The amount of income that bonds now generate is better than it’s been in over 15 years

We can now purchase high-quality corporate bonds in the range of 5% to 7%. An investor now receives much higher income and the potential for solid capital gains as bonds pull back to par. In other words, you are being paid nicely to wait for interest rate cuts to eventually happen. None of us can accurately predict the demise of inflation or the end of the rate hike cycle, but it’s getting very close.

And let’s face it, the trajectory of rate increases last year exceeded everyone’s expectations, including most central bankers. We’ve never had a year with returns across all fixed income as bad as last year, and we’ve also never had two negative back-to-back years in fixed income investing. While there was a lot of uncertainty about getting inflation back towards 2%, that appears to be coming to an end. We believe central banks are more or less done raising interest rates, and the anticipated recession doesn’t appear, at this point, to be that severe. In this environment, we believe fixed income has the best risk-reward characteristics we’ve seen in many years.

Relative to equities, the bond market is already pricing-in some bad economic news, and corporate bonds are no exception. The equity risk premium has narrowed materially, while the yield on many high-quality corporate bonds now exceeds the dividend yield on their stock. Bail-in bonds for Canadian banks yield in excess of 5%, LRCN issued by major Canadian banks are trading at around 7.5% yield-to-worst, and with bonds, you’re obviously higher in the capital structure than common equity.

Because so many bonds were issued when interest rates were extremely low, and credit spreads very narrow, numerous securities are trading at deeply discounted prices. It’s rare to see government or high-quality corporate bonds trading in the $80’s (recall bonds mature at $100). So, in today’s environment, we’re not only getting great income from this asset class, but there’s also the potential for a solid capital gain. Although it’s hard to predict exactly when the shift in monetary policy will happen and when central banks will start cutting rates, we are in the later innings of this tightening cycle.

As a fixed income portfolio manager, I’ve lived it before; the move up in interest rates is always a disaster for all asset classes. Ironically, this time, it’s been great for bonds as the “income” is finally back in “fixed income.”

Mark Wisniewski, Partner and Senior Portfolio Manager at Ninepoint Partners

Outlook for interest rates and recession

Monetary policy typically acts with a 12- to-18-month lag, and given the very rapid pace of rate increases, it’s now increasingly likely that the Fed and the Bank of Canada might be done. Inflation continues to decline, although slowly, and economic activity is decelerating. We’re seeing clear signs of a slowdown in global economic activity. Housing and business investment, the most interest rate-sensitive sectors of the economy, are clearly trending down.

Canada has been somewhat luckier than the U.S. overall, even though the latest Canadian inflation report ticked up YoY. We are making some progress in THE shelter category, which is approximately 30 percent of the Consumer Price Index. That’s encouraging because shelter costs have recently seen major escalations.

"The bottom line for both central banks is that monetary policy is working"

The U.S. is in a slightly different position, with inflation still running relatively high, and it’s not expected to move back down materially until later this year, particularly core inflation. Other indicators, including employment rates, are starting to show some early signs of decline, signaling a potential slowdown.

The bottom line for both central banks is that monetary policy is working, the economy is slowing, house prices are going down, demand is decreasing, and the labor market is starting to weaken. All of this leads to the intended outcome – lower inflation. Unfortunately, just like Mr. Powell has warned, this will come at a cost, and it seems increasingly likely that this cost will be an economic slowdown or very possibly a mild recession here in Canada and maybe the U.S.

How severe? It’s difficult to say. Usually, the areas of greatest excess suffer the most. Given the massive boom in Canadian real estate over the past decade and higher household leverage, we would expect the downturn to be more acute here than in the U.S. We can’t know precisely when a recession will hit or how severe it will be, but monetary policy will go from being a headwind to being a tailwind for bonds.

Now, whenever that recession or slowdown happens, investors typically look for the safety of government bonds as interest rates begin to move lower. Given the huge increase we’ve seen in rates, it wouldn’t be unusual to see a 1% to 1.5% move lower in long-term government bond yields – reversing some of 2022’s losses. In our view, higher-duration government bonds (greater than 10 years) will be the best performers initially. Then, as the market factors-in rate cuts and eventual economic recovery, equities and corporate credit will rally. We believe that an excellent opportunity in high yield and investment grade credit will then follow.

The first line of defense for any fixed income investor is portfolio yield. With the massive increase in interest rates and the widening of investment-grade credit spreads, fixed income now yields substantially more than at any time in recent memory. Not that long ago, we’d have been happy to earn 3% on investment-grade credit. With high-quality corporate bonds yielding in the range of 5% to 7%, we don’t have to take much risk to earn nice returns. What a difference a year and a half makes! Investing in bonds is the best it’s been in 15 years, and if interest rates or credit spreads actually rise from here, there’s much more yield in these securities to absorb any price volatility.

Recession or not, soft landing or not, is anyone’s guess, but fixed income has priced most of this in. Consequently, I think the glass is much more than half full.