Canso’s Corporate Bond Newsletter makes sense of recent, confusing fixed income performance

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Central banks kept on tightening, and the yield curve reached its highest degree of inversion since 1990. And yet, through all the second quarter volatility, equity markets rallied and high yield bonds generated capital appreciation. Which raises the question: Does any of this make sense? In their July 2023 Canso Corporate Bond Newsletter, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. clear up the confusion over the yield curve, investors’ fear of missing out, high yield’s perhaps unsustainable resilience and where investors might look for opportunities in bond markets now. Here are the highlights.

(To read the full report, please click here.)

The return of real yield

The second quarter had its ups-and-downs for Canadians, the newsletter remarked. On the plus side, a Canadian golfer won the Canadian Open for the first time in decades; on the minus side, Taylor Swift has skipped over Canada for her latest blockbuster concert tour. Bond investors could nevertheless find reason to wholeheartedly celebrate, because real yields turned positive. May inflation (3.4%) was lower than the yield on three-month Treasury bills for the first time in two years.

Declining inflation, however, did not deter the Bank of Canada from its “rate-hiking kick,” the newsletter noted. (On July 12, the central bank followed up on its “surprise” June hike by raising the overnight rate another 25 basis points, to 5%.) As the Canso team noted, the continued tightening put the lie to the market’s growing confidence at the end of the first quarter that rate cuts were coming in response to the U.S. regional banking crisis. “The second quarter,” the team wrote, “showed us once again that the bond market is not a reliable predictor” of rate moves.

The Big “Long”

Central bank maneuvering meant the bond market had “to recalibrate its expectations in short term maturities,” the newsletter said. But the Canso team pointed out that longer-term bonds have been remarkably steady. Canada 30-year yields rose only modestly in Q2, finishing June where they started the year, and U.S. long-bond yield increases were similarly subdued.

While boosting long-bond performance in the quarter, rising short rates and steady long rates translated into a yield curve at “its most inverted position since 1990,” the newsletter noted. With three-month T-bills yielding more than long-term A-rated corporate bonds, investors were getting no compensation above the “risk-free” rate for taking on credit risk. Clearly “for some,” the Canso team wrote, “fear of missing out, or risk of losing out, on falling yields is just too much.”

High-quality corporates ended up back in the red during Q2, although tightening credit spreads and higher running yields mitigated some of the damage. Meanwhile, high yield bonds and leveraged loans outperformed, and “credit spreads on the lowest quality debt narrowed without regard for tightening market conditions or much increased default risk,” the newsletter noted. Positive equity markets, driven by optimism over AI, continued what the Canso team calls “the ‘risk-on’ theme” in the quarter.

Where’s the beef?

For investors looking at bond values, this might present a confusing picture. Yet the Canso team wrote that while credit indices generally are tighter, “investment grade spreads remain well off post-pandemic lows and the best relative value continues to exist within higher quality corporates.”

In particular, the team pointed to Financials, which dominate Canadian investment grade markets. In 2022 and into this year, banks have “flooded the domestic market” with bond new issuance, causing Canadian senior bank spreads to “widen markedly over the past 18 months, dragging the overall Canadian [bond] index wider than its U.S. counterpart.”

The newsletter further noted that some Canadian Financials are trading at much higher yields than other similarly-rated corporates, meaning that borrowing for some banks is more expensive than for some non-financial A+ rated companies.

The team’s conclusion: “Canadian Financials are cheap.”

The higher they fly …

High yield bonds saw tightening credit spreads in Q2, and they ended the quarter substantially tighter than at the start of the year. As the newsletter noted, the lowest-quality issuers outperformed the rest, with returns from the CCC-rated segment more than double those of higher quality BB-rated bonds.

But the Canso team pointed to several red flags. One is that although high yield new issuance seems to be strong on the surface, it is in fact modest in a historical context, and that is likely driving down spreads.

Another caution is a noted increase in secured high yield bond issuance, suggesting that lower-quality companies “have had to offer security to fulfill their funding needs or refinance looming near term maturities.”

Finally, the newsletter noted that high yield defaults are rising; the combined total defaulted value in the U.S. in the first half surpassed the total for all of last year. However, the team also remarked that 12-month rolling default rates are below average and remain modest compared to cycle peaks. With tighter market conditions, the need to refinance low-cost debt and the impact of higher rates on floating-rate loans, they see more upward pressure on defaults on the horizon.

“If the inversion in the yield curve is signaling recession and lower rates, the high yield market did not get the message,” Canso wrote. “At current valuations, we continue to believe that outside of some special situations, [high yield does not offer] enough compensation for the risk.”

The more things change …

As much as market expectations and central bank moves have created uncertainty in bond markets, the Canso team said their approach remains largely the same. In their view, yield curve inversion does not support current high yield or leveraged loan valuations; high quality, liquid bonds are still more attractive “while we wait for valuations on more speculative corporate issues to provide better compensation for their risks.” In the meantime, they added, “we have conviction that tightening credit markets will lead to better opportunities.”

The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.

This story was created by Content Works, Postmedia’s commercial content division, on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.