Investment sentiment remained fairly positive in the third quarter—even with volatility over the summer, high yield spreads ended Q3 tighter than where they began. In fact, the “Spread to Worst” on the ICE BofA U.S. High Yield Index touched 313 basis points on Oct. 21, 2024, a level not seen since the eve of the Great Financial Crisis, according to the team at leading Canadian institutional investment management firm Canso Investment Counsel. More below on recent developments for bond markets, including the Bank of Canada’s latest interest rate cut, TD Bank’s money-laundering probe and Canadian investment grade credit spreads.
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Is the answer to too much debt more debt?
On Sept. 18, 2024, the monetary tightening chapter of 2022-2024 officially came to a close. The U.S. Federal Reserve lowered the target range for the federal funds rate by 50 bps, as inflation continued its move towards two per cent in the U.S. and job gains moderated. According to the Canso newsletter, “The Fed and bond investors seemed to be in agreement that everything was under control.”
In October, the Bank of Canada (BOC) implemented its fourth consecutive interest rate cut. This time around, it was a 50 bps reduction, bringing the overnight rate down to 3.75 per cent. Inflation has been cooling much more quickly in Canada than in the U.S., in part because higher interest rates have a more direct impact on our real estate- and financial services-heavy economy, noted the Canso team.
Meanwhile, the federal government announced that it would be extending mortgage amortization out to 30 years and increasing the cap on mortgage insurance from $1 million to $1.5 million.
This, as the Canso team pointed out, was intended to “make mortgages more affordable” and kick-start an ailing industry. Yet the newsletter also noted that the reason there is a housing affordability crisis in this country is that consumers have been binging on cheap mortgage debt for years. In Canso’s view, the answer to too much debt is not “more debt.”
Marching along
TD Bank’s money-laundering probe culminated with a guilty plea and fines surpassing US$3 billion. As the newsletter noted, the issue came to light in May 2023 when TD pulled out of its First Horizons acquisition due to “regulatory approvals.” At the time, there was speculation that TD’s pulling away was an opportunistic response to the U.S. regional banking crisis. But three months later, the bank confirmed a formal investigation was underway.
TD has attempted to remediate the situation in a few ways. The CEO, Bharat Masrani, apologized for the bank’s shortcomings and announced he will retire as CEO in 2025. TD has been overhauling its systems and strengthening its internal compliance team. “The Bank’s share price has bounced up and down over the past year but is largely unchanged, down only 5% since the regulatory issues first came to light,” the Canso team noted. “Credit spreads, on the other hand, have shaken off the negative news and continue to march tighter alongside Canadian peers.”
The conclusion—sort of
It was a subdued start to the summer within fixed income markets. Angst over unemployment data and underwhelming earnings sent yield spreads sharply higher headed into the August holiday weekend. No summer vacations needed to be cancelled though, as markets quickly rebounded, according to the newsletter.
“The Fed’s path to monetary easing was unimpeded and, for now, the U.S. economy continues to look resilient,” the team wrote. “Both risk assets and safe havens posted strong finishes for the third quarter.” They added that a decline in yields, tighter corporate credit spreads and robust fund flows all positively impacted fixed income markets, while equity markets shrugged off mixed economic signals and ascended to record highs.
The Sundin Premium
Canadian investment grade credit spreads widened alongside broader market volatility in August, before rallying in September to end the quarter tighter than where they started, according to the newsletter. South of the border, the U.S. investment grade market looked similar, but volatility was more pronounced. “Investment grade spreads have now touched … the slimmest borrowing premium since Mats Sundin was captain of the Leafs back in 2005,” added the team.
Through the first three quarters of the year, Canadian investment grade spreads have tightened by 19 bps and the U.S. by 13 bps. Canadian financial issues have been slowly closing the gap with the rest of the corporate market since significantly underperforming in 2022.
“Canadian BBB-rated issues have also performed relatively well this year, but in absolute terms are much wider than down south, particularly within longer term bonds,” the Canso team wrote. “While the basis between the two has been grinding tighter, the Canadian market still has room to run to reach previous cycle tight levels.” The same can’t be said for this part of the market in the U.S., which is looking quite expensive with spreads much closer to all-time tights.
Warning signs
A few things to note from the quarter:
Aspen: In early September, there was a $1-billion new corporate bond deal between Aspen Investments LP and TC Energy Corp. “With due diligence complete, indications in, and the order book divvied up, investors sold existing holdings to fund the settlement of the new bond, scheduled for September 9th,” noted the newsletter. But the deal never went through, and there’s some speculation as to why, with disagreement over modelled cash flows being a popular guess.
Australia: The Australian Prudential Regulation Authority proposed changes to its capital framework for banks. If adopted, the use of hybrid bonds such as Additional Tier One (AT1) securities will be phased out by 2032 and replaced with Tier 2 and Common Equity Tier 1 capital, noted the newsletter. The AT1 bonds have been under scrutiny since the 2023 regional banking crisis, when their shortcomings were revealed. Canso will be watching this closely.
Boeing: This past quarter, Boeing was also put on notice, with S&P placing
its credit rating on CreditWatch Negative. Boeing currently sits just
one notch above junk from S&P, Moody’s and Fitch. Given that it is
rated by all three agencies, it would need to be downgraded by two of the three
before falling out of most investment grade indices. If this were to
occur, with US$52 billion of index-eligible debt, Boeing would be the
largest fallen angel on record, according to the newsletter.
Pricey junk: “Lower quality CCC rated bonds didn’t move much for most of the year, but that changed in this past quarter,” noted the newsletter. “Bonds rated CCC & lower were 152 bps tighter in the third quarter, relative to BB and B rated bonds, which were marginally wider. Year to date, the lowest quality bonds are now outperforming.”
End game
The Canso team remains patient, content to wait on the sidelines and focus on liquidity. “We view high yield credit spreads as priced for perfection, and don’t feel as though we are adequately compensated for assuming this risk,” they wrote. “If that means forgoing yield in the short term and improving quality, so be it.”
This story was created by Canadian Family Offices’ commercial content division on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.