In Article 4, Section 1 of the US constitution, there is a clause that stipulates that every U.S. court in each state must give “full faith” and “credit” to the decisions of other courts. Well, after one of the worst meltdowns in fixed income markets in memory (or on record, depending on the specific market), investors are now looking at whether they can again have full faith in credit. In other words, with yields rising (bond prices falling), is it time to move money back into this market to achieve a higher income and potentially an appreciation of capital?

 

There is no single nor simple answer to this question, because there are different types of fixed income instruments in question, from government bonds to corporate bonds, investment grade to high yield and domestic to foreign bonds. Coming into this year, with the prospects of higher central bank rates in response to higher inflation, it made sense to overweight corporate debt and floating rate instruments (like loans). The rationale was that if investors felt that central banks would lift rates aggressively to stave off inflation, government bonds (aka low risk fixed income) would decline in value more than corporate debt, since the economy was still growing, and corporations were still making profits.

 

 

If we simply took a passive approach to this (investing in government versus corporate bond indexes) the difference in portfolio performance wouldn’t have been that much different. In the above chart, I have compared two such passive exchange traded funds (ETFs) – the iShares Core Canadian Government Bond Index and the iShares Core Canadian Corporate Bond Index. At the worst point on May 6^th, the corporate bond index was down about 11.7% compared to close to a 13% decline in the government index. As we have told clients, such declines are rare and not even comparable to 50% corrections in stocks (the likes of which we've had two of since 2000).

 

We know from history that buying equities after massive declines has proved to be a winning strategy for portfolios, but what of buying bonds after similar pullbacks? I would say that the same principle applies. If an asset is underpriced relative to its underlying value, then it should be bought; but what if it is just cheap in a cyclical sense and not relative to where it has traded historically. The following two charts show the Bloomberg US Treasury Index and the Bloomberg US Corporate High Yield Corporate Index.

 

These are total return index charts, which means they are inclusive of interest earned on the bonds within each respective basket. The government index has appreciated over the past 40 years, representing an average annual gain or performance of 6.5%. The high yield index has generated an average annual return of 8.4%. Not bad, and with the recent price declines, many pension funds see an opportunity to generate much of their required annual required returns of 7-8% by shifting capital to bonds.

 

The only problem is that the period which created these respectable returns was one that also saw a secular decline in interest rates as inflation expectations were eradicated by an aggressive monetary policy response in the late 70s. People have been talking for years about how the multi-decade bull run in bonds is over, but they are getting more vocal now that monetary policy is going in reverse and rates are moving higher. On Wednesday, the Bank of Canada announced a 0.5% increase in its overnight rate to 1.5%.  Goodness gracious! What aggressiveness. I remember back in 2007 when the target was raised to 4.5%. Most were not aware of what was coming down the tube in terms of how policy tightening would be the match to the over-leveraged housing sector gasoline tank (in the USA at least). Unfortunately, the growth in debt has exceeded the growth in the economy and that means that the sensitivity to interest rates as increased. 

 

 

In other words, it doesn’t take as much of an increase in borrowing costs to bring about a slowing in the economy than it did decades ago. Consider this. The nominal value of economic output in the US has increased by approximately 630% over forty years. The gross value of debt in the US has increased by 2,750% over the same period. As much as the bond bears want to say that this rare correction can continue and continue, the economics laws of physics argue the counter. We may see an incremental increase in yields; but the higher they go, there will be a disproportionate impact on dollar-value borrowing costs.

 

As we have discussed in recent commentaries, this effect eventually materializes into weaker spending growth as more of the household budget goes to the non-discretionary category of servicing debt. Slower consumer demand growth turns into weaker overall economic growth and probably a slower pace of price inflation. The caveat to this theory is that inflation expectations ramp up and become embedded, such that inflation gets sticky and harder to beat down by central bank actions. There have been elements of this for sure, but look at what happened to labour shortages or home price inflation. Yet, both are showing signs of plateauing.

 

Let’s bring this back to the fixed income portfolio. On the one hand, we have witnessed massive declines in the valuations of government and corporate debt. There is some risk of further interest rate increases, but with a Bank of Canada rate of 1.5% and bond yields pricing in another 1-1/2% increase, bonds look priced pretty close to fair value. However, if economic activity is truly slowing down, then government bonds could outperform corporate bonds. And that means investment grade bonds. High yield bonds, or those companies with credit ratings below triple B, could underperform government bonds to a greater degree.

 

 

Towards the end of May, the gap between the US 10yr government bond yield and the 10yr high yield index average yield touched 5 percentage points. This is double the spread from last summer, but I wouldn’t exactly say it is cheap relative to previous periods. In fact, this spread is still below the long-term average. Which means we don’t want to venture into this space, especially when low-grade companies typically default at a higher pace during recessions. 

 

By contrast, investment grade bonds  should offer a better risk-adjusted return in periods where economic activity is fading. The strategy, therefore, should continue to be one of blending investment grade credit, an appropriate exposure to floating-rate debt and government bonds. Depending on how severe a slowdown becomes, these allocations will need to be adjusted towards the higher quality end of the credit spectrum. Right now, it’s a question of how much faith we have in central banks bringing inflation under control, without losing the economy.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

 

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