To BBB or not to BBB

Looking at BBB-rated corporate bonds in Canada, one might think they could be closely tied with the direction of rates.  Traditionally, lower rates precede an economic slowdown, as bond market participants expect central banks to cut rates. With a slowing economy, the equity market should fall and credit spreads should widen as investors demand higher returns for holding debt which is now riskier due to the increased likelihood of default.

Yet these predictors of a recession aren’t always correct. Here we show the yield of Canadian Government mid-term bonds (dark blue) and the spread between a BBB-rated and a A-rated mid-term corporate bonds (light blue).  A corporate spread widening occurred in 2015, peaking in early 2016 as benchmark government interest rates dropped more than 1.25%, hitting all-time lows. At the time, the main stories were the negative rate policy in Europe, and the price of oil plummeting towards $26. But the economic slowdown never materialized; wide credit spreads became a buying opportunity and we had a fearless rally in Corporate bonds even as government rates continued falling throughout 2016.

 

This time, while government bond rates are flirting with new all-time lows, we are starting seeing cracks in the economy. Even though spreads are hovering near where they were in 2015, we believe the chances of a slowdown are higher this time around. Thus, patience could be rewarded with even wider spreads and, consequently, buying opportunities.  We think it’s time to be prudent with BBBs.

 Jean-Guy Mérette

 Vice President and Portfolio Manager
 Active and Strategic Fixed Income Team