The bond market finally got some respite from the beating it sustained throughout the better part of the first three quarters of 2022, but by then, the damage was already done.
That’s according to Canso Investment Counsel Ltd.‘s January 2023 Corporate Bond Newsletter: “As we’ve said many times, the very low level of bond yields made them very sensitive to rising rates, with little yield to offset the price loss pain. That’s why bond prices have been crushed.”
Previously, the worst-performing year in the Canadian corporate bond market was a 3% decline in 1994, which pales in comparison to the nearly 10% drop in 2022.
Volatility in overdrive
While bonds were less volatile than stocks, the level of bond market volatility was unparalleled. “We looked at the 10-year Government of Canada bond, and on 128 separate trading days (nearly 50% of total trading days in 2022), it moved up or down more than 5 basis points (bps). This was more than any year in the past quarter century. Furthermore, the bond moved more than 15bps on 13 trading days in 2022 – more trading days than the previous 10 years combined!”
Markets remain unsteady as investors vacillate between a fear of losses and the fear of missing out.
Long duration proves costly
When interest rates rise, bond prices fall. And, the longer a bond or bond fund’s duration, the greater the losses will be. The best-performing bonds in 2022 had the shortest duration, which translates into the least interest rate sensitivity.
“In high quality bond markets, wider credit spreads contributed to negative returns this year (2022),” Canso said in its newsletter.
“Canadian investment grade credit spreads widened 25bps more than their U.S. counterparts, but their lower duration powered a meaningful outperformance.”
Floating to the top
“As the Bank of Canada hiked its overnight rate from 0.25% to 4.25% over the course of the year, 3-month CDOR also marched higher. CDOR, the reference rate for most floating rate securities in Canada, has had a meaningful impact for floating rate bondholders this year, softening price declines while increasing coupon payments.”
Short duration helped floaters outperform because floating rate bonds don’t decline in value if interest rates rise, but rather benefit from higher coupon payments. The length of time to the next coupon reset is the extent of duration risk with floaters, making them especially appealing during periods of rising interest rates.
Defaults under control … for now
“Despite the sharp rise in borrowing costs, tighter markets and an uncertain outlook, default activity continued to be muted. The high yield market has not seen a new default over the last five months. For the year, JP Morgan lists 17 defaults and a further 18 companies completing distressed exchanges. While these numbers are up compared to 2021, default rates have not yet materially followed credit spread widening. The reverberations of the elevated default rates in 2020 combined with accommodative markets and record levels of issuance in 2021 continue to be supportive of low default activity. Investors should not rest on these laurels as more and more companies will be forced to reckon with the reality of the current market environment.”
Lower risk doesn’t mean risk free
Bonds are safer than equities, but that doesn’t make them risk free. Only cash and GICs qualify as such, but in times of high inflation a cautious stance could lead to negative real rates of return. Investors have to carefully assess where it makes sense to assume risk and whether that risk is appropriate for them.
As Canso always says: “If we are compensated for risk, we will take the risk, but if we are not, we are happy to catch the next bus, and there is always a next bus.” Read the full January 2023 Corporate Bond Newsletter here.
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