Waiting for the next opportunity in fixed income markets

As central banks continue to normalize interest rates, bond markets will be far more volatile than in the past, says CIBC's Patrick O'Toole.

Michael Ryval 22 November, 2018 | 6:00PM

Central banks have been gradually hiking interest rates and putting downward pressure on bond markets. While long-term bond specialist Patrick O'Toole concedes that the rate-hiking momentum will continue into 2019, he argues that the economic backdrop may cause central banks to take a breather sometime next year, and that may present bond-buying opportunities.

"The guidance from the Federal Reserve is that they will hike again in December and three times in 2019, and once for good measure in 2020. They're telling us they are going a little above 3% [for the Fed Funds rate]," says O'Toole, vice-president, global fixed income at CIBC Asset Management in Toronto. "They've said, 'We believe 3% is neutral.'" Meanwhile, the Bank of Canada has also said that a neutral stance is 3%, and with the bank rate at 1.75%, it has some ways to go.

"That means the Bank of Canada could be hiking rates five or six times in the next couple of years. But we'll see," says O'Toole, an Ottawa native and a 29-year industry veteran who worked at several fund companies before joining CIBC in 2004. "This is all predicated on everything going along swimmingly," says OToole, noting that the implication is that economic growth remains solid and inflation does not get out of hand.

O'Toole agrees that the central banks have good reasons to raise rates since economies have come a long way from the 2008 global financial crisis. "But who knows where neutral is? The banks keep lowering that level and are now down to 3%. The Fed has evolved, in sync with how growth has evolved. Growth is lower and inflation is lower than what people thought it would be," says O'Toole, lead manager of the $948.5-million Renaissance Canadian Bond. That bond fund forms a core component of the $2.4-billion Renaissance Optimal Income Portfolio, which is comprised of seven Renaissance funds and is in the Canadian Fixed Income Balanced category.

"Our view is that once we are in the mid-2% level, it's a good place to take a pause and re-assess where we stand to date. Both central banks should stop around the mid-2% level."

One reason for this line of thinking is that it takes 12 to 18 months to know the full impact of a series of rate hikes. "By mid-2019, we'll be around 2.5% [for the overnight rate] and the economies are expected to slow in the second half. Inflation may not be as robust as some are predicting," argues O'Toole. "The central banks may say, 'Let's see how things play out for the next while. Our plan is to move to neutral. But let's see the impact of these increases and see how the economies and consumers are adjusting.' The Bank of Canada is saying they will move on schedule. But we'll see what happens. We look for a pause from both central banks."

O'Toole notes that as central banks continue to normalize interest rates, bond markets will be far more volatile than they have been in the past. "We've seen one of its quietest periods in the last two years. But we are going to start reverting back to more volatility. And that's not a bad thing. It reflects the fact that we are getting back to normal." In other words, as central banks are ending their support for fixed income and equity markets, markets are forced to re-price assets.

"But this will result in more opportunities for everybody," says O'Toole. "Next year we should be seeing better opportunities. There should be opportunities to buy corporate bonds at better credit spreads. That's both for investment-grade corporate and high-yield corporate. We have reduced some of the risk this year in the latter two categories and want some ammunition to take advantage of that opportunity in the next 12 months."

O'Toole believes that the economic backdrop is solid, and he is not expecting losses in Canadian stock and bond markets for the next 12 months. "Growth is still above trend. It's just lower than what we've seen in the last year. We should be happy with that. That means you are still seeing growth, and no worries as far as making coupon payments, or re-financing bonds as they come up for maturity," says O'Toole. "It's a decent backdrop. But investment-grade corporate bonds have outperformed government bonds for the last two years, by about 2.5 percentage points."

Overseen by CIBC's Business Control Group which determines the asset allocation for Renaissance Optimal Income Portfolio, about 33% of the fund-of-funds is in corporate bonds, held in Renaissance Canadian Bond, Renaissance High Yield Bond and Renaissance Floating Rate Income (the remaining 67% is in a mix of Renaissance Canadian Dividend, Renaissance Global Infrastructure, Renaissance Global Bond and Renaissance Real Return Bond). "About a year ago, the corporate bond weighting was about 40% in aggregate," says O'Toole.

"It's been a great run as far as corporate bonds outperforming government bonds. That will be the story going forward -- but not to the same extent. Don't expect the same performance," says OToole. "We expect that relationship to shift a little in the next year and we look to increase the corporate weighting should we see spreads increase to more attractive levels."

O'Toole is reluctant, however, to say whether he will return to the 40% level of a year ago. "It will depend on whether spreads increase and what the outlook is once that happens." What has not changed, however, is the fund's running yield of about 4.1%, before fees.

Meanwhile, the fund has a defensive tilt since the duration for the portfolio's bond portion is one year shorter than the 7.6 years in the benchmark FTSE TMX Universe Bond Index. And O'Toole remains a staunch supporter of high-yield bonds, noting that they outperformed in 2013 when government bonds took a beating during the so-called "Taper Tantrum" brought on by comments made by Ben Bernanke, former Federal Reserve chair, that it was time to end the quantitative easing program.

By way of example, O'Toole likes high-yielding names such as Netflix Inc., which has a BB-rated bond maturing in 2025 that is yielding about 235 basis points above comparably-dated Treasury bonds. In a similar vein, he likes T-Mobile U.S. Inc., the third-largest cell phone provider in the United States.

"It has more customers than Bell, Telus and Rogers combined. Its balance sheet is healthy enough that in our view it has investment-grade credit metrics, although it's rated BB," says O'Toole. "The 2027-dated maturity has a spread of about 250 basis points above comparable Treasuries. It's a pretty attractive company."

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Michael Ryval

Michael Ryval