High Quality Corporate Bonds – An Opportunity for 2023
This year has been turbulent for all asset classes, and particularly so for bonds as they have failed to provide the expected downside protection against falling equity markets. Inflation has skyrocketed, forcing central banks to pivot from extremely loose to extremely tight monetary policy within the same year.
This year has also revealed how heightened uncertainty leads to elevated volatility and widens the range of potential outcomes. As most of the traditional approaches to fixed-income investment disappointed in 2022 due to fast-rising rates, investors have started evaluating how they can optimize their fixed-income portfolios more effectively. High-quality corporate bonds can help to cushion a bond portfolio against the negative implications of rising rates and we believe interesting opportunities have emerged for astute investors.
Investing in Uncertain Times
High-quality corporate bonds are a prudent way to add excess yield over and above the risk-free government yield, which is best achieved by allocating a percentage of the portfolio to corporate bonds. Over the past two decades, corporate bonds have become a larger and more diversified sector within Canadian bond indices. As government bond yields were forced lower through accommodative monetary policy during much of the last decade, investors’ need for higher yields made corporate bonds increasingly more attractive. Over this period, investors have become more comfortable with higher allocations to investment-grade corporate bonds within their portfolio.
Corporate bond spreads have historically been highly correlated to the economic cycle. As fears of an economic recession have mounted, investment-grade corporate bond spreads have widened significantly and are now approaching the widest levels in almost a decade, outside of the COVID pandemic. These wide levels are driven by various macro factors such as hawkish central banks, slowing growth, as well as ancillary issues from the Russia/ Ukraine conflict. However, wider spreads result in higher yields, which provide a good portfolio defense against any further rate increases and improves the future return prospects for bond portfolios. For example, the breakeven spread widening represents how much credit spreads would need to widen before the excess return of corporate bonds versus government bonds turns negative. As credit spreads have increased across both the quality and maturity spectrum, the breakeven point has moved higher resulting in greater portfolio insulation to spread movements.
We believe the current spread-widening episode is unique and presents interesting opportunities for investors willing to look past the headlines and dig deeper into the fundamentals. While most previous economic downturns and credit spread widening events revolved around excess risk-taking and poor credit underwriting, causing general growth uncertainty and financial market instability, the current economic backdrop stems from loose monetary policy and fiscal stimulus over the last two years. For the most part, corporate and consumer balance sheets are substantially stronger this time around.