How Investors Can Navigate Today's Challenging Fixed Income Markets

Commentary from Ebad Saif and Kevin Minas

Fixed Income yields offer exceptional risk-adjusted value at current levels. With the back-up in yields, sovereign bonds are better positioned to provide investors with protection against future equity market drawdown risk.

Given the increasing likelihood of a recession, we remain focused on enhancing the resiliency of our fixed income portfolios by moving from longer to shorter dated corporate bonds, improving the credit quality of our holdings and tilting portfolios to defensive sectors.

Current state of fixed income markets

With the broad-based widening in credit spreads, there are portions of the credit market that are well positioned to provide investors with attractive yields and protection against future spread widening.

Credit spreads, also known as high-yield bond spreads, are the difference between a high-yield bond and a bond benchmark. Higher-yield bonds offer higher interest rates for investors because there is higher default risk associated with the bond when compared to investing in more secure options such as treasury bonds.

Credit markets have experienced material spread widening year-to-date. U.S. high-yield spreads have increased from 3% at the start of the year to close to 5% as of October 2022. Canadian investment grade bonds have also experienced material price weakening from spread widening in 2022.

Interest rates and the bond market

Volatility in financial markets continues as a result of tightening monetary policy by global central banks, geopolitical uncertainty in Europe, elevated interest rate volatility and rising inflation. The Bank of Canada has increased its overnight rate by 3.50% in just 9 months, bringing it to 3.75%. On October 26, 2022, the Bank of Canada raised the overnight rate by 50 bps instead of the broad-based market expectation of 75 basis points. This could be a potential sign of an upcoming pause or pivot from central banks’ regarding rapid rate hikes. ?

The central banks are acknowledging that the Canadian and U.S. economies are likely to experience soft, if not negative, growth and may also experience a recession as they continue to increase interest rates. Our economic outlook over the next 12 months expects investors to be on the lookout for a global recession. We are also expecting both Canadian and U.S. gross domestic product (GDP) growth to increase.

Key risks we’re focused on in our fixed income portfolios

Cracks such as the unexpected rise in UK Gilt yields are appearing in more places as global interest rates move higher, market volatility increases and the strong U.S. dollar puts strains on the global economy. We expect these market pressures to grow, leading to negative year-over-year growth in the first half of our 12-month forecast. As government support measures decline, strong growth in demand for durable goods such as electronics and furniture slows and the housing market continues to cool off.

Our fixed income portfolio positioning: Growing risks and our economic outlook

Short-term vs. longer-duration bonds: Investment grade credit overview

We expect shorter-dated corporate bonds to weather the storm better than longer-dated bonds and are positioning our corporate exposure more in this part of the market. Shorter bonds have sold off recently, providing more attractive vale and safer entry points as higher yields provide added protection. Shorter-duration bonds also have lower credit spread risk as they’re closer to the maturity date which means lower volatility than longer-duration bonds. Lastly, shorter-duration bonds also have higher spread break-evens.

A bond spread break-even is the amount of credit spread widening corporate bonds can experience before their total return underperforms Government of Canada bonds . A higher spread break-even, all else being equal, means a higher margin of safety for the investor. We’re currently overweight the financial sector as it provides attractive valuation and liquidity. We also have an overweight in energy because of our positive outlook for the sector.

Investing in high yield credit and higher quality name brands

We expect opportunities to increase our positioning in high yield bonds as recession risks rise, so we remain cautious for now.

Within our high yield exposure, we have tilted the portfolios towards higher quality names and economically resilient sectors such as packaging. We continue taking advantage of market dislocations that have resulted in some strong companies to now trade at favourable valuations. This provides an opportunity to reposition the portfolio. For example, we added to Newell Brands. They sell defensive, consumer staples products under brands such as Sharpie, Graco, Rubbermaid and PaperMate.?

A look at the bond high yield spread history

Emerging Market Debt (EMD)

We have reduced exposure to EMD as tighter monetary policies from emerging market central banks over the last two years are starting to take their toll on economic performance.

Other notable headwinds for EMD include heightened geopolitical uncertainty and declining manufacturing activity as measured by global purchasing managers indices and global export volumes.

We have exposure to commodity producing countries, such as Chile and Australia. Recent market volatility also provided an opportunity to purchase Mexican bonds at an attractive valuation.

Duration

Market expectations of the magnitude and timing of interest rate hikes may be too aggressive as recession risks rise. Market volatility should provide opportunities to tactically position duration longer as rates have become oversold. Current duration positioning is neutral, but we are watching our economic indicators closely to move duration longer.

Term Structure

We expect the yield curve to steepen as markets move and central banks are anticipated to slower interest rate hikes. In this scenario, the long end of the yield curve would underperform. Therefore, we have positioned portfolios to be underweight in the long part of the curve which would be the most negatively impacted by a steeper yield curve.

Private Debt

We increased exposure to investment grade infrastructure debt and private commercial mortgages. These low duration, high quality sectors provide attractive portfolio stability and diversification.

Each of the investments we make in these asset classes require strong covenants directly negotiated with the borrower to provide greater oversight and control over the investment. In the case of commercial mortgages, there is also recourse to the physical building structure, providing further credit enhancement.

We particularly like infrastructure and commercial mortgages in the current environment as these exposures offer greater credit protection than traditional public credit sectors.

What can investors expect next?

The pressure from higher interest rates will likely lead to a global recession. Central banks seem willing to accept a recession to purge some of the excesses demand for goods, services and property etc. that came from the massive amounts of liquidity injected to offset the negative impacts from the pandemic.

We have been actively adjusting positioning in our fixed income portfolios , bracing for an economic slowdown and remain biased towards a defensive strategy. This allows us to have ample liquidity in the portfolios to take advantage of market dislocations and leverage our in-house fundamental credit analysis, global economic research and tactical asset allocation capabilities when opportunities arise.

Yields are already starting to reflect many of the economic risks we discussed. While some risks remain, the opportunity for investors to use cash to lock in elevated fixed income yields may be a short-lived investment strategy. Our fixed income portfolios are positioned to capture attractive current yields, while keeping liquidity ready to navigate further potential instability.?