Fixed Income: Opportunities and Risks

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. 

Adam Ditkofsky, senior portfolio manager, global fixed income at CIBC Asset Management.  

So, one of the major questions that seems to be discussed reflects the fact that experts are predicting that the Bank of Canada will continue its rate-cutting cycle, with expectations that overall policy rate will be cut to two and a half per cent by July 2025.  

I would agree that we should continue to see the Bank of Canada continue to cut its overnight rate over the next 12 months, especially since inflation has essentially normalized back within the Bank of Canada’s policy target range of one to 3%; it’s now roughly around 2%, which is ahead of expectations. And while economic growth is still positive, this has largely been driven by Canada’s strong immigration policy, which is currently trending at more than one million new immigrants per year. 

Overall, I say that the Canadian economy is facing a lot of cracks. Businesses’ spending remains low, productivity remains weak. Consumers remain sensitive to interest rates, especially those who need to refinance their mortgages in the coming months. And while job growth is still positive, our unemployment rate continues to climb, now higher than six and a half percent at the end of September, with close to three people being unemployed for every job available in the country.  

So, I think the more debatable aspect of this question is, how far will the Bank of Canada go? And while some experts, again, are predicting two and a half percent, market expectations, which is what’s priced in to the derivatives markets at any given point in time, remain very volatile. And we continue to see these expectations change daily, especially after we saw the jobs number in the U.S. for September, which came in much stronger than expectations, above 250,000. And this saw bond yields move higher by about, call it a quarter of a percent, and saw expectations for rate cuts change from two and a half percent within 12 months to about 3%.  

Now, of course, there’s a lot of factors that can impact markets over the next year, but ultimately, with regards to how many rate cuts will depend on whether we see elevated inflation reemerge or if we’ll see further weakness in the economy. So far, the economy has been resilient, but if we see growth slow faster than anticipated, the bank will likely need to cut more, and if inflation starts to reaccelerate, we may need to see the bank pause.  

Right now, in early October, markets are still expecting two more quarter percent rate cuts by the bank in 2024, and under our baseline forecast, we see Canadian GDP growth at 1.8%, inflation at 2.4% and the bank cutting to 3% — all of which are modestly higher than where consensus has. And so far, the recent repricing of the bond market this quarter, and talking about the last quarter of 2024, which has seen modestly higher rates, has been consistent with this forecast.  

Now, this is also in line with the Citi Economic Surprise Index, which reflects whether economic data has surprises to the upside or downside, and this has also been trending higher since August.  

Now, in terms of how will this impact the fixed income market and what other factors that are impacting the fixed income, we need to remember that markets try to be as efficient as possible, so everything that is known today is priced in to the market. So, expectations of further rate cuts had already been priced in to the bond market. Now that doesn’t mean we won’t see rates move. I’d argue that should central banks continue to cut rates, we’d likely see a modest move lower in longer-dated bonds. But we need to realize that the yield curve, which reflects the difference in yield between shorter-dated bonds and longer-dated bonds, has been inverted for a long time, meaning that shorter-dated bond yields are higher than longer-dated bond yields. Any move lower from now would be more pronounced in shorter-dated bonds, meaning the bonds maturing in five years or less.  

So overall, all this means is that a lot has been already been priced in to the market, so we aren’t expecting yields to materially move, particularly for 10-year and 30-year bonds.  

Now, there are a lot of factors that can also impact the bond market, which include the upcoming elections, both in the U.S. and Canada, and, of course, increasing risks related to the escalating conflict in the Middle East, which could quickly bring yields lower should conflicts further escalate.  

One area of the bond market we haven’t talked about is credit, which has been extremely strong this year, especially as the soft-landing economic scenario has continued to unfold.  

Both investment grade and high yield have outperformed the broad bond market over the past 12 months, and investors continue to benefit from higher yields and tightening spreads. For context, Canadian investment-grade bonds currently yield between four to 5%, while high yield has been stable around 7%.  

Now, we continue to expect corporate bonds will continue to outperform, especially as demand remains extremely robust and provides investors with attractive yields. Another interesting observation, though, has been that the correlation between government bond yields and corporate bond spreads has somewhat normalized. What this means is, its return to being negative. So, this is unlike the relationship we saw in 2022.  

So, this should provide more stability for corporate bonds as they benefit from lower yields in risk off periods and tighter spreads in risk on periods, both partially offsetting each other. This means more stability, less volatility, and both being favourable characteristics for the fixed-income investment market. 

Another question reflects the fact that there’s a lot of innovation in active fixed income right now. This is really in response to the move higher in yields that we’ve seen over the past few years. Especially with corporate bonds, yields, again, being close to 5%.  

One area where we’ve seen innovation relates to products that are absolute return–oriented, as opposed to benchmark oriented. For example, we’ve been able to develop funds, which we refer to as strategic return funds, or target-date maturity funds, to generate returns to a specific target date where then the funds close. These funds focus on investing in corporate bonds and holding them to maturity to eliminate day-to-day interest-rate risks. But we’ve also been able to take advantage of many bonds currently trading at a discount, so a portion of the returns benefit from favourable capital gains treatment. Now these types of funds are one-, two-, three-year funds with closes after those periods, with after-tax returns above 5% on a tax-adjusted basis.  

Other opportunities now also include the incorporation of derivatives into portfolios to take advantage of specific inefficiencies in the bond market and target specific characteristics of the bond market as well. An example, we have our alternative credit bond fund. We use derivatives to invest in corporate bonds. So, we’re using derivatives also to eliminate the interest-rate risks within the bond to isolate the corporate bond spread component of the bond itself, eliminating any interest-rate risk exposure. At the same time, we can also invest in one-year government bonds to take advantage of higher yields at the shorter end of the yield curve. So, this also enables us to get much stronger returns.  

These are just two examples, but given where interest rates are now, we believe there are a lot of opportunities for investors in these markets. 

Where can investors find yield and what should their fixed-income strategy be?  

Well, a lot has transpired in the market over the past year, with central banks now being in a rate-cutting cycle, and while rates have moved lower this year, we believe there are still a lot of opportunities in the market.  

One important aspect is the fact that the correlation between risk assets and fixed-income securities has normalized. This means the relationship has again turned negative, meaning bonds once again provide a balanced portfolio with risk diversification and protection qualities, especially in risk off periods. Now, if you couple this with elevated interest rates, central banks being in cutting cycles right now, and the normalizing of inflation, we feel both government bonds, corporate bonds and innovative income-oriented solutions all offer attractive opportunities at this point.  

Now, in terms of the biggest risks to fixed income through the year-end, the first being a reemergence of inflation. Although this would likely reduce the number of rate cuts that are currently priced in to market, we still think that there would be rate cuts still. Very much so in this market. We don’t see the markets going back to that seven to 8% inflation rate. But that, again, would be negative for interest rates.  

I’ll also highlight as well that a lot of this excessive optimism that we saw in the summer with very aggressive rate cuts coming over the next 12 months, some of that was priced out in early October, with rates moving higher after we did see the most recent U.S. jobs number for the month of September.  

Now, the second big risk is, of course, the upcoming election in the U.S., which can cause a lot of uncertainties in the market depending on the results. And right now, that seems to be neck and neck. And the third being the escalation of military tensions globally, which could be very supportive for bond yields, but again, very negative for risk assets.  

Ultimately, there’s a lot of uncertainties in the market right now, which reflects why it’s important for risks to be appropriately balanced and managed within investment portfolios.