Quarter of Discontent

Fixed Income Market Update

It was a quarter of discontent in North American fixed income markets as optimism surrounding an end to the monetary tightening cycle continued to wane. While the Federal Reserve’s annual Jackson Hole summit in late-August, which historically has had notable impacts on markets, passed without many headlines, “back to school” season brought with it its typical market cooling winds. Seasonally, September is the most challenging month of the year for financial assets, both bonds and equities, and 2023 proved to be a particularly difficult year. The S&P500 was down 4.9% on the month, while the broad US bond market fell 2.5% - thus the traditional US 60/40 balanced account declined 3.9%. The Canadian fixed income market was down 2.6% in September, which dragged down its Q3 return to -3.9%, its worst 3-month return since October 2022. On the bright side, with overall yields in the US and Canada at their highest levels since the GFC, averaging 5.4% and 4.9%, respectively, and policy rates nearing their expected peak, the income and return prospects for fixed income investors have improved materially. Below we present a summary of some key market moves in the Fixed Income space over the first half of the year (numbers are to September 30^th).

Highlights:

• The worst trailing 3-month return for the broad Canadian (-3.9%) and US bond markets (-3.2%) wipes out YTD gains and pushes returns thus far in 2023 into the “red”, -1.5% and -1.1%, respectively.
• Corporate bonds continue to notably outperforming Government bonds in Q3 despite the risk-aversion from investors and heavy issuance calendar in September.
• Lower rated corporate bonds outperforming higher rated corporates materially in Q3, YTD and over the past year.
• Continued upward pressure on shorter-dated government bond yields, even more pressure further out the yield curve.
• Thus, yield curves steepened in Q3, reversing the YTD flatten.
• Risk premiums in the corporate bond market were surprisingly resilient given the difficult backdrop for financial markets during the quarter. We believe that the resilience of the North American economy and the end of the rate hike cycle, should be supportive for risk premiums in the short-to-medium-term. That said, the spike higher in yields raises the risk to the economy and potential for higher credit spreads. Valuations are currently only ~10 bps higher than their YTD tights, despite the difficult September.
• Inflation has moderated, but core measures remain persistently above central bank targets.
• As a result, while policy rate expectations for further rate hikes after remained stable, the markets are discounting fewer rate cuts in late-2024 and early-2025. The “Higher for longer” narrative is firmly in place.

Performance:

Chart 1:

Source: FTSE/Russell; Bloomberg

Government Bonds:

Table 2

Chart 2:

Source: Bloomberg

Chart 3:

Source: Bloomberg

Credit Risk Premiums:

Chart 4:

Source: Bloomberg

Inflation:

Chart 5:

Source: Bloomberg

Monetary Policy:

Chart 6:

Source: Bloomberg

Rates positioning: (i) modestly short duration; (ii) yield curve neutral; (iii) overweight Cdn prime residential mortgages; (iv) overweigh RRB’s; (v) overweight Canada versus US but reducing position on opportunity.

Credit positioning: (i) overweight credit but reducing on opportunity; (ii) maintain a quality bias in favour of IG over HY, and more defensive credits within IG; (iii) overweight Cdn corporates, underweight US.