Time for large rate cuts may be over

Text transcript

Welcome to Advisor to Go. Brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

Aaron Young, vice-president fixed income, CIBC Asset Management. 

As we enter 2025, a lot of questions we get from clients and advisors are around what to expect next in fixed-income markets. And again, it’s a very good question to ask, given what we have seen over the past couple years, where the dominant theme has been lower central bank rate policies acting as a tailwind for fixed-income returns across the board, whether it be government bonds, corporates, etc. We think part of that has played out. There’s still room for central bank easing and the follow-through to overall bond markets. But we think the larger moves that we saw in 2023-2024 are nearing the tail end of that. 

So, really, what does fixed income look like going forward? Our argument would be finding the right balancing act between income potential — which we now have back in the market — but also an ability to maintain that income potential, not returning to an environment of zero-interest rates, where yields on bonds were so low that they almost weren’t worth owning in some respects.  

So, as we kind of settle out to that level, we think fixed income really does provide a good balance of opportunities within a total portfolio — whether it be these yield levels, which are still relatively elevated and offer great income opportunities for investors, but also the volatility around where do central bank policy rates end, what’s the impact on the shape of the yield curve, what’s the impact on corporate credit, securitized? And for an active fixed-income manager, volatility is great, because we can build off of that underlying income profile and add additional value by taking advantage of inefficiencies in the market, mispriced sectors, mispriced bonds, and the ability to add extra value or protect capital above that kind of baseline income. 

With the overall move in policy rates and the short end coming down in fixed-income markets throughout 2024, we really think now the focus should turn to the shape of the yield curve. What does that look like? And what does the shape of the yield curve say in Canada versus the U.S.? What’s that relative value there? 

So, our argument is, in the short end, a lot of the rate cuts in Canada and the U.S. have been priced in. There could be some moves higher or lower, based on market expectations, flows, etc. But, generally speaking, that juice has sort of been squeezed from that fruit. 

What we would argue is there’s interesting opportunities in a curve re-steepening. That move has happened to a large extent. But there’s still pockets of yield curves in Canada, U.S. and developed markets where we can position for curve steepening. And we think that’s a good trade, a good investment idea to generate alpha. And we would also say the relative value between Canada and the U.S. — so Canada government bonds versus U.S. Treasuries — is something to keep a close eye on, given the rather divergent monetary policy slash macroeconomic backdrop. With that divergence, you get some interesting opportunities to own, say, longer term U.S. Treasuries over Canada’s because of the additional yield pickup and the possible price appreciation embedded in that curve versus a Canadian interest-rate curve, especially in the long end, which is really priced very, very well, very low yields. [It’s] hard to see how it could get even richer from there. 

* * * 

With the Bank of Canada continuing to cut rates in 2025, I think that means investors need to do away with some of the behavioural biases that they have remaining from the violent interest-rate increases that we experienced in 2022, where it paid to be short duration, if not zero duration or in floating rate product. That kind of trend of ‘duration is not my friend’ is not as exciting in 2025. In fact, we would argue clients and investors in fixed-income asset classes really need to look at extending.  

Now, I’m not saying you should go out and have really long duration in the 30-year part of the curve. But I would argue the floating-rate structures, the ultra-short money market durations, etc., are not going to be as beneficial as the Bank of Canada continues to cut. And I think what we’ve seen in the market, and what’s clear is that central banks globally, the Bank of Canada, the Fed do have tighter controls over obviously the overnight policy rate and its implications for short-term bonds out to, say, two or three years. They have less control over what happens in the 5-, 10-, 20-, 30-year parts of the yield curve. 

Even though short-end rates are coming down, that doesn’t mean yields on those levels will also be falling precipitously. So, we would argue it’s a bit of ‘extend to defend’ — the idea of taking a bit more interest-rate risk, because you’re going to get a bit more yield now that the curve is renormalized. And you’re going to lock in that yield for a bit longer time. And that behaviour has not paid well over the last few years. But we need to reorient ourselves, to say we’re back in a bit of a normalized environment where the curve is upward sloping. I get paid to take a bit more interest rate risk. And I get to lock in that kind of income or yield for a longer period of time than having to constantly reinvest my earnings every year in ultra-short-term bonds.  

