Is there more pain to come in the bond market?
“Carnage in fixed income markets is the worst seen in most of our lifetimes.”
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After an all-too-brief respite in midsummer, the carnage in fixed income markets resumed in September, as central bankers remained firm and vocal in their commitment to whip inflation, apparently at any cost. What does it all mean for bond investors? Is this the beginning of the end of the fixed income bear market – or the end of the beginning? What are the risks going forward, and what is the right stance for investors to take now? In their most recent Corporate Bond Newsletter from early October, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. tackled those and other questions. Here are a few highlights.
It wasn’t that long ago that central banks were sitting on the sidelines as inflation started to tick up, but those days and the term transitory now seem like a distant memory. Markets might have thought they saw light at the end of the tunnel in the summer, but Federal Reserve Chair Jerome Powell snuffed it out during his Jackson Hole, Wyo., speech in late August.
“Powell stated, in the clearest possible terms, [that] he and his colleagues were committed to bringing inflation back to the Fed’s 2 per cent target,” the Canso team noted. Now, “central bankers from Sydney to Ottawa, Frankfurt to Washington, are confirming, then reconfirming, commitment to wrestle inflation under control.” That has left financial markets in a state of perpetual “lurching from central bank announcement to economic release, and then on to the next,” as they search for any signs of weakening central bank resolve.”
When will the hurting stop?
One can hardly blame investors for desperately searching for anything that would give them hope. As the Canso Corporate Bond Newsletter noted, “the initial stages of interest rate policy normalization erased trillions of dollars of bond market value in just nine short months.” Yet, looking at history, there might be much more pain to come. As the Canso team points out, the last time overnight rates were this high was back in the spring of 2018, when inflation was well below the Bank of Canada 2 per cent target. Compare that with the latest Consumer Price Index read of 7 per cent, and it looks as if the fight against inflation could go to extra rounds.
As inflation wars rage on, there are signs of potential crises bubbling to the surface. The United Kingdom’s now former Prime Minister, Liz Truss, stumbled badly out of the gate with a Thatcherian economic program that sent bond markets reeling. European financial behemoth Credit Suisse veered towards a crisis of its own; it announced a major revamp, cutting costs (and jobs) while raising capital by selling new shares.
Meanwhile, bond markets kept on getting worse, Canso noted. With dismal returns across the spectrum of asset classes in the third quarter and year-to-date, the “carnage in fixed income markets is the worst seen in most of our lifetimes.”
Pockets of resilience
The devastation, however, has not been total. The Canso team points out that leveraged loan returns came in positive in Q3, topping all other major fixed income and equity classes. As well, Canada’s bond market did comparatively well, with positive returns among broad, investment grade and high-yield bond indices for the quarter.
Even as the Bank of Canada moved overnight rates up by 175 bps in Q3 and short-term bond returns fell, “longer term government bond yields in Canada finished the period largely unchanged,” the newsletter said, resulting in a positive (but still modest) return for the broad index. That compared favourably with the U.S. broad bond index, which “significantly underperformed its Canadian counterpart” as U.S. Treasury yields rose across the curve, the Canso team noted. It was a similar story in investment grade bonds, where returns in Canada were positive and significantly higher than the negative returns for U.S. Investment Grade bonds.
The brief return of favourable market conditions in Canada and the U.S. in late summer also encouraged new issuance, the newsletter said. As well, in sectors that have benefited from renewed economic activity, some corporations – such as Delta Airlines, in travel, and Suncor, in energy – took their excess cash and used it to buy back bonds through debt tenders.
Not-so-high times
In high yield markets, however, the news was more uniformly bad. The ICE BofA U.S. High Yield Index posted negative returns for the quarter. High yield issuance slowed to a trickle as credit spreads widened, and several companies had to rethink their acquisition aspirations under tighter monetary conditions.
Meanwhile, according to JP Morgan, default and distressed exchange volume in Q3 reached its highest level since the second quarter of 2020, at the height of the pandemic panic. Yet the Canso team also noted that “U.S. high yield and leveraged loan defaults … remain low on a historical basis” and “over time there will be less money available to lower quality companies.” The implication: “We expect this dynamic to lead to more corporate defaults … [and] the stress being observed may just be the start.”
Remarking that “the market moves year-to-date, and the resultant losses to fixed income investors, are without precedent,” the Canso team concluded that caution remains the byword going forward. They put emphasis on higher-quality and liquid securities – “saleable in the worst of market scenarios” – and on researching issuers as credit markets tighten. The goal, they wrote, is to be well positioned to take advantage when the next shoe drops – “and there is always a next shoe.”
Click here to read the October 2022 Corporate Bond Newsletter
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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