Economic forecasts continue to shift and evolve as we went from a recession or hard landing scenario seeming unavoidable, to a soft landing being virtually guaranteed.
All of this unfolded pretty quickly, as Canso Investment Counsel Ltd. wrote in their April 2024 Corporate Bond Newsletter, “risk premiums have dropped, borrowers have renewed access to capital and the percentage of economists predicting a recession has dropped considerably from the ‘100%’ tally of not so many months ago.”
Central bankers have their work ‘cut’ out for them
This prompted continuous reassessment of the situation by central bankers, mortgagors, and investors. The newsletter goes on to say that, “once again, the bond market consensus has recalibrated its expectations on the timing and magnitude of central bank action. At its peak late last year, markets had priced in six rate cuts in Canada, while the sentiment has shifted back this year with yields now implying only two and a half cuts. The Bank of Canada has just announced that they are holding their policy rate steady at 5% for a sixth consecutive meeting and continue to signal that they are getting closer to rate cuts but need to see that the ‘downward momentum (in inflation) is sustained.’”
Equity markets have been on a tear while bonds struggled, as yields rose across the entire curve. Longer duration Government of Canada bonds were affected the most while the impact on U.S. government bonds was a bit more muted. As investment grade credit spreads tighten, U.S. offerings are relatively expensive — making Canadian investment grade bonds appear to be a better value.
The team at Canso went on to observe that, “investment grade corporate bonds were somewhat insulated by gains from tightening credit spreads and finished the first quarter around even. High yield bonds performed well, as their shorter term helped to protect them from higher yields and they benefitted from a persistent appetite for risk that pushed their spreads tighter.”
Start ‘spread’-ing the news
The portfolio managers at Canso Investment Counsel Ltd. commented in their latest Corporate Bond Newsletter that, “a bounce back in government bond yields has propped up the yield and masked reduced compensation for credit risk. We worry that the lower compensation for credit risk is not fully appreciated by high yield investors.” They further reinforced this concern noting that, “high yield spreads finished the period at 334 bps, which continues to offer insufficient compensation for underlying credit risk.”
Credit spreads have tightened year-to-date, but below investment grade market yields remained steady. However, when it comes to new high yield issues, the average yield declined from 10% at the end of 2022, to just below 8% at the end of March 2024.
Historical norms suggest to the experts at Canso Investment Counsel Ltd., “there is little upside for most high yield credit beyond its running yield.” Higher valuations mean bond prices are above par, which when coupled with higher credit risk and lower yields, make it challenging for investors to generate a return beyond the coupon interest. There’s not much upside for investors who want to buy high yield bonds and hold until maturity.
For several years, investors were so desperate for any bit of incremental yield they could find, they clamoured to access all manner of private credit investments. And it seems that many retail and institutional investors alike are still chasing yield. But the credit team at Canso Investment Counsel Ltd. warns that, “the appetite for risk in credit markets continues to dislocate from fundamentals. This is particularly true within the most speculative ends of credit, where risk premiums pushed tighter again this quarter.”
Stretched to the limit?
Valuations are stretched — for stocks and bonds — making it vitally important that investors are aware of and understand their credit risk exposure. The Canso Investment Counsel Ltd. team cautions that, “it is more important than ever for investors to roll up their sleeves and perform rigorous due diligence to understand the true risks in an investment.” This is now all the more relevant as maneuvers like Liability Management Transaction are increasingly common and can obfuscate capital structures and existing debt obligations.
Canso remains committed to its approach, which requires adequate compensation for any risks assumed. “With valuations more and more stretched, our portfolios continue to migrate towards quality and liquidity while we scour the markets for special situations. We continue to believe that protecting capital, rather than reaching for yield, will win out once again.”
For more on Canso’s thoughts and observations regarding both investment grade and high yield bonds, check out the April 2024 Canso Corporate Bond Newsletter.
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