So, I really think, against the backdrop of continued lower interest rates from the Bank of Canada — and we can argue where those rates bottom out — it really is worth looking at extending a bit out the curve, locking in that yield for a longer period of time. 

Against the backdrop of lower policy rates, yields coming down, although it has been volatile, we do like to think about the yield environment in the two key components. So, there’s what we call the base rate, which is really your government interest rate. So, these are the yields that we can buy through U.S. Treasuries, Canadian government bonds, U.K. gilts, French OATs, German Bunds, etc. And then there’s also the credit-risk component, which is the additional yield we get from buying everything from corporate investment-grade bonds, high-quality issuers, securitized debt, etc.  

We would argue right now where you can find yield is actually in the safer part of the risk curve. So, the way we’re positioned in our funds, and the way we would tell advisors and clients to look at the fixed-income market in general, is there’s lots of opportunity in relatively low-risk yield.  

So, things as plain vanilla and — to be frank — boring as government bonds, provincials and things like securitized debt. And we’ve talked a lot about agency MBS in the U.S. as an example of additional yield — which we like – but without taking incremental amounts of credit risk. So, again, backed by the full faith of the U.S. government, with a yield pickup above plain U.S. Treasury, that’s still attractive, highly liquid — more liquid than probably the entire Canadian bond market, to be honest with you — and at a pickup without going down in quality or liquidity. That’s the kind of trades we want to do all the time, because they won’t always exist. 

And on the flip side, I would say caution. Not to own credit risk, but caution around where are you taking credit risk? How far out the risk curve are you going in terms of credit? Spreads, especially in investment grade and high-yield land, are at levels that are extremely tight. Do we think now is the time to go all-in on credit risk, to get a few extra basis points in yield? Probably not. There’ll be better entry points in the future. 

* * * 

My tips for investors going into 2025, when looking at their fixed-income investments, are really a recap of what we talked about earlier. 

So, I would say, number one is getting rid of recency bias, recognizing that, in this environment where yield curves have normalized, yields are at decade highs. You should be looking at fixed-income instruments and fixed-income vehicles that offer a duration that’s not zero, or [an] interest-rate-risk above zero. Again, I get the scars from 2022 when rates went from 0% to 5% plus very quickly. Those are deep scars. But if that playbook is used in the current environment, I think it’s going to be a disadvantage to fixed-income investors. So, duration is not the enemy here. 

The second one, I’d say, is a repeat of what I would call quality income. So, there’s lots of yield out there, given where interest rates have gone from that zero bound. And you really don’t need to put your neck out, in terms of credit risk or overall risk, to capture those yields. So, again, when looking at attractive yield numbers, break it down. Say how much of that is coming from the base rate — the quote-unquote risk-free rate — versus how much credit risk am I taking? And do I feel comfortable with that? 

And my third point would be, again, we’re seeing macroeconomic backdrop, exogenous shocks, Trump tariff policies, all these things which are very hard to model and very hard to predict the actual outcomes of. That means volatility in all markets, including fixed income. Volatility in fixed income really lends itself to active management. 

It’s an asset class that’s highly inefficient. If we have volatility, we’re very confident in our abilities to add value, to pick up those basis points for clients, to protect capital and take advantage of the inefficiencies that exist in our market. So, any passive holdings that you may have now is a great time to look at rotating into active and getting that extra value-add and risk mitigation.

**

This program is intended for Advisor Use Only. The views expressed in this material are the views of CIBC Asset Management Inc., as of the date of publication unless otherwise indicated, and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. This material is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice, it should not be relied upon in that regard or be considered predictive of any future market performance, nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this material should consult with their advisor. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates”, or other similar wording. In addition, any statements that may be made concerning future performance, strategies, or prospects and possible future actions taken by the fund, are also forward-looking statements. Forward-looking statements are not guarantees of future performance. These statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results and achievements of the fund to differ materially from those expressed or implied by such statements. Such factors include, but are not limited to: general economic, market, and business conditions; fluctuations in securities prices, interest rates, and foreign currency exchange rates; changes in government regulations; and catastrophic events. The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. CIBC Asset Management Inc. does not undertake, and specifically disclaims, any obligation to update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise prior to the release of the next management report of fund performance. Past performance may not be repeated and is not indicative of future results. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc. ^® The CIBC logo and “CIBC Asset Management” are registered trademarks of CIBC, used under license.