Has the great white shark left the area?
And is it safe to go back in the bond pool again?
Until a couple of years ago, the broader bond market was one of the most reliable places possible to allocate capital. In a 39-year bull market, the 5-year U.S. Treasury bond yield fell from its 1981 high of 16.2% to an ultimate low of less than 0.3%. Even in the later stages of the bull market, capital appreciation from falling yields allowed investors to earn total returns well above coupon levels. In the five years ending Dec. 31, 2020, the U.S. Treasury Total Return Index delivered 4.7% annualized.
But bull markets eventually end and this one has ended with a bang. In Canada, broad universe-tracking total return measures are down over 13% from August 20201. Longer-duration index trackers are down even more. The iShares 20+ Year Treasury Bond ETF is down more than 30% in total return terms from its 2020 high.2 High-yield credit has fared a little better, but in 2022 index-tracking funds, such as the iShares iBoxx USD High Yield Corporate Bond ETF, have still delivered a loss of over 7% in total return terms.3
To the serious capital allocator, the facts above are already well understood. We imagine a good allocator at summer’s end surveying the bond market like Roy Scheider, vigilant sheriff of Amity Island in the movie Jaws. As he scans the waters for telltale shark fins, there’s a question pressing on his worried mind: “Is it safe to go back in the water?”
Clearly, the typical retail investor is still scared of the bond market. Year-to-date net outflows from U.S. investment-grade bond funds amount to over $120 billion, or approximately 6% of total assets, while high-yield net outflows have amounted to over $20 billion, or approximately 5% of total assets.4
When in stampede mode, selling investors don’t take much notice of changes in underlying fundamentals. We believe, in the current market environment, pausing to reassess the fundamentals of the bond market makes a lot of sense.
Simply put, the drivers that would make one interested in high-quality bonds are starting to flash a lot of green lights, in our opinion.
The yield curve is inverted. Core inflation measures, which were ramping upwards in the first part of 2022, have begun to stall. Many commodity prices are substantially lower than they were in the first quarter of 2022, including lumber (down 65%) and copper (down 25%). Confidence surveys of consumers and business leaders are suggesting a significant economic slowdown is brewing.
After seeing nothing but rate hikes out of global central banks, a surprise rate cut out of China may signal a potential turning of the rate hiking cycle. We recognize that Fed Chair Jerome Powell is still talking a hawkish line, but we find it interesting that despite his rather gunslinging speech at Jackson Hole vis-à-vis the promise of “moar” rate hikes, the U.S. 5-year yield is still over 20 basis points lower than it was in mid-June.
Where’s the opportunity?
Given this picture, where do we see the best opportunity?
There are a few different spots. The simplest to wrap one’s head around are the shorter-term obligations of solid investment-grade issuers like PepsiCo Inc. and McDonald’s Corp. where yields have risen to around 4.5% at the 3-year tenor.
We also see value in high-yield credit in senior securities with substantial valuation coverage. As an example, Uber Technologies Inc.’s 2025 Term Loan B is currently priced to yield over 6%, despite occupying the top $2.5 billion of a capitalization structure that is valued today at $65 billion.
We also have deep conviction in a select number of higher-yielding issues, such as the 2025 put-able convertible bonds issued by Liberty TripAdvisor yielding in excess of 13%. But in these somewhat more esoteric positions, we have been purposefully cautious in position sizing and portfolio weighting, given the economic headwinds.
Overall, we see this as a market that may be led by high-quality issues and issuers, and that is where we are focusing our weighting in our Pender Corporate Bond Fund going into the last third of 2022.
1. XBB (iShares Core Canadian Universe Bond Index ETF) total return from Aug 31, 2020, to Aug 31, 2022. Source: Bloomberg).
2. TLT (iShares 20+ Year Treasury Bond ETF) total return from high on Aug 4, 2020, to Aug 31, 2022. Source: Bloomberg).
4. CreditSights, Aug 25, 2022.
Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income Manager’s Commentary, August 2022. Used with permission.
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