Canso’s Corporate Bond Newsletter on the hard lessons of a horrible year for bond investors
What is the landscape as we enter a new and hopefully better year for fixed income?
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Last year was truly annus horribilis for bond investors, who will no doubt be very glad to put 2022 in the rear-view mirror. But as the most recent Corporate Bond Newsletter, published in early January 2023, from leading Canadian institutional investment management firm Canso Investment Counsel Ltd. suggests, the relief that comes from leaving behind one of the worst years ever for fixed income should not blind investors to its hard lessons. What were the important trends? Why was there so much volatility? And what is the landscape now as we enter a new and hopefully better year? Here are the highlights from the Canso team.
To read the full report, please click here.
Apocalypse 2022 redux
What a year 2022 was. Russia invaded Ukraine, Elon Musk took Twitter private, Canada made the World Cup, the cryptocurrency world finally had its day of reckoning, and central banks did their best Fast & Furious routines by dramatically hiking rates to combat rampant inflation. And amid all the headlines, equity and fixed income markets both got pummelled. “Bond markets experienced one of their worst years in history,” while “U.S. equity markets entered bear market territory,” the Canso newsletter observed. And despite a fourth-quarter mini-rebound in stocks and bonds, the “standard asset mix 60/40 balanced fund investor experienced the worst annual return since The Great Depression.”
The numbers show just how badly bond markets performed. The Canso team notes that the previous worst-performing year for the FTSE Canada All Corporate Bond Index was 1994, but not anymore: in 2022, the Index declined by more than three times as much as it did back then. That made 2022 a true outlier in the 41-year history of the benchmark corporate bond index – and a very unfamiliar experience for most bond investors and bond managers.
A Shock to the System
As the newsletter pointed out, the FTSE Canada All Corporate Bond Index was launched in 1981, the same year Bank of Canada interest rates hit their all-time high of 21.2 per cent. Over the next 40 years, bond managers became accustomed to a world in which rates only ever went down and bond prices only ever went up. But by the time the pandemic hit in 2020, “the very low level of bond yields made them very sensitive to rising rates, with little yield to offset the price loss pain,” the Canso team wrote.
The return of inflation and rising interest rates in 2022 rocked that world, and bond prices have indeed proven very sensitive. It was, the Canso team wrote, “something that bond investors have seldom seen in their professional lives, and never for a sustained period.” That unfamiliarity with rising yields, the newsletter argued, contributed to extraordinary bond market volatility in 2022.
How extraordinary? Canso looked at trading days where the yield on the 10-year Government of Canada bond moved by more than five basis points, which is a significant shift in the world of fixed income. There were 128 of them in 2022, accounting for nearly half of total trading days, and more than in any year in the past quarter-century. Just as tellingly, there were 13 days in which the bond’s yield moved by more than 15 bps – more often than in the previous 10 years combined. Canso’s conclusion: “The lack of experience with a rising rate environment has made the bond market very volatile, as investors don’t know what to do with their new reality.”
Only the Brave
Such erratic market behaviour may make investors skeptical of any apparent trends. But there were a few “bright spots,” which were just less-terrible spots. Shorter-duration bonds, which have the least sensitivity to interest rates, were among the best of a bad bunch. That was (relatively) good news for Canadian bond investors, because even though Canadian investment grade credit spreads widened more than their U.S. counterparts did, “their lower duration powered a meaningful outperformance,” the newsletter observed. Floating-rate securities also did well by comparison to the rest of the market. Leveraged loans outperformed, ending the year only slightly negative amid limited supply and continuing demand for yield. And investors in securities tied to the Canadian Dollar Overnight Rate, or CDOR, benefited from sharply rising yields as the Bank of Canada rate rose from 0.25 per cent to 4.25 per cent over the course of the year.
Meanwhile, credit spreads in investment grade corporate bonds might be highlighting an opportunity. Canadian credit spreads widened to around the same levels they hit in 2011 and 2016, behind only 2008 (the Great Financial Crisis) and 2020 (the pandemic meltdown), and that could make investment grade bonds “look like reasonable value” now, in Canso’s view.
The risk, of course, is that wider spreads are reflecting poorer fundamentals, but the newsletter pointed out that large-scale redemptions in fixed income funds and very high issuance from Canadian banks have been big drivers. And when the Canso team looked at the spreads of lower-quality BBB bonds and higher-quality A-rated bonds, they didn’t observe a significant difference – and you would expect to find this if markets were pricing in a meaningful deterioration in credit fundamentals.
There’s Got to be a Morning After
It was a different story in high yield markets; however, where “weakening fundamentals are becoming more evident in the valuations of the most speculative issuers,” the newsletter noted, and investors are “disproportionately fleeing the uncertainty of the riskiest assets.” In 2022, high yield issuance and market demand were down dramatically from past years, and those companies that did issue bonds had to pay punishingly high coupons. “The easy money pandemic binge to ‘get invested’ and buy anything with yield has been replaced by a morning after hangover for high yield investors,” the Canso team wrote.
Even as borrowing costs are up and markets have tightened, high yield default rates have been relatively muted. As the economic outlook remains highly uncertain, that could suggest that more pain for high yield is still to come. “Investors should not rest on these laurels,” the newsletter noted, “as more and more companies will be forced to reckon with the reality of the current market environment.”
In that new reality, Canso’s approach remains the same, characterized by a commitment to reliability, stability, and performance. That means taking risks only when well compensated for doing so, the newsletter noted. “If we are not, we are happy to catch the next bus, and there is always a next bus.”
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.
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