Rising yields shift focus to mid-duration bonds

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Welcome to Advisor to Go, brought to you by CIBC Global Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Pablo Martinez, portfolio manager, CIBC Global Asset Management 

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One of the key drivers of performance, obviously, is where we are standing on the yield curve. If we put more attention to the short end of the yield curve, the part that we presently like is an overweight in the three- to five-year part of the yield curve.  

Because of inflation fears that have been stemming from the conflict in the Middle East, and higher energy prices, the short-term bond rates moved up quite materially. The five-year bond rate, for example, has moved up by about 70 basis points. That provides significant improvement in the running yield of those bonds. We believe that part of the yield curve is one of the most appealing as a resolution to the conflict, even a partial resolution would see this part of the yield curve rally strongly.  

The duration effect would provide the biggest bang for your buck, especially compared to the shorter end of the yield curve. I’m talking about the one- to two-year bonds here. We see less value in those shorter bonds, as those are being driven by central bank policy. And we believe even though the market is expecting central banks in Canada and the U.S. to maybe hike rates between now and the end of the year, we believe those expectations are overdone. There’s not a whole lot of value in holding bonds in a one to two years, as opposed to holding them in three to five years.  

While we currently have an overweight right now, we’re still playing defence. This is a very uncertain environment. There’s a lot of moving pieces out there. What we want to have is to keep some ammunition because an overshoot in yields is still possible.  

If we do get a degradation in the conflict in the Middle East, if we get energy prices moving up quite materially from where they are right now, we might see yields moving up. And that would provide us with a catalyst to extend duration because, what we believe is that, even though we might get further fears of inflation that will probably recede and transform into fears for growth, which would lead rates down, and that part of the yield curve, that three- to five-year part of the yield curve, would perform the best.  

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If we look at the broader bond market, we still do see good opportunities in some pockets of the corporate bond market. What we have to realize is that corporate bond spreads now have mostly retraced the losses that occurred at the beginning of the conflict in the Middle East, which means that, on a historical basis, they are still expensive. But on a risk-return basis, we believe that bonds at three- to seven-year area are the most attractive. 

When we look at corporate bonds in the long and the yield curve, 20 or 30 years, those bonds for us don’t really provide the kind of risk-return that we are looking for, in the sense that there’s not a whole lot of bonds available in that area, [and] not a whole lot of corporate issuers issue in the 20- or 30-year area of the yield curve. And there’s always a lot of demand, especially from insurance companies, which means that those bonds are very expensive.  

So that’s why we like that three- to seven-year corporate bond pocket. Mostly because of the increase in overall rates in that area, it provides a very attractive all-in yield. And also, the shorter duration means that it acts as protection in case of a risk-off environment. If we do get a surprise, and we do get a backup in corporate spreads, we will get better performance from that three- to seven-year area compared to the longer end of the corporate bond yield curve.  

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The latest move that we’ve seen in corporate bonds provide a great environment to buy into the investment-grade bond funds. Some of our clients might be tempted to seek refuge in GICs in this very volatile environment, but we have to remind them that the rates for GICs are in good part determined by the overnight rates from central banks.  

And especially in Canada, that rate is very low, and we expect it to remain stable. The Bank of Canada has many times said that they are willing to look through the present inflation spike in energy prices, and they want to make sure that they have the current long-term view in place before changing anything with their overnight rate.  

GICs do not provide much return, because they’re driven by the central bank rates, whereas the investment-grade bond fund returns are driven by the short end of the bond yield curve. And that short end of the bond yield curve has risen quite materially and provides a very attractive entry point.  

Furthermore, those higher rates that we’re seeing now means that there are more bonds available at a discount, which means that we’re able to buy bonds that provide a better fiscal advantage to our clients, and better GIC equivalent yields as well.  

And finally, our outlook for growth and risk assets remain positive. Corporate bonds should perform well in this environment. And when we look closely to the one- to five-year ladder, which is a new addition to our portfolios, those can provide us with a good way to diversify our risk. Because we’re buying equally into each of the five years, it provides us a better diversification of risk for duration, and as well, it increased materially the amount of corporate bonds that we hold, so it means that clients are more diversified in duration and also in corporate bond holdings.  

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In this very volatile environment, one of the key risks that we are looking at, obviously, is a degradation in the conflict in the Middle East. That obviously would lead to a significant increase in energy prices and also to a downward revision in our economic growth outlook. If such an environment occurs, obviously, we would see a push higher in inflation expectations, higher in yields as well, which is not good for bond portfolios, obviously.  

But the second reaction to this would very quickly turn into fear for growth, and that obviously would be good for our short bond portfolios, as yields would move down with the risk-off environment. The problem, though, would be that corporate bonds would be more at risk.  

We do have a team of analysts dedicated to corporate bonds; they’re monitoring on a daily basis the risks associated with all the corporate holdings in our portfolio. We’re not really concerned with spread widening for the investment-grade bond fund because we do hold the bonds to maturity. But we do want to make sure that all our holdings are in line with our risk tolerance.  

Obviously, another risk that we’re monitoring is the non-renewal of the trade deal that Canada has with the United States. Our base case still remains that a deal will be struck, but then again, we know that there’s been some rash decisions that have been taken at the border. So that means that we need to be cognizant of the fact that Canadian growth might be at risk due to the non-renewal of such a treaty.  

That would mean again, downwards revision to growth, and also a closer look at the core bond holdings. While we do not believe that it would be material for the names that we do hold, it would mean that some of the holdings might have to be tweaked to reflect the heightened risk. But then again, our base case scenario remains that there will be a deal that will be struck with the U.S., and that would unleash capital spending in Canada, and there will be a significant increase in growth when that happens.

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