With central banks near the end of the tightening cycle, veteran fixed income specialist Roshan Thiru argues that after a difficult 18 months, Canadian corporate bonds have become highly attractive, and he expects they will generate attractive returns in 2024.
“For the bond market as a whole, it has felt like forever. We were stuck in a market that was waiting for a clear signal that we have hit peak interest rates and inflation was starting to cool down and that central banks are done with their hiking campaigns,” says Thiru, lead manager of the $591.7 million three-star gold rated Manulife Corporate Bond F, and senior managing director and head of Manulife Investment Management’s Canadian fixed income team in Toronto. “But it finally feels like we have traversed that market, and we are now in a market where the pivotal question seems to be, is the magnitude of the economic slowdown that is on its way and when will central banks start to cut rates?”
Given a recent rally in rates, Thiru notes that corporate bond issuers have taken advantage of yields and spreads coming off their recent peaks and issued new debt. “There was a period when bond issuers were highly reluctant to issue bonds because rates were at levels not seen for over 15 years. The 10-year U.S. treasury bond had hit almost 5% in October,” recalls Thiru, a 24-year industry veteran who heads a fixed income team that oversees approximately $20 billion in assets that are split between mutual funds and institutional accounts. “With a rally in the market a lot of issuers, such as utilities that tend to issue long bonds, decided to issue 3-year bonds with a one-year call option. Now, given the rally, those issuers are back again. They have decided to bite the bullet because they don’t know where the rates and spreads are they were at peak levels just a month ago. They are accepting the new reality in rates and have begun to issue long bonds again.”
Bargains in Bond Inflection
Thiru argues current conditions represent an “unprecedented opportunity for us to pick up some great credits at especially attractive all-in yields. That’s exactly what we are buying and locking in those yields for the next few years to come.”
For 2023 (as of Dec. 29), Manulife Corporate Bond F has returned 8.65%, versus 9.40% for the High Yield Fixed Income category. Over the longer term, the fund has been a second-quartile performer since it returned an annualized return of 3.49% and 3.17% over five and 10 years. In contrast, the category returned an annualized 3.83% and 3.27%, respectively.
Thiru acknowledges that the fund has slightly lagged the category, but he also notes that the fund has a relatively lower high-yield weighting than the category which is skewed to high-yield bonds. As a result, the fund has also exhibited lower volatility than the category.
Thiru likes to put things into historical perspective. “If you go back to 2008, overnight rates have been zero bound. If you bought bonds for income generation, it was hard to come by. And if you bought bonds for capital preservation, the Canadian bond market gave you negative returns for the last two years. And if you were buying bonds for negative correlation, I’d argue that last year you got negative returns for equities and really bad returns in the long bond market. My point is, the traditional value proposition of bonds as an asset class over the last few years, did not do as good a job as they should have,” says Thiru.
Faith Restored in Bonds?
“But, given the swift re-calibration of yields that we’ve seen, the traditional value proposition of bonds has been restored. Income generation? Check. Capital preservation through time? Check. Yields have gone up so much. With the recent tightening, you are still at over a 4% yield for 10-year U.S. treasuries. Over time, bonds should give you a negative correlation [to equities] as well,” says Thiru, who maintains that his bullishness is not just over the next three or six months but for a two-to-three-year period. “The asset class is paying you to wait.”
Still, the job of the central banks may not be over, and another rate hike may be in the cards. Yet Thiru does not think so. “Interest rates are already in restrictive territory and the Canadian economy is showing clear signs of slowing because it’s reacting to higher interest rates. Canadians are the most leveraged of the advanced nations,” says Thiru noting, for instance, that household debt relative to disposable income has expanded to around 180%, or about 30 percentage points higher than in 2007. “The monetary tightening is clearly doing its magic and slowing the economy. For all I know, we might be in recession territory between now and the next eight months. The main question about our economy is the degree of weakness.”
