Corporate bonds will continue to climb: Manager

“Last year was tough owing to the fall of ‘risk’ assets in the fourth quarter,” says O’Toole, vice-president, global fixed income at Toronto-based CIBC Asset Management Inc. “The Federal Reserve hiked interest rates in September and said it would continue to raise rates above 3%. The stock market balked at that and risk assets, which include corporate bonds that are riskier than government bonds, suffered to a certain extent as well.” O’Toole notes that in 2018 the fund did beat its own benchmark, a blend of 80% investment-grade Canadian bonds and 20% U.S. high yield bonds.

“The fund continues to do what it was designed to do: beat the broad universe in Canada over the long run. Corporate bonds are riskier than government securities and over the long run you should get a better return,” argues O’Toole. On a three- and five-year basis, the fund averaged 4.29% and 3.99%, respectively, versus 3.19% and 3.37% for the category. Since the fund’s inception in January 2010, it has returned 5.92% per year versus 4.5% for the benchmark FTSE Universe Bond Index.

Lower Fed rate and great to date

This year’s turnaround is attributable to the Federal Reserve backing off about raising interest rates and actually lowering them in July. “Government bond yields have moved down quite dramatically since last October,” says O’Toole, an Ottawa native and 30-year industry veteran who joined CIBC in 2004. “Ten-year government bonds are down more than one percentage point, both here and in the U.S. In addition, credit spreads [the differential between corporate and government bonds] which had increased in the fourth quarter of 2018 have declined this year, as government bond yields continued to fall. Even in the high-yield space spreads [over government bonds] have done well, as the U.S. economy continues to perform well. It’s been a solid start to 2019.” O’Toole works within a 20-person team that manages about $60 billion in fixed income assets and includes Jean Gauthier, managing director and chief investment officer, global fixed income.

To illustrate how the market has shifted O’Toole notes that at the start of 2019 the spread between investment-grade corporate bonds and government bonds was about 139 basis points (bps). Today, it is 117 bps. The spread for high-yield bonds, or those rated BB and lower, has dropped to 407 bps from 530. Falling spreads result in capital gains, while widening spreads do the opposite.

‘Clamouring’ for Canadian corporates

O’Toole believes the bull market for government bonds may have further to run, although he concedes it does not necessarily auger strong performance for a corporate bond fund [Tweet This!]. “It all depends on why yields are falling. If government of Canada bonds are rallying due to the clamour from global investors for a positive return, which is what we’ve seen this year, then the fund is fine. When you look around the world, there is US$14.5 trillion in debt with a negative yield—something like 25% of investment-grade government bonds have negative yields—and 95% of all developed market sovereign bonds are yielding below the so-called Fed Funds rate,” says O’Toole, noting that even 30-year bond yields in Germany, for instance, are in negative territory (which means investors pay governments to hold a German sovereign bond rather than earn interest).

“Investors are saying. ‘We want something with yields above 0%, and U.S. and Canadian bonds are well above zero.’ So they continue to buy government bonds and corporate bonds because the spread is more than 100 bps,” says O’Toole, adding that 5-year Canadian corporate bonds are yielding about 2.3%.

But there are risks on the horizon. “If government bond yields are falling because demand remains high, and our economies are doing well, then the corporate bond fund will do well,” says O’Toole. “But if yields are rallying because people are worried about recession—which is what we have seen in markets recently—then you could see a repeat of the fourth quarter of 2018 [Tweet This!] where risk assets don’t perform well and corporate bonds lag government bonds.”

Yielding to elevated risks

Global growth has been slowing, adds O’Toole, and in North America the inversion of the yield curve (where short-term bonds are yielding more than long-term bonds) is regarded as a premonition of an imminent recession. Indeed, history has shown that has happened before. At the end of 2007, spreads for mid-term investment-grade corporate bonds were about 140 bps, the highest level for data going back to 1988. “The great financial crisis hit in late 2008, so the corporate bond market gave a warning signal. Right now, though, the market is telling us, everything is fine. We’re not seeing a spike in corporate spreads that says we’re worried about a recession coming. But you are seeing it in the [inverted] yield curve, which has been an excellent forecasting tool.”

From a strategic viewpoint, the managers have responded to slightly elevated risks by lowering the portfolio’s weighting in high yield bonds to 18%, from 24% in 2017.  The balance of the fund, 82%, is in investment-grade corporate bonds. “Maybe the Fed did tighten too much [last year], and they’ve sown the seeds for a recession. As a result, we’ve been reducing risk in the portfolio,” says O’Toole. “We expect spreads to move a little higher. We have some ammunition to increase our high-yield weighting should spreads move in to the mid-500 zone in the next year or so.”

From a sector standpoint, 24% of the portfolio is financial services (versus 34% for the fund’s blended benchmark), 20% energy (neutral versus the benchmark), 16% industrials (versus 18%), 13% real estate (versus 21%) and 4% infrastructure (versus 14%). The fund’s duration is 6 years, compared to 6.3 years for the benchmark and 8 years for the FTSE Bond Universe Index. Its running yield is 3.6%, after fees.

The portfolio is highly diversified and has about 465 securities. However, since large banks and telecom providers have several different-dated bonds, there are in fact 190 individual issuers.

In selecting corporate bonds, O’Toole and his team look for an issuer with long-term competitive advantages, meaningful market share, consistent financial results, favorable leverage metrics compared to its peers, management of environmental and social governance risks and attractive yield versus its competitors.

One of the top positions is Teranet Holdings LP, a so-called monopoly provider of electronic search and registration services for residential real estate in Ontario. “They have an exclusive contractual agreement with the province until March 2067,” says O’Toole. “Long term prospects for residential real estate remain strong given population and economic growth in Ontario. Teranet has positive free cash flow and strong management,” says O’Toole, adding that the organization is wholly owned by OMERS Infrastructure Management, a unit of Ontario Municipal Employees Retirement System. The 30-year bond is yielding 3%.

Another favorite is BCE Inc. (BCE), a leading telecom and dominant provider of cellular phone services. “It has a strong market presence and great cash flow. Last year, it generated $3.6 billion in free cash flow and $2.6 billion in dividends, which was up 4.4% year-over-year,” says O’Toole. “It has a great track record of managing costs and, at 9.3 million wireless subscribers, nearly one-third of the market.” The 30-year bond is yielding 3.5%.