The consensus regarding financial markets and the economy seems to have evolved into a more benign, if not positive, outlook. Whether this optimism proves to be accurate or not, it might be a good idea for investors to reassess their fixed income exposure. I have some ETF recommendations that may work particularly well at this juncture.
This new spirit of optimism seems to be fuelled by two major factors. The first is that the S&P 500 Index is up about 11 per cent year-to-date. Investors are very influenced by recent events, and a return of more than 10 per cent in five months is impressive. The forecast bear market and recession (at least in the U.S.) have failed to materialize despite the yield curve being inverted for almost two years. The second factor is that recent consumer price releases are being taken as evidence that inflation has been successfully defeated by the efforts of heroic central bankers and government finance officials.
Canadian annual CPI declined from 2.9 per cent in April to 2.7 per cent in May. The year-over-year trend looks favourable, but inflation has proven to be stickier than we were assured in 2022 and is not yet below the Bank of Canada’s goal of 2 per cent. U.S. CPI figures are less encouraging, at an annual rate of 3.4 per cent at the end of April; stripping out food and energy, it was 3.6 per cent. I attribute the difference between the two countries’ inflation numbers to be a result of the weakness of the Canadian economy.
For the year-to-date period ended April 30, the FTSE Canadian Bond Index was down 0.91 per cent. Bond yields eased toward the end of 2023 but started rising again in the first few months of this year.
One thing that’s striking about subsector performance is how well corporate bonds have performed relative to government issues. For example, midterm corporate bonds have returned 2.46 per cent for the 12 months ended April, 2024. Government of Canada bonds are down 3.20 per cent for the same period, compared with a decline of 1.45 per cent for similar term provincials. (All figures include interest payments.)
A return advantage for corporates of more than 5.5 percentage points is large, but the longer-term numbers paint a similar picture. Over the four-year period ended April, 2024, midterm corporates returned 0.68 per cent on an annualized basis, compared with a decline of 3.35 per cent for Government of Canada bonds.
Corporate bond performance has been outstanding, and those who championed them can take a deserved victory lap. Corporate spreads have narrowed to near all-time lows. The ICE B of A Single A U.S. Corporate Index Option-Adjusted spread is only 0.75 of a percentage point. Similar corporate spread measures are also near their lows.
However, when I look at the past four decades or more, I become pessimistic. Corporate spreads eventually widen from their lows and corporates underperform. Sometimes, spreads stay constant for two to three years before widening out. During that quiet period, corporate investors earn the additional yield. However, in no cases did spreads go significantly lower than previous lows.
We need to be aware of the risk and return profile of corporates now. The extra yield corporate bonds are providing right now relative to government bonds is unusually small. Over time, that extra yield will likely grow again. Since prices move inversely, that would mean corporate bonds are set to underperform government bonds on a relative basis.
A long corporate bond yield may have a spread of more than 1.5 percentage points over a similar term Canada government bond, or one percentage point over a provincial bond. If spreads are constant, the investor will earn the additional spread as income. However, if history repeats itself, as it has always done in the past, then the spread between long corporates and governments could widen by more than two percentage points. That would mean, mathematically, long corporates could fall in price by well over 20 per cent relative to governments. Also, during panics, government bonds benefit from the “flight to quality” trade while corporates struggle.
The spread between U.S. and Canadian government bonds is also unusual right now. U.S. 10-year Treasuries yield more than 0.80 percentage points above similar term Government of Canada bonds. This spread is at or near all-time highs. In my view, this is unjustified given the inflation outlook of the two countries and the fact that Canada is a poor place to invest. Eventually, this spread will narrow. This should affect capital flows and create volatility in the loonie. If investors want to go long U.S. Treasuries but are concerned about currency risk, a good option is the BMO Long-Term U.S. Treasury Bond Index ETF (ZTL-NE), which is hedged against USD/CAD risk.
I believe rates will be slightly lower in the long end by year-end, and thus the yield curve will be more normal in shape. Avoid corporate bonds and any bonds less than two years in term. Overweight U.S. Treasuries. Increase exposure to long provincial bonds. A simple way to do this is to purchase the BMO Long Provincial Bond Index ETF (ZPL-T). Long government issues will also hedge against a bear market in stocks, which I believe is only a matter of time.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.