Fixed income must-read: Highlights from Canso’s July 2022 Corporate Bond Newsletter
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As central banks around the world aggressively raised short-term interest rates, the value of all assets – stocks, bonds, real estate and just about everything in between – fell sharply in the second quarter of 2022. In fixed income, yield spreads of corporate and high-yield bonds have widened, although still not by as much as during previous economic crises. The question for investors: do rising yield spreads and more attractive coupons provide enough incentive to take on the apparent risks? In their most recent Corporate Bond Newsletter, leading Canadian institutional investment management firm Canso Investment Counsel Ltd. takes a look under the hood of bond markets to see if they currently present any opportunities for investors.
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Rising rates, falling fortunes
In the face of runaway inflation, central banks in the first half of 2022 raced “to restore price stability and their own credibility,” the Canso team noted. The impact on financial markets and beyond has been dramatic and stark: the asset values across the board has been hammered. “Stocks, bonds, crypto, real estate – if you owned it, it went down,” they wrote. “Rarely have so many lost so much, so quickly.”
More hikes followed around the world. The European Central Bank raised its policy rate by 50 basis points on July 21, the first hike from the ECB in more than a decade. And on July 27 (after publication of the Canso newsletter), the U.S. Federal Reserve hiked by 75 bps, as was widely expected. Yet perhaps the most electric moment in this round of monetary shock therapy was the Bank of Canada’s July 13 increase of a full percentage point, which caused the yield curve to invert – suggesting just how deep concern over an economic slowdown runs. And yet the Canso team also noted that investors seem to be placing “a high degree of confidence that central bank actions will wrangle inflation back to target.”
The price of that anticipated “success” includes devastated financial markets. The newsletter highlighted how higher government bond yields have devastated corporate bonds. The Canadian Investment Grade Corporate Index fell less than its U.S. counterpart, but that is probably little solace to investors, as credit spreads moved substantially higher in both markets –ending the second quarter well above their long-term averages. (Understandably, the selloff got deeper as risk increased. In the U.S., BBB-rated corporate bond spreads widened much further than higher-quality A-rated issues, the newsletter noted.) In Canada, however, new issuance ended the quarter only slightly down from last year’s record-setting pace, as large financial institutions floated bonds with headline yields above 7 per cent. That “translated into significant investor demand for these issues,” Canso noted.
High yield blues
It was a different story in the riskier high yield market. New issues fell dramatically, as higher yields, widening risk premiums and concerns over recession dampened activity. In the U.S., high-yield issuance in the first half came in at just over a third of last year’s H1 total, and non-U.S. issuance followed a similar pattern, down 80 per cent versus last year.
Not surprisingly, high yield spreads soared, nearly doubling during the second quarter and ending it above their long-term average for the first time in two years. Yet as the Canso newsletter remarked, “There may be more pain to come, as high yield credit spreads still have a long way to go to reach the wide levels experienced in past crisis periods.”
The Canso team also noted that lower-quality high yield bonds saw much more widening of credit spreads, disproportionately accounting for the spread shift overall. That suggests how investors “have fled from the uncertainty of the riskiest assets,” the newsletter said. This is not surprising, it added, because speculative issuers are encountering tighter liquidity across capital markets, meaning that they will eventually have to bear “significantly higher refinancing costs.” The year has already seen the most defaults since 2020, and Canso expects that “we are at the very beginnings of increased default activity.”
As a result of higher Treasury yields and wider credit spreads, lower-quality credit saw yields rise well above their long-term average – a sharp reversal from last year, when the average yield of the index reached an all-time low.
Time for a dip? Think twice
The newsletter noted that “Higher yields and wider spreads have put the ‘income’ back into fixed income,” making “the return potential afforded by credit markets…more interesting than six months ago.” Yet the backdrop against which yields are rising and spreads are widening should give investors pause. In Canso’s view, the markets have entered “the normalization phase of the latest cycle, exiting a period of extraordinary excess.” Concerns over recession are increasing, and corporate defaults seem set to increase. That suggests there is more pain to come. As a result, “we do not believe potential returns offset the risks we see ahead,” the newsletter concluded. “We are continuing to value quality and liquidity above all else.”
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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