumer price changes over short-term economic growth and financial stability. This has resulted in higher policy rates that have translated into higher yields across market curves. Here at home, the Bank of Canada has been one of the most aggressive amongst its developed market peers, raising rates a cumulative 400 basis points over nine months in 2022. Uncertainty surrounding inflation, rates, and growth has been one of the main contributors to elevated market volatility.
Now let’s turn to the good. Yield increases across Canadian market segments are now at levels not seen in well over a decade. The rise was painful, but the reset improves the total return potential for bonds. The starting yield for bonds has historically been a strong predictor of future returns.
Complementing the starting yield is the current market dynamics. Inflation has the potential to remain sticky and above central bankers’ target of around 2%. This may result in policy rates remaining elevated for a longer period than markets currently expect, which may prove to be a long-term positive for bond investors that can benefit from the higher yield carry. Eventually, monetary policy will start to take hold in the broader economy and we expect the pace of growth and inflation will eventually trend lower. Therefore, we have a downward bias on rates. When it comes to it, bond returns could not only consist of current yields, but may also be complemented by capital gains from increased bond prices.
Opportunities Abound, But Quality Matters
High-quality corporate bonds are a prudent way to add excess yield over and above the risk-free government yield, which is best achieved by allocating a percentage of the portfolio to corporate bonds. Over the last two decades, corporate bonds have become a larger and more diversified sector within Canadian bond indices.
We believe the current spread-widening episode is unique and has presented interesting opportunities for investors willing to look past the headlines and dig deeper into the fundamentals. While most previous economic downturns and credit spread widening events revolved around excess risk-taking and poor credit underwriting, the current economic backdrop stems from loose monetary policy and fiscal stimulus over the last two years. For the most part, corporate and consumer balance sheets are substantially stronger this time around.
Despite these strong micro fundamentals, as we move closer to a possible recession over the next 6-12 months, credit spreads are expected to remain somewhat volatile in the near term due to the underlying macro factors driving the global economy. Uncertainty about the economy and monetary policy is not expected to subside. However, within the Canadian investment-grade corporate space, the current spread widening has presented many interesting opportunities.
Companies with strong business risk profiles and high credit ratings are trading at levels rarely seen since the 2007-08 global financial crisis. In addition to the above, some technical factors have also contributed to good relative value opportunities this year. For example, larger than normal supply in the primary market by financial issuers resulted in sector spreads widening by a larger margin than in non-financial sectors. This has made some of these debt securities appear much more valuable, on a relative value basis, than they were just a year ago.
Corporate Mid-Term Spreads (vs Canadian Non-Agency)
Source: Bloomberg, Fiera Capital Inc. As at December 31, 2022.
Source: Bloomberg, Fiera Capital Inc. As at December 31, 2022.
Dynamic Markets Appeal to Active Management
Investors may be well served to consider defensive fixed-income and building high-quality bond portfolios to remain resilient during what is expected to be a volatile year ahead. We advocate for pursuing prudent yield and total returns in a risk-aware manner. The market will be sensitive to the evolving inflation, and economic and policy developments. We, therefore, support a flexible and nimble active approach during these uncertain times.
As the adage goes, volatility creates opportunity. We believe there are many good quality companies where valuations have moved in tandem with the risk-off mood and have begun to price in an economic growth slowdown. Better entry points may present themselves, but we believe the worst of the market repricing has passed. Investors need to be certain they understand the risk and ensure they are being appropriately compensated.
Against this backdrop, there is some benefit in having an increased focus on tactical opportunities provided by high-quality strategies that include potentially increasing an allocation to corporate bonds. We believe shifts in markets have provided an opportunity to take advantage of the full investment grade market, that is corporate bonds with ratings BBB or above. Flexibility to move across sectors, position along the yield curve and manage portfolio duration can help to improve risk-adjusted outcomes over the long-term.
This may include active broad market strategies, such as the Horizon Active Cdn Bond ETF (HAD), which includes allocations to government and high-quality corporate bonds that could stand to benefit from the improved market yield profile while adding what we believe will be an effective ballast against other parts of a multi-asset portfolio, as the economic backdrop potentially weakens.
For investors in search of a conservative potential yield boost from a higher corporate allocation, the Horizon Active Corporate Bond ETF (HAB) focuses on Canadian investment-grade corporate bonds with tactical allocations across credit qualities, capital structures, and sectors. HAB offers investors the opportunity to exploit higher rates and wider credit spreads while controlling for risk through an active approach.
In Summary: 2023 Could Be a Big Year For Bonds
In summary, the transition from accommodative to restrictive policy has been a challenging journey; however, the reset in yields should provide a formidable tailwind for bonds. A single year of poor performance during a transitional phase should not dissuade investors. On the contrary, bond yields have been ratcheting up to levels that have the potential to make the next leg of their journey formidable and an opportunity that should not be missed.