Inflation Should Slow – Except for Housing
Thiru argues that the risks are more skewed to a mild recession or a slowdown than to no recession. “A recession could come though financial tightening because we are so leveraged, both at consumer and government levels. Or you could have a classic growth-led recession due to softening demand because things are more expensive. On the inflation front, we see inflation moderating in Canada, except for shelter [housing] because there seems to be a lack of sufficient housing in Canada. Housing prices have not come down as much as they should have, given where interest rates are. We expect inflation to moderate some more, as consumer demand weakens and labour markets continue to weaken,” says Thiru, adding that so-called headline inflation will be in the mid-2% range and will keep falling over the next 12-18 months. “We can expect central banks to keep financial conditions tight by being on hold current market rates.”
When it comes to corporate bonds, Thiru argues that they have begun to recover from last year’s sell-off and Canadian investment-grade issues are still cheaper than U.S. counterparts. Their spreads over government bonds are 150 basis points (bps), versus 110 bps for U.S. issues. Overall, Canadian corporate bond yields are yielding about 5.5%.
Canadian Shield Boosts Confidence in Bonds
The second attraction, says Thiru, is that Canadian corporations are much more stable than their U.S. counterparts. “We are insulated from foreign competition and almost every industry here is an oligopoly. That may not be so great from a consumer viewpoint, but it creates a lot of confidence from an investor’s point of view. If you are a long-term corporate bond investor, I would argue that Canada is an awesome place to invest. That’s why we like Canadian corporate bonds from a valuation and fundamentals point of view. They are not immune to widening spreads. But historically, our corporate bonds have widened less than U.S. corporate bonds, as we saw in the 2008 financial crisis.”
From a strategic viewpoint, about 49% of the portfolio is currently in investment-grade bonds, 41% is in high-yield bonds and 7% is in long government treasuries. “We don’t chase yield. We chase valuation. We wait for volatility and make changes as the market shifts.”
Thiru notes that the fund’s mandate is to hold around a 50/50 mix of Canadian investment-grade bonds and high-yield bonds which are mainly issued in the U.S. “The lowest high-yield weighting we can have is 33%, and the largest weighting is 66%. This current weighting is one of the lowest that we have had in high-yield. This is also one of the few times that we have had a sizeable position in government bonds in the portfolio. We can reduce the high-yield weighting another 6-7% and that would be the threshold. We can also use derivatives if need be.”
Positioning for Quality and a U.S. Comeback
The increased allocation in investment grade corporate bonds and government bonds is effectively increasing the credit quality in the portfolio. “At the same time, we have increased the fund’s duration,” says Thiru, adding that an exposure to U.S. treasuries is in expectation of capital appreciation for an asset class that took a major hit last year. “We have done two things to reduce risk.” From a duration standpoint, the fund is at 5 years, or only 0.3 years longer than the blended benchmark of the FTSE Canada All Corporate Bond Index and the BAMLUS High Yield Master II Index. The fund has a running yield of about 7%, before fees.
From a geographic viewpoint, the fund is divided between 57% in Canadian securities, 39% in the U.S., and about 4% in other countries. “North America is a pretty good place to invest. There is a lot of risk in Europe and a lot of stuff going on in Asia. We don’t need to be in those markets, especially when valuations are quite attractive here. You can get a 7% yield in this mandate and it’s one of the highest quality portfolios we have had. I can take this yield to 8% or 9% if I want to. But I don’t want to chase yield in this environment.”
Running a portfolio with about 350 holdings, from 210 issuers, Thiru is precluded from naming any of the issuers because of compliance regulations. “We have so many holdings because of diversification and risk management,” says Thiru. “Security selection is based on deep, fundamental research. When we look for credit we want fundamentally strong companies where the valuations make sense. And if the credit profile is improving and the valuations make sense and there is potential for spread compression, that’s exactly the kind of companies that we will buy.”
Brighter Days Ahead for the Bond Market
Looking ahead, Thiru maintains that the worst of the bond bear market is well behind us. “What we expect for next year is a continued slowdown in the economy and maybe a mild recession. In that environment, you may not see rate cuts until mid-2024. But throughout 2024 and into 2025, it’s reasonable to expect a continued moderation in inflation,” says Thiru, adding that he believes that central governments, which have borrowed so much over the years, should begin fiscal tightening. “This means a continued rally in rates over the next 12 -18 months. If you are a bond investor, it’s a great place to be.”
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