Fixed income must-read: Highlights from Canso’s April 2022 Corporate Bond Newsletter

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Canadian and U.S. central banks ended the era of pandemic-response easy money, and for bond investors there’s been no place to hide. In their most recent Corporate Bond Newsletter, leading Canadian institutional investment management firm Canso Investment Counsel Ltd. takes stock of the damage in bond markets and explores the issues and opportunities for fixed income investors in Q2 and beyond.

To read the full report, please click here.

The policy two-step winds down

One might expect war in Europe and the meltdown of a major Chinese property developer to send shockwaves through financial markets. But as the Canso team noted in their most recent Corporate Bond Newsletter, markets seem more concerned with something else – namely, the monetary policy response (or lack thereof) to soaring inflation, which in Canada and the U.S. reached multi-decade highs. In anticipation of rising interest rates, investors have pushed bond yields up for more than a year – and accelerated the bond selloff in the first couple months of 2022. They finally got what they’d been predicting for a while when the Bank of Canada hiked a total of 75 basis points on March 2 and April 13, and when the U.S. Federal Reserve announced a 50-bps hike on March 16. As the Canso team wrote, “History books will show the official end of emergency monetary policy accommodation to offset the COVID-19 pandemic came on those dates in 2022.”

There are almost certainly more rate increases to come – and fast. “Long gone are market expectations of a series of gradual hikes in 2022 and 2023,” Canso wrote. “Whatever policy implementation path central banks choose, it is almost certain overnight rates will end 2022 at or near 2 per cent, barring some unforeseen market calamity.”

Adding fuel to the bond market fire: the Fed stopped buying bonds in March – signalling the stoppage, if not the end, of quantitative easing, or QE, as it’s come to be known. But that end is has come, with the Fed beginning to unwind its balance sheet on June 1. It bloated to US$8.5 trillion as the Fed turned on the money taps in response to the COVID-19 pandemic.

On a global basis, the decimation of bond markets has had a remarkable effect on one “anomaly” of easy monetary policy: negative bond yields – created in large part by massive quantitative easing (bond-buying) by the European Central Bank and the Bank of Japan over the past several years. With rates rising, the Canso team noted, the global quantum of negative-yielding debt has declined by more than 80 per cent.

The Big Hurt

“Rising bond yields decimated financial markets in the first quarter of 2022,” the Canso team wrote, adding that the “carnage” was nearly universal. The lone bright spot: the commodity-heavy S&P/TSX composite index. Just about everywhere else, however, was a sea of red, and the bleeding was especially acute in bond markets, including corporate issues. In fact, the newsletter noted, the “Canadian corporate bond market recorded its second-largest drawdown on record in the first quarter of 2022.” It hadn’t performed this badly in more than 40 years.

Expectedly, longer-duration bonds have been particularly hard hit, but the carnage does not stop there. Mid-term and even short-term corporate bonds also declined sharply. “There was no place to hide in fixed income,” Canso said. “Even investors seeking safety and capital preservation in short-term bonds found no refuge.”

High-yield bonds fared little better, declining through the quarter despite a late rally and some spread compression. The Canso team remains cautious, however. “Viewed over the long term,” they wrote, “the current… spread does not represent a compelling buying opportunity. We remain concerned over risks derived from current valuations and see limited upside in all but a select few high-yield opportunities.”

Liquidity is king

In non-investment-grade debt markets, appearances can be deceiving. The Canso team noted that in late 2021 and early 2022, some companies tried to get ahead of rising rates by issuing debt at what appeared to be temptingly high coupons. Unfortunately, investors “who reached for yield in these issues have endured falling prices as coupons fall well below current market levels.”

In the first quarter, the leveraged loans market was the least-bad fixed income segment, declining only slightly. But the appeal of leveraged loans’ floating-rate coupons is undermined by several factors, according to Canso; those include higher credit risk, the likelihood of defaults as rates rise, and the weakened protections offered in case of default. Despite leveraged loans’ “decent performance on a relative basis,” Canso remains cautious.

Indeed, “caution” remains the byword for Canso going forward. As the higher costs of debt feed through the economy, everyone from governments to individuals will begin to feel the pinch, while quantitative tightening will reduce the amount of money in the economy. That could well lead to significant economic slowdown. In the meantime, war in Ukraine and trouble in China – not to mention the pandemic – continue to “cast a shadow over financial markets,” the Canso team said. They favour high-quality floating-rate corporates and Canadian/U.S. government bonds, because “this is not the time” to reach for yield – but rather to put a premium on liquidity.

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.