Transcript: High bank debt issuance causing distortion in bond markets
Derek Brown of Beutel Goodman Investment Counsel says there are opportunities to be found in high-yield debt and investment-grade fixed income
- September 27, 2022 September 27, 2022
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For today’s Soundbites, we’re talking about finding opportunities in fixed income. Our guest is Derek Brown, senior vice president and co-head of the fixed income team at Beutel Goodman Investment Counsel.
We asked what durations and grades he’s looking for, how he ensures diversification in fixed income, and we started by asking where he’s finding opportunities right now.
Derek Brown (DB): Well, I think that 2022 has been a relatively difficult year in the fixed-income markets. The bright side, with interest rates moving higher is that fixed income actually is providing income at this point. We’ve gone perhaps almost a decade where the yield on the index was hovering in the 2% range. 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. So, I would say that’s the most interesting thing, specifically when you look at something like a short-term bond index, which is yielding actually more than the overall universe index. Because of the inverted nature of the Canadian and U.S. yield curves, we’re actually seeing that you get higher yields at the front end of the curve, as opposed to in the long end. So, investors, specifically private wealth or retail investors who don’t really need that 30-year bond duration, they can kind of hide out in under five-year bonds and still pick up a significant yield.
Is now the time for risk-free bonds?
DB: Risk-free bonds would be Canadian government or U.S. government bonds. That’s how we would define risk free. And when you buy a bond like that, really you’re looking at that coupon that you’d be getting paid. And then some sort of duration impact to dampen the volatility you would see in your equity portfolio. So, as we move into certain parts of the cycle, it makes sense to pull back on your credit risk and put that into some risk-free bonds. The downside to that is you do lose a little bit of coupon that you would be getting from that extra corporate bond risk. We tend to prefer the 10-year part of the curve. That should benefit the most when we move into the next phase, when the Bank of Canada starts cutting interest rates.
What he’s seeing in investment grade bonds.
DB: Investment grade bonds are a very interesting opportunity, specifically in Canada right now. The bulk of the investment-grade universe in Canada is made-up of Canadian bank debt issuance — generally A rated or above. But in 2022, we’ve seen a huge amount of supply from Canadian bank issuers. We’ve seen probably over one-and-a-half times the normal annual amount issued so far into the summer. This has been driven by a variety of factors: the Bank of Canada hiking interest rates, deposits have been coming off the bank balance sheet as people are spending their stimulus cheques over the course of 2022. And this has really forced them to kind of issue a lot into the market. And what that’s done is actually dislocated spreads. We’re now seeing A-rated Canadian banks trading wider than the vast majority of triple-B bonds in the market. So, we do think there’s some really interesting opportunity here in investment-grade bonds.
Where are the high-yield opportunities?
DB: Right now, we see some opportunities in high yield, specifically in what we call crossover space. So, this would be rising stars. So, double-B rated bonds of issuers who are doing well in this environment. So, often that’s some sort of consumer staples or telecoms or things like that, energy companies as well. They’ve done quite well over last few years. And they’re on the verge, a lot of them, of getting upgraded to investment grade. So, when this happens, there’s a pretty substantial credit spread compression. So, in high yield we’re looking for idiosyncratic opportunities, as opposed to overall, call it, beta exposure. So alpha opportunities not beta. In addition, in the high-yield space, that’s where you get what are called term loans — generally high-yield issuers who are issuing secured loans with a variable interest rate. And these instruments do very well in rising rate environments. These are some of the opportunities that were looking for in high yield.
And finally, what’s the bottom line on investing in fixed income in the current market?
DB: I would think the most important thing for the average investor to know about the fixed-income market right now is that a lot of rate hikes have already been priced into market. We’ve seen yields move dramatically higher this year and we’ve seen negative returns because of that. It has created an opportunity where, from here, most likely the performance has an asymmetric risk profile, where we’ve priced in so much rate hikes that it’s unlikely we can price in too much more. We can; rates can go higher from here, but not as much as they can go lower. So, we’re now looking at a point where even if rates go nowhere over the next 12 months, you’re getting a 4% positive return in a generic universe bond mandate. We’re finally getting back that buffer that we used to have in fixed income to kind of hedge an equity risk in a portfolio. So fixed income really hasn’t looked this attractive probably since pre-great financial crisis.
Well, those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Derek Brown of Beutel Goodman Investment Counsel.
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