As yields have risen and prices have fallen across the entire spectrum of bonds – government or corporate, investment-grade or high-yield – 2022’s interest rate environment led to a brutal first few months of the year for fixed income markets. The Bank of Canada raised its benchmark rate by 25 basis points in March, by 50 basis points in April, and then by another half-percentage point on June 1. With the latest 100 bps rate hike, bond market conditions could deteriorate further. If higher interest rates lead to an economic slowdown and weaker corporate credit quality, the damage might prove even more severe.
While corporate spreads (the difference between yields for corporate bonds and benchmark government bonds) have widened, which tends to make corporate bonds more attractive, the increase has been modest. Jeff Carter, portfolio manager at leading Canadian institutional investment firm Canso Investment Counsel Ltd., says that “With rate and credit risk high, we’re still positioning ourselves defensively and trying to be patient.”
In this environment, the challenge for fixed income investors may be less about looking for opportunities to chase yield, and more about trying to find shelter from the storm. The good news, say Carter and fellow Canso portfolio manager Vivek Verma, is that there are alternatives to traditional bond allocations that provide a good defence against rising rates. On a strategic level, institutional investors can use hedging strategies; on a tactical level, some fixed income products offer floating-rate coupons that move up and down as their benchmark rates fluctuate. The less-good news, however, is that each of these alternatives comes with their own set of risks.
One approach employed by some investment management firms – including Canso, through its Canso Credit Income Fund (CCIF) – is to try to hedge out interest rate risk. Basically, the fund manager short-sells government bonds and buys corporate bonds of the same duration on the other side of the trade. The goal is to carry only the spread between the corporate credit and the benchmark government bond yields, insulating the portfolio against the impact of rising (or falling) benchmark rates.
In the first four months of the year, investment-grade corporate bond returns fell by double-digit percentage points, but Canso’s hedged portfolio only fell by the low single digits, according to Carter and Verma.
Yet as Verma points out, this approach means that “you are hedging out interest rate risk but carrying the credit risk. If the credit spread widens, if credit quality deteriorates or the market becomes illiquid, then the strategy could fail.” Carter notes that “buying credit and hedging it out is a bet that spreads are going to stay the same or tighten,” but the current rate and economic environment suggests that spreads still have room to widen.
“We feel it’s still early to re-enter credit positions,” he adds. “So, we’re still defensive.”
On a tactical level, meanwhile, there are many floating-rate securities available to investors, and Carter says it’s useful to think of these instruments as existing along a spectrum. At one end – the riskiest – are leveraged loans. These are typically commercial bank loans, made to below-investment-grade companies, and then repackaged (or “syndicated”) and offered to other banks or institutional investors. Most of these syndicated loans carry a floating-rate coupon, nullifying interest rate risk. Yet the credit risk can be high – analogous to that of high-yield bonds – and while most leveraged loans are “senior” (meaning lenders have highest priority for repayment in case of default), investors need to perform thorough due diligence on the loans’ covenants. “You’re buying dicier credit,” says Carter, “so if the company goes into restructuring, you need to know what the risks are.”
As well, the upside of leveraged loans may be capped by the fact that if the company does well or market conditions improve, the issuer can call the loan, meaning investors only get their money back. “With a high-yield bond, if the issuer does well or becomes investment-grade, investors benefit from a big compression in spread,” Carter explains. “But in the leveraged loan market, if an issuer becomes investment-grade, the loans might just be called at par. So, you don’t win either way.” Verma adds that settlement periods for buying and selling leveraged loans can be very long – sometimes as much as a month. That elevates liquidity risk. In the end, “leveraged loans can be useful instruments,” Verma says, “but they are not for the faint-hearted.”
On the other end of the spectrum are high-quality fixed-income products like floating-rate mortgage-backed securities (MBS). In Canada, MBS are guaranteed by the Canada Mortgage and Housing Corporation and AAA-rated, so the associated credit risk is very low. The floating rate, meanwhile, is benchmarked to an index that resets monthly, so as benchmark rates go up, the coupon becomes more powerful.
“If the Bank of Canada continues to tighten the way that markets are now expecting, you get a nice bump from higher rates,” notes Carter, “and you are not locked into a fixed rate or a fixed duration where you may see large mark-to-market write-downs.” While pools of MBS are generally issued at a five-year maturity, their effective duration is closer to three years, he says, because pools are pre-payable.
Given the meltdown in fixed income markets so far this year, it’s understandable that investors want to seek shelter from rising interest rates — but rising rates are not the only risk out there. Hedging strategies and floating-rate products might help insulate portfolios from the central bank’s next move, but credit quality, liquidity and the macroeconomic backdrop remain important considerations in fixed income. If investors fail to weigh those risks carefully, they might find that the shelter they were hoping for has actually turned into trap.
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