Fixed-Income Investing as Interest Rates Drop

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.  

Bond investors have been very patient and waiting for the rate-cutting cycle that we’re now currently in. And the question we often get from clients is, What will be the impact of further rate cuts? And we’re seeing it in real time.  

We saw during, you know, mid to late October, the Bank of Canada came out with a bit of a surprise cut of 50 basis points instead of the standard 25. And really, what we point to clients is that rate cuts are definitely good for their fixed-income holdings. If you look at even in the past year, something as simple as Canadian investment-grade corporate bonds returned to you higher than 10% for a low-volatility asset class. 

But we also think the idea of waiting for rate cuts to actually hit the headlines and to have the Bank of Canada or the Fed come through is actually a bit too late in terms of capturing the upside that’s there. And how we talk about it on the desk is a lot of this gets priced in. Markets are relatively efficient and very much forward looking. So, by the time we see, say, for example, the 50-basis-point rate cut we got from the Bank of Canada just recently, that has already been priced in to the market. And if you look at returns for fixed income in general, whether it’s in the U.S. or Canada or globally, the market was anticipating this rate-cutting cycle, and bond yields, bond prices, total returns, reflected this anticipation. And really now, we’re just seeing it come out in terms of central banks actually making those moves to cut rates.  

Now, do we think the rate-cutting cycle in Canada and the U.S., for example, is over?  

No, we think there’s still more room to run. Central Banks are still operating in somewhat restrictive policy levels. However, we would argue the quote unquote easy money to be made in terms of purely riding the wave of interest rates coming down and fixed income outperforming — that’s probably behind us. There’s still more opportunity here, but it’s a little more nuanced than we saw before, where really policy rates only had one way to go, which was down.  

We think now, for fixed income, you really need to be focused on total return, which is both a combination of price appreciation through further cuts in rates, picking the right bonds, and also, you know, the income potential that comes with yields where they are right now, and the ability to build a relatively safe portfolio that will generate an income that’s still interesting for your clients.  

Into the coming year, what investors really need to focus on is what we call internally here kind of the flexibility premium. So, again, the broad influence of rates coming down, that tide lifting all ships within fixed income, still playing out but probably near the later innings. Now, we think the focus becomes total return and can you be flexible with capital to find the best opportunities in the space? And we often point to, investors think of fixed income as this monolith, as a single asset class that offsets their equity risk. In some respects, that’s true, but fixed income is a very complex market with lots of different sub sections, areas of interest, opportunities to generate alpha for clients. And we think managers in the space who are ready to explore those different areas are really going to have an advantage going into 2025.  

So, I would suggest to everyone you know, think a little bit away from broad benchmarks. Think a little bit away from the kind of boring asset class — I just want it for a bit of income and safety — and think about given where interest rates are, yields are back at levels that are actually interesting. But there’s also volatility being introduced into the market, whether it be different central bank policy rates, geopolitical risks, the U.S. election upcoming of 2024. All of these things, while headline risks and kind of scary to hear about, actually open up a lot of opportunity in fixed-income markets. If you can find a manager that has that flexibility to be able to take advantage of that, we think that’s how fixed income continues to be a really strong portion of your total portfolio going forward. 

A lot of the focus, recently, given where short-term rates were and the high Bank of Canada policy rate, the high Fed policy rate, a lot of people have been focused on the short end of the yield curve and trying to maximize yield within those shorter tenors, whether it be something as simple as cash or money-market instruments through to one- to three-year bonds. And that’s where you found the most yield, really, because the curve was inverted, meaning longer-term yields — you really didn’t get compensated for going out the curve or taking more of that term risk.  

Now that we’re seeing policy rates come down and sovereign curves really in most developed markets starting to what we call go back to normal or re-steepen, which really is to say the longer-term yields are moving up while the shorter-term yields are coming down — now you actually get paid a bit to go out the curve or put money into solutions that have a duration, or average term to maturity, that’s longer than, say, one or two years.  

And what the benefit of that is, you’re really capturing current yield levels and locking that in, so to speak, for a longer period of time. Because just as fast as short-term interest rates went up, we’re clearly seeing they’re coming down just as fast. So, you may have gotten a really great yield for one year, but fast forward to now, you have to reinvest that money, and lo and behold, yields are not as high as they used to be.  

So, I would position clients to say, you know, 2022 was a real risk where we saw interest rates come up from zero, and having interest rate risk really caused negative performance in the fixed-income space, really wherever you were. But we can’t get caught in that recency bias to say we never want to have interest rate risk again. And right now, in the time where the curve is steepening, it really pays to go what we would call intermediate duration, moving out to say a four- or five-, six-year kind of profile. Yields are still attractive, lock those in now. And as we all know, yields are a great predictor of future returns. So, if you’re looking on a three- or five-year yield basis, these are levels that we think will really benefit portfolios over the next three to five years.  

Everyone continues to look for yield, that’s kind of the bread and butter of fixed-income investing. What I would say to those is, know where your yield is coming from. There’s really two components to any bond you buy, whether it’s a government bond, through to a corporate bond, all the way to, you know, high yield, leveraged loans, private credit, whatever the sub asset class you’re looking at, there really is two components to that all-in yield, say, of 10%.  

One of it is the base rate. For corporate bonds, tends to be equivalent-term government bond. For things like leveraged loans or private credit, it’s a base rate like a SOFR [secured overnight financing rate] or a Cdor [Canadian dollar offered rate]. So, a policy rate that’s set by the market. And that is really the rate you get just by having fixed-income risk. Forget all the credit components of lending to an issuer who is not the government. That’s really the base of where you get compensated for having fixed-income risk.  

The amount you get compensated above that is really what you’re getting paid to take on credit risk. And what that really means is to lend to a non-government entity — call it a Canadian corporate issuer, a private company down in the States through a private credit fund, etc. — that’s the compensation you get paid to own that.  

Right now, government policy rates and government bond yields and base rates have backed up quite a bit, and they’re very attractive. The spread, that additional compensation, depending on where you go, is relatively tight. You’re not getting paid, at least in historical standards, a lot of money to take on credit risk, whether it be through investment grade, high yield, loans, etc.  

So, what we would say to clients is, in the search for yield, unlike back in pandemic era, pre-pandemic era, you don’t need to put your neck out egregiously to earn an attractive yield, because those base rates are much higher than they’ve been in past decades.  

So, we’re not saying avoid corporate credit risk or avoid private credit. There’s lots of really interesting opportunities there. But if you’re buying it purely for yield, you want to make sure the manager you choose and the fund you choose is very risk aware, knows where the best compensation for that credit risk is and is not just putting forward an all-in yield number that on the surface looks attractive, but maybe you’re not getting properly paid to lend to a corporate issuer or a private company.