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For today’s soundbites, we discuss corporate spreads with Brian Kloss, a portfolio manager with Brandywine Global Investment Management. We talk about the potential impact of rising rates, sectors he likes moving forward, and timing the market for best results. We started by asking where corporate spreads are heading.

Brian Kloss (BK): Right now, we think spreads are probably headed for a whole bunch of nothing. If anything, they might grind tighter, a little bit, through the balance of 2021. You might have a bifurcated market. There’s probably certain sectors that are going to be wider. But in much of 2020, you had explicit support for investment-grade corporate credit, especially at the front end, five years and in, which really then provides implicit support for longer-dated and even lower-quality assets. That is still in place. Coupled with a growing economy, we think spreads are probably near their tightest, but don’t see any reason for them to widen dramatically, and maybe you could get a little bit of spread tightening. So maybe [with] an IG [investment-grade] you could pick up another 20 basis points of tightening. And in below investment-grade [bonds] potentially 50 or 75, maybe even 100, if everything pans out.

What interest rates could have to say about that.

BK: It depends on exactly how fast rates rise. If that pace is too quick, that could create an issue for the underlying corporates, which then would lead us into some type of spread widening. I guess the other issue that we start to think about is, if I start to look further out — and this is probably two years, maybe three years out — we’re going to be seeing a roll off of the fiscal support. Monetary policy will probably have run its course, and then we’re going to start to think about heading towards a slow-down in the economy, and at some point, we’ll probably hit some type of recession — or it may not quite be called a recession, but that will start to see a spread widening at some point.

Some sector assessments.

BK: So, we’ve been favouring the commodity sector, especially copper. The electrification of the grid, moving towards a greener environment, whether it’s electric vehicles, whether it’s solar, whether it’s wind, copper should be a significant beneficiary. In addition, it’s not just the demand side, it’s the supply side. I think Canada has some very strong resources, and should continue to benefit from that. I also think the auto sector was attractive, as well as the hospitality sector. What we still have to figure out is the opening of the economy and how business travel is going to come back. We do believe that recreational or leisure travel will come back, and we think there could be attractive opportunities for investors. I think when we start to think about where the risks are, it still seems to be where we were prior to the pandemic. Risks, in our estimation, are still bounded in retail. We were moving to online shopping. Shopping was changing. So, we can take some risks in some places but, overall, that’s probably a more challenged sector.

Some recent experiences in picking bonds.

BK: One of the success stories was what we were just talking about a few minutes ago. It was around copper. We’ve actually been able to capture what we think has been very attractive returns through both investment-grade allocations towards Freeport-McMoRan Inc. [based in Phoenix, Ariz.] and below investment grade towards [First Quantum Minerals Ltd., of Vancouver, B.C.]. Really playing out this theme about the electrification of the grid, alternative energy, and the supply constraints. And I would argue that is one of the success stories. The more challenging ones are investment theses that haven’t worked out. One of them was around Petrobras [Petróleo Brasileiro S.A. of Rio de Janeiro, Brazil]. It ultimately was a good bond, but we overstayed our welcome, as concerns around the country and the governance have really created some challenges for Brazilian assets. We were able to have an entry point within Petrobras at a very attractive level. We saw those spreads compress. But more recently, valuations probably reached fair value and unfortunately, we probably overstayed a little bit longer. So, it’s not that we took a loss on it, it’s just on a market-to-market basis, it’s lower than where the high-water mark had been.

And, finally, what’s the takeaway here?

BK: For corporate spreads, we actually think it’s a very strong sector. We actually believe that if you can pick up some incremental yield in the corporate space, we think you’re going to be well compensated for that over the next 12 months. We would actually argue that you should be shorter on the curve. You should be focused on those procyclical types of names: commodities, basic materials, and if you want a little bit of safety, you can throw in some of the health care technology as well. But we’re very constructive on corporate credit, and we think spreads should be very stable, if not maybe even a little bit tighter.

Well, those are today’s Soundbites, brought to you by Investment Executive, and powered by Canada Life. Our thanks again to Brian Kloss, portfolio manager with Brandywine Global Investment Management.

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