Cautious 2024 outlook for bonds: Canso Investment Counsel Ltd.

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After spending most of the year grappling with inflation and higher interest rates, bond markets staged a remarkable rebound in the last two months of 2023. But will the good times keep rolling in 2024? In their January Corporate Bond Newsletter, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. looks at some of the factors driving the late-season rally — and reasons for investors to avoid getting carried away.

Click here for the full January 2024 Canso Corporate Bond Newsletter.

Not with a whimper, but a bang

Only four months ago, bond markets looked poised to finish another year of losses. Recalcitrant inflation and central bank signals of higher-for-longer rates drove government and corporate bond indexes to near-negative territory by October — depressingly reminiscent of 2022, which was among the worst years on record for bond performance.

What a difference a quarter can make, as the Canso Corporate Bond Newsletter points out. In November and December, “inflation continued to decline, labour market strength showed signs of moderating and Federal Reserve policymakers signaled their rate hiking efforts may be coming to an end,” the Canso team wrote. “The shift in tone sparked an expansive rally, propelling equities, investment grade and high yield bonds higher.” U.S. high yield and investment grade bonds finished 2023 positive, and in Q4 Canadian investment grade enjoyed its second strongest quarterly performance of the 21^st century.

Part of that recovery is owing to plummeting government bond yields, which had a roller-coaster ride through 2023. According to the newsletter, 10-year Government of Canada bond’s yield moved by more than five basis points on more than 50 per cent of trading days — a sign that the “end of the 40-year bond bull market in 2022 and the move into whatever comes next continues to confound investors,” the team wrote. (The volatility in government bond yields so far in 2024 appears to reinforce that point.)

The hunt for yield resumes

Q4 saw credit spreads tighten across the board in corporate bond markets. Moves in Canadian and U.S. investment grade risk premiums tracked closely throughout the quarter, but spreads in Canada “continue to look like a better relative value, as they persist notably higher,” the newsletter noted. One reason for that: the underperformance of Canadian financials, which flooded the market with new issuance in 2022.

The Canso team pointed out that credit spreads for financials ended the year higher than non-financials — an inversion of the normal trend that typically occurs only in times of crisis. With new issuance from financials moderating in 2023, “these differences should support tighter relative spreads for Financials” going forward, the team wrote.

In the high yield market, the “Fed fuelled rally” drove credit spreads tighter, too — perhaps too tight. As the Canso newsletter noted, by the end of the year U.S. high yield spreads had fallen well below 400 basis points — “well inside of the series average” and offering “little spread upside relative to risk.” All the optimism over rates potentially coming down also reopened the window for new high yield issuance, including unsecured deals.

“Opportunistic issuance,” as the Canso team calls it, created a huge surge in high yield new issues in 2023 compared to 2022, although they were still “below the trailing 10-year average.” The Canso team wrote that this rejuvenation “gives us the sense that capital is not exactly scarce in the most speculative ends of the credit market.”

New issuance activity in the high yield bond market began to show signs of life. According to the Canso team, this may signal yet another shift in the M&A cycle for the oil and gas sector, which saw ExxonMobil acquire Pioneer Natural Resources and Chevron take over Hess Corp. That may be a reversal of the trend that has held since 2020, when producers began to cut capital and operating expenditures in response to falling oil prices.

“It now appears that ‘expansion’ has shifted back into focus,” the Canso team noted. “Will investors be wary of where we are in the cycle?”

The more markets change

The team at Canso noted that while the U.S. economy continued to expand going into the new year, Canada’s economy may be on the brink of a technical recession. Investors are coming out of the end-of-year frenzy to “get invested,” and credit “tends to overshoot to the upside before overcorrecting to the downside,” the newsletter added.

But guessing which way the markets will go in 2024 is a mug’s game, and while they look toward the new year with “cautious optimism,” the Canso team is not getting ahead of themselves. “We focus on individual companies, the quality of their cash flows, the terms of their bond offerings and the compensation we expect to receive,” they explained. “We prefer to protect our capital versus reaching for yield, even if that means missing out on some late-cycle fun.”

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.