High bank debt issuance causing distortion in bond markets

Unusually high issuance of Canadian bank debt has dislocated investment-grade bond spreads in the Canadian market, says Derek Brown, senior vice-president and co-head of fixed income with Beutel Goodman Investment Counsel.

He said rate hikes by the Bank of Canada and strong consumer spending have led banks to issue substantially more debt this year — more than one-and-a-half times the normal annual amount by mid-summer.

“What that’s done is actually dislocated spreads,” he said. “We’re now seeing A-rated Canadian banks trading wider than the vast majority of triple-B bonds in the market.”

Speaking on the Soundbites podcast this week, Brown said he and his team have begun to overweight investment-grade bonds “quite substantially” as a result.

He also thinks there are deals to be found in high-yield bonds, specifically in what he calls the “crossover space” of rising stars among double-B bonds that are doing particularly well in the current environment.

Some consumer staples companies, telecoms and energy companies are on the verge of getting upgraded to investment grade, he said. By way of example, he pointed to the airline industry, which suffered serious losses during Covid.

“When you look at the actual securitized assets on their balance sheets, and the increase we’ve seen in travel over the last six months or so, some of them are really set up well over the next 12 to 18 months to move back to investment grade.”

He said situations like this can result in credit spread compression, which can benefit the savvy investor.

“So, in high yield, we’re looking for idiosyncratic [alpha] opportunities, as opposed to overall beta exposure,” he said.

The high-yield sector also includes term loans, which have recently been returning 4% or 5% annually, while fixed income in general is down close to 10%.

“Term loans are generally secured loans with a variable interest rate. These instruments do very well in a rising rate environment,” he said.

The good news for fixed-income investors is that after a tough beginning to the year, fixed income is actually starting to provide income.

“We’ve gone almost a decade at this point where the yields on the [FTSE Canada Universe bond] index were hovering in the 2% range,” he said. “A few weeks ago, we saw the index move back to about 4%, which is much more what we’ve seen pre-financial crisis. With yields moving higher, investors are actually getting compensated for a lot of the duration that’s in their portfolio.”

Brown said rising interest rates may persuade some investors to move toward safer fixed-income products, but there are still exciting deals to be found.

“Canadian banks look attractive. Crossover high-yield credit looks attractive. Term loans and floating interest rate notes also look attractive,” he said. “Fixed income really hasn’t looked this attractive, probably, since pre-great financial crisis.”

Finding opportunities, however, starts with recognizing that some slices of the fixed income pie are poised to outperform others in the current high-rate environment.

“A lot of investors look at fixed income as kind of this monolith. That it’s all the same. We look at fixed income investing as a matter of sector selection. There’s a variety of flavours within fixed income and it’s really important to use active management to pick and choose what areas of fixed income you’re exposed to,” he said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.