Fixed-Income Outlook and Opportunities

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.  

Pablo Martinez, vice-president and portfolio manager, CIBC Global Asset Management.  

We do believe that bond yields remain attractive.  

If we go back earlier in 2024, at the onset of the year, we had bonds that, for the 10-year Canada government bonds, for example, was standing at 310. And we thought those yields were attractive. We were coming out of a period of financial repression after the pandemic, and finally yields had moved up, and they were attractive to investors.  

And not only that. We also believe that yields will be moving in a range for the most part of 2024, and that’s actually pretty much what happened. If we go back throughout the year, yields went from 310 to about 370, 380 if we look at that period in April and May as inflation was stickier than what the market had expected. We saw yields moving up to that area. And then, as months went by, inflation numbers were more under control, and the market started anticipating central banks would be cutting rates. And rates dropped to about 3% where we stand now in early September.  

So yes, bond yields were attractive to begin the year, and they remain attractive right now, where we are. 

We believe that they remain attractive, because the range that we had set earlier in the year is pretty much intact. We do believe that that range might be a bit lower than what we have seen earlier in the year, but the main forces you know that are keeping bonds in that range are still alive.  

So, we don’t really believe that rates have a whole lot of room to move significantly lower from here, basically because we think that a lot of good news are being priced right now. When we look at what central banks are saying, what the markets are pricing, markets are pricing a whole lot of good news.  

And actually, if we look at futures expectations for the overnight rate in Canada, one year from now, the market is expecting the overnight rate to be at two and a half percent. So, a lot of good news are being priced in for inflation.  

Basically, the market is pricing a bit of a Goldilocks scenario, in the sense that the market’s expecting a soft landing of the economy. The market’s expecting inflation that will keep slowly adjusting toward the neutral rate, and also pricing the central banks that are shifting their focus to the job market, and the central bank that will be able to lower rates without triggering any kind of price spike, especially in housing.  

So, there’s a lot of good news being priced, and that’s why we have seen rates moving down so low.  

The only way in our minds that rates could move significantly lower is if something surprising happens, something that surprises the market. In that case, it would be a more pronounced economic slowdown. If that occurs, then yes, we could break the range.  

The Bank of Canada, it’s very interesting to see what they’ve been doing during the year. At the onset, at the beginning of 2024, we have to remember that a lot of aggressive cuts were being priced in the market. 

But now that they have started to cut, the question is, How low can they go?  

I mean, obviously they want to drop rates as much as possible without triggering inflation. But we have to realize that they are walking on thin ice. They want to ease the pain of borrowers, especially those that are renewing their mortgages. They want to do so without triggering a new bidding war on housing. And they also want to keep inflation at bay. And we have to remember that a lot of the good news on inflation has come from the goods side. When we look at inflation on the services side, it still remains sticky.  

So, they are walking on thin ice, but they do want to cut rates.  

Our view on this and how it’s changing the way that we manage bonds, well, it’s a bit similar to what we have seen earlier in the year. We do believe that the central bank, they have some leeway to cut, maybe not as much as what the market believes, and that’s why we believe that probably we’ll see a bit or some of those cuts being priced out of the market as news on inflation and employment comes in. 

Normally, North American markets are not too affected by cross current on international investments, but we did get a bit of a scare in the month of July and August, as Japan increased its overnight rate. That led to an unwinding of what we call the Yen carry trade. The Yen carry trade, to put it simply, it’s a trade where investors are using cheap Yen financing to purchase higher yielding assets. In this case, a lot of it was being invested in the U.S. stock market, especially in the high-tech stock market.  

So, what we have seen was that when the central bank in Japan started to increase the rate, that trade became less profitable. A lot of investors unwounded this trade, and that led to a lot of volatility in the market. Not just in the stock market, but also in the rate market, on the currency market. And even though it was pretty much short-lived, this is a reminder that when markets reach historical highs, the risk of a curveball increases.  

So, we have to be able to manage through this, keep our head cool, and remember that we’re investing for the long run here, not for a quick profit.  

Another factor that did impact fixed income, and it’s been like that throughout the year, was the appetite of investors for corporate debt. So, we have seen corporate bond spreads that have tightened during the year, but they still remain attractive. And it’s quite understandable. Investors see the spread that can lead to a good corporate name yielding above 5%, and they just jump on it. And that’s quite understandable. Corporate profits have been steady, and they’ve been very positive, and that, obviously, you know, improves the capacity of corporations to service their debt.  

So yes, investors are profiting from the fact that they can get very decent yields for good corporate names. So, these are the factors that have been impacting fixed income lately. 

Even though corporate spreads have compressed during the year — they have given us very good returns — they do remain attractive. They remain attractive, and especially in the short end of the yield curve. We have big proponents of overweighting that sector, and it has been paid a whole lot, not only because the yield is interesting, but also because of the fact that the yield curve at the short end of that same curve has dropped quite dramatically as central banks have lowered their overnight rates.  

So, we had gains from corporate spread and also from moves in rates.  

That being said, we believe that there’s still good value in that sector, three- to five-year corporates. Mainly because, when we compare them to 10- and 30-year bonds, well, you know, there’s a lot of institutions that are natural buyers of longer-term corporate securities. And because corporations don’t really issue that much in the 20- to 30-year sector, there’s a lot of demand and scarcity on those bonds. So, they become very rich, very expensive, especially compared to the five-year corporates. Corporations normally issue, it’s more natural for them to issue in the five-year sector. So, there’s a lot more offer, there’s a lot more of names, and there’s a lot more opportunity in that sector. So that’s the sector that we find the most attractive, compared to the longer-end corporate curve, where the risk/reward is just not there.  

And speaking of sectors, there hasn’t been a whole lot of change in the sectors that we tend to favour. We still like names associated with energy, the midstreams, oil and gas. The one sector that we also have added was senior housing. Obviously, this is being driven by demographics, the aging of the population. It makes it a natural selection for us.  

And also we are constructive on autos. There has been a lot of pent-up demand for autos during the pandemic, and we still see very good demand on the auto side.  

But you know, we have to be careful, because not all sectors are the same. We are still staying away from office REITs. So, REITs are not of the same value, and we tend to stay away from the office REITs. Basically because of the fact that, you know, offices did not yet completely adjust to the new way that people are working. There’s still a lot of people that are working from home. A lot of corporations are adjusting in a more stable way to have their employees working hybrid. And unfortunately, you know, this will still have an impact on office REITS, so we’re tending to stay away from those.  

It’s very difficult to target a duration that we’ll keep during the year. The market has been so volatile this year, and the moves in rates have been so violent that we have to keep with a strategy of trading that range. And as we said before, we are still expecting the rate market to move within a range. So, when we get to more extreme levels, like we are, you know, early September, we’re seeing that we’re breaking 3%. If we realize that, you know, that trend is tending to reverse, if we see that that resistance at 3% is being maintained, we wouldn’t hesitate to maybe reduce duration in that sector.  

But again, we’re not marrying those positions. The market is very volatile, and if we realize that we are getting at the top of the range, let’s say three and a half in a 10-year Canada, then we wouldn’t hesitate and dynamically move to increase duration.  

So right now, I would say that most of our portfolios, active portfolios, are neutral. We were slightly long as yields moved lower. Now we have reached a level where we want to be more prudent. As we are nearing the lower end of our trading range, we want to be prudent. We want to maintain a duration that’s close to neutral, and if we realize that yields are a bit overvalued, we would not hesitate to short those bonds.