Even as central banks held off on interest rate cuts and government bond yields rose, corporate credit spreads tightened in the first quarter and bond issuance reached new highs. In their most recent quarterly Corporate Bond Newsletter, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. questions current market optimism and asks whether investors are being adequately compensated for risk.
Click here for the full Corporate Bond Newsletter.
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Is everybody happy?
Inflation has been beaten, interest rates will inevitably come down, and a “Soft Landing” for the economy—the Holy Grail of monetary policy engineering—is clearly within grasp. At least that’s the way the market seems to be seeing things right now. U.S. equities broached new records in the first quarter, while in fixed income, risk premiums tightened and issuers found plenty of buyers. But the team at Canso thinks that victory over inflation and recession is far from assured. “For those keeping score at home,” they wrote in the most recent Canso Corporate Bond Newsletter, “mark us in the ‘too early to tell’ category on whether a ‘Soft Landing’ has been achieved.”
Markets in the first quarter don’t seem to share their skepticism. The S&P 500, Bitcoin, and the price of gold all touched or broke all-time highs through April, while Japan’s major stock index neared its December 1989 peak. (That spike occurred at the height of the Japanese asset price bubble, which went on to burst spectacularly in 1992.)
Higher yields, tighter spreads
Government yields crept higher in the quarter. “The bond market consensus has recalibrated its expectations on the timing and magnitude of central bank action,” the newsletter noted, as the U.S. Federal Reserve and the Bank of Canada are holding off on rate cuts longer than markets anticipated. Higher government bond yields pushed rates up across the curve, with longer-duration bonds feeling the largest price impact. Corporate bonds, however, were at least partly sheltered from the blow by tightening credit spreads.
In investment grade bonds, Canada narrowed the credit spread gap with the U.S., tightening by 15 bps versus 10 bps for their American cousins, but “continues to trade materially wider than the US” as noted by the team. Canadian financials, which have been a drag on the index since 2022, performed well in the quarter, but the Canso team wrote that bank spreads still “have further to go to move back to a more normalized relationship” relative to other corporates. Overall, the Canadian investment grade index spread of 136 bps compares favourably with the U.S., which “is looking more and more expensive,” the newsletter added. “Canadian investment grade continues to look like better relative value.”
The team also noted, however, that credit quality in the Canadian investment grade market has declined. BBB-rated bonds (the lowest quality among investment grade) finished the quarter comprising nearly half of the overall market weighting—the same proportion as in the U.S. investment grade market. That could put a cap on how far spreads can tighten further or how high valuations can go. “With more BBB,” the team wrote, “we should expect that Canada would be somewhat wider than other cycle tights.”
The same pattern occurred in high yield in the first quarter, although the tightening was even more pronounced, with U.S. high yield spreads tightening by 29 bps. Yields overall, however, “remained steady,” the Canso team observed. “A bounce back in government yields has propped up the yield and masked reduced compensation for credit risk,” they added. “We worry that the lower compensation for credit risk is not fully appreciated by investors.”
Meanwhile, high yield issuance reached its highest quarterly volume since 2021. Refinancing surged. The newsletter highlighted the case of Royal Caribbean cruise lines, which in Q1 called an 11.625% senior bond issued in 2022 and refinanced at much more favourable terms. The result: the company “went from borrowing at a 12% risk premium on a secured basis, to a 2% risk premium on an unsecured basis in a little under 4 years,” wrote the Canso team.
This trend occurred even as corporate defaults have been increasing. The newsletter also pointed to the sharp rise of “distressed exchanges” in the leveraged loan market, which are basically instances of negotiations between lenders and borrowers to avoid outright default—“all with the goal of reducing the face value of existing obligations by coercively disadvantaging existing lenders.”
Take shelter.
When it comes to higher-risk fixed income, the takeaway for the Canso team is clear. Rigorous due diligence is more important than ever, and so is caution. “At current valuations, it is important for investors to be discriminant and understand the credit risk they are assuming,” they wrote. “At this point in the cycle, that almost never happens.”
High yields and tighter credit spreads suggest that “the appetite for risk in credit markets continues to dislocate from fundamentals,” the team explained, particularly “within the most speculative ends of credit.” In this environment, they are focusing their portfolios on quality and liquidity, while keeping an eye out for unique opportunities. As the rest of the market reaches for yield, “We continue to believe that protecting capital … will win out once again.”