The Bank of Canada’s decision to cut interest rates a second consecutive time was no surprise to veteran fixed-income investor Crista Caughlin, who oversees the $3.7 billion 3-star silver medalist Mawer Canadian Bond A. Yet Caughlin is treading cautiously and avoiding any significant bets on corporate bonds, which have recently been a more rewarding way to play the bond market.
In late July, the BoC cut its the policy rate by a quarter of a percent, from 4.75% to 4.50%. That followed a cut of the same magnitude in June.
“We are on an easing cycle,” says Caughlin, a portfolio manager at Calgary-based Mawer Investment Management. She joined the firm in 2020 after working for 19 years in fixed income at Connor, Clark & Lunn Investment Management. “Unless we start seeing a deterioration in growth, and employment losses, I would expect them to cut another 100-150 basis points and get closer to a policy rate of 3.0%-3.5%.”
Caughlin expects the BoC will make cuts at a gradual pace, and may skip doing so at one meeting. “If we do start seeing growth deteriorate and we are in a recession, I could expect them to cut more aggressively.”
Mawer Canadian Bond
• Morningstar Medalist Rating: Silver
• Morningstar Rating: 3 stars
• Morningstar Category: Canadian Fixed Income
• Fund Size: C$3.7 billion
Lower Inflation Giving Room for Lower Rates
One of the central points in Caughlin’s argument is that inflation has been falling. “What’s happened over the last three months is that core inflation was running at 3%. While inflation is coming down, it’s not clear that we are out of the woods yet. Inflation is not running at the 2% target [set by the Bank of Canada]. It is still running at a 1%-3% range, so that’s positive. But it’s bouncing around a bit, so the bank will still maintain a cautious stance and go gradually.”
Caughlin and her team avoid making forecasts, and think instead in terms of how various scenarios might play out. The so-called “soft landing” appears to be happening, since central banks are achieving their goal of gradual easing in rates, while wages and employment are normalizing. But her team is worried that the path toward lower inflation may be bumpier than many expect, causing central banks to have “stops” and “starts” and keeping rates elevated for longer than necessary.
“That actually may be happening right now,” argues Caughlin. “As that plays out, particularly in Canada, it increases the probability of a hard landing. We still have a lot of mortgage renewals and a lot of debt in the economy. Growth is already weakening. A lot of it has been supported by immigration, which may be slowing here. And a lot of it has been supported by fiscal policy, which is also slowing. That hard landing scenario is something we are worried about.”
A hard landing is characterized by negative growth and rising unemployment. “The unemployment rate is increasing right now. But we are actually still adding jobs, because our population is still growing. The hard landing scenario would be one where we are losing jobs on a monthly basis. That’s a recessionary scenario.”
The economy is growing at around 0.5%, says Caughlin, and there have been a few quarters when growth was flat. Conversely, growth in the United States is running at around 3%. “The big difference between us and the US is the health of our consumers. A lot of people have been squeezed in Canada because of our mortgage market. Mortgage rates, and consequently payments, have increased substantially. People are refinancing at higher rates, so more of their money is going to just paying interest. And people with variable mortgages have seen their payments increase. But we are just at the beginning of that development taking effect. The big refinancing will happen in 2025.”
Caughlin argues that the Bank of Canada is conducting a tricky balancing act. “If they lowered the policy rate to 3% in the next two months, suddenly people will be refinancing at a rate that is less restrictive. But the bank can’t do it if inflation remains elevated. So if they cut too quickly and spur inflation again, they will be forced to go back to those extremely elevated rates seen many years ago. They really need to make sure that we’re not going to get another spike in inflation.”
Indeed, she admits she worries about an inflation spike eroding consumer confidence and eventually causing an economic downturn. “Not that it will push people into bankruptcy, but it will push them into being unable to spend, which ultimately causes a recession. That’s the central bank’s balancing act: bringing inflation down but not pushing the economy into recession.”
Bond Yields Attractive
From a strategic viewpoint, Caughlin says bond yields are at levels not seen since 2008. “Fixed-income markets are more attractive than have been in more than 10 years,” says Caughlin. “You could look at two-year and three-year bonds, but there is a lot of easing already priced into the market at that level. But if we are wrong on inflation—and there is a risk that inflation might move higher—that’s the part of the curve that will get hit the most.”
The corporate bond market has higher yields than government securities, says Caughlin, noting the spread (the difference in yields between government bonds and corporate bonds) is about 120 basis points, or 1.2 percentage points. “But we are actually close to ‘tight’ levels, historically, if not at all-time tight levels. In the US, there are pockets in the market where spreads are at all-time ‘tights.’ In Canada, we actually think that the corporate bond market looks somewhat expensive.” She notes that the average spread in the FTSE Canada Universe Overall Bond Index is 125 bps, or about 10 bps away from the lowest level after the 2008 financial crisis.
“This tells me that a lot of good news has been priced in and may not be reflecting the risks that still exist in the market,” says Caughlin, adding that she is focused on short-term corporate bonds and avoiding the long end of the market.
Tilting Toward Government Bonds
Although the portfolio is almost equally divided between government securities and corporate bonds, Caughlin is cautious on the latter. “We own a lot of high-quality bonds and shorter-duration bonds. On a risk-adjusted basis, our exposure to credit [corporate bonds] is flat relative to the benchmark,” she says. By weight, corporate bonds account for 45% of the fund, with about 55% in federal and provincial government securities.
“We are not concerned that we will have a wave of defaults in the Canadian investment-grade bond market. The concern is that spreads will widen. But if spreads do widen, we should do better than the benchmark,” observes Caughlin, adding that the caution is also reflected in the duration of 7.1 years, which is slightly below the benchmark’s 7.2 years. The fund’s running yield is 4.2% before fees.
“The risk that spreads will widen is there, mainly because we are at all-time tights,” says Caughlin, noting that the yield differential could widen anywhere from 50 to 100 bps. Putting things in perspective, she mentions that the yield differential widened 100 bps during the COVID pandemic, 250 bps in the financial crisis, and 75 bps in the 2016 Canadian recession.
Over the last two years, Caughlin has reduced risk. “Our exposure to credit is relatively flat. We are expecting some higher yields and wider spreads. If credit spreads do widen, we have dry powder at our disposal,” she says, adding that she may sell some holdings and buy longer-dated bonds. Among the corporate bonds in the portfolio, which has 115 bond holdings in total, is a 2027-dated security issued by oil refiner North West Redwater Partnership (NWRWPT), which yields 4.3%, and a 2029-dated bond issued by Telus (T), which yields 4.5%.
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