What Goes Up Must Come Down

“What goes up must come down” is generally attributed to Sir Isaac Newton and obviously refers to the inevitable impact of gravity. After a sharp move higher from August through to November, government bond yields have since succumbed to a similar gravitational pull lower in recent weeks. The bell weather UST 10-year yield boke above 4% on August 1st. A mere 57 trading days later, it reached 5%. Cue the Universal Law of Gravitation and in only 40 trading sessions, the yield was back below 4% - truly a remarkable period of large, quick, and contrasting moves in the rates market. Looking at the rolling 10-day move in the 10-year yields highlights the directional force and then reversal of these recent yield moves (Chart 1), with the 10-day change consistently hovering around the +/- 20-40 bps since August.

Chart 1:

Source: Bloomberg

In November, the UST 10-year yield declined 60 bps, helping to propel fixed income markets to their best monthly returns since January 2015 and second-best monthly return since before the GFC (Chart 2). The Canadian fixed income market rose 4.3% on the month, while the US aggregate market gained a similarly impressive 4.4%. The very strong MoM performance turned a 6-month decline of 5.2% at the end of October into a gain of 0.8% at the end of November – a reversal of fortune the magnitude of which we have not experienced, again, since the financial crisis (Chart 3). YTD the Canadian Universe bond benchmark has now recovered to a gain of 3.2% while the US market has rebounded to a positive return of 1.6% to the end of November. The investment-grade corporate bond sector continued to outperform its Federal government counterpart, rising 3.8% MoM and generating excess returns of ~60 bps over Government of Canada bonds. YTD IG corporate bonds have returned 4.9% and delivered excess returns over governments of ~290 bps. Provincial government bonds, which have on average a longer term-to-maturity and thus interest rate sensitivity, were the top-performing sector on the month, jumping 5.7% in November. YTD Provincial bonds have returned 3%.

Chart 2:

Source: FTSE/Russell; Bloomberg

Chart 3:

Source: FTSE/Russell; Bloomberg

In the US corporate bond market, IG issues returned 5.6% MoM and 4.2% YTD and delivered excess returns of 177 bps and 417 bps MoM and YTD, respectively. High-yield corporates returned 4.6% MoM and 9.4% YTD and delivered excess returns of 232 bps and 711 bps MoM and YTD, respectively.

Clearly the last 6-weeks or so have been a much more bond-friendly environment for investors!

Things That Make You Go Hmmm

I am often hesitant these days to use cultural references as I am of a vintage that many of them are met with a blank stare from those fortunate enough to have been born after the reference in question, but I will use the above reference anyway (The Arsenio Hall Show, just in case).

On November 30^th, Dynamic Funds hosted its first ever Fixed Income-focused Dynamic LIVE Advisor conference. It featured discussions with portfolio managers from across our entire fixed income platform, covering a broad range of asset class-specific topics. Over 1700 advisors attended (virtually), making this the largest Dynamic LIVE event so far and clearly a sign of the significant focus and interest in the fixed income space from advisors and investors. If you didn’t have the chance to attend, the replay is available until the end of the year, and I know you will find it useful.

In putting together the material for that discussion there were a number of things that came up that made me go “Hmmm”. I won’t address them all here, as I would love for you to watch the event replay, but I will highlight a couple.

Historic Rise in Yields

Spoiler alert: I am bullish on bonds. In fact, I am the most excited I have been about the asset class for a long time. Why? Here are a few of the reasons:

• Policy rates globally have peaked.
• Yields have moved significantly higher.
• There is “income” back in fixed income.
• The margin of safety now embedded in yields is material – therefore better upside potential than downside risk.

Market commentators have rightly been quick to point out that bond yields are at their highest levels since the financial crisis. At the peak in October, the average yield of the overall US investment-grade rated bond market was 5.8%, less than 10 bps below its 2006 high. As mentioned, there is “income” back in fixed income. And while the yield level is incredibly important to investors, it is the magnitude of the move higher, in an historical context, also bears highlighting.

By looking at the rolling 3-year change in the UST 10-year yield, we can get a good sense about just how big a rise in yields we have experienced the past few years. At its high, the 3-year increase in 10-year yields reached 420 bps. This is by far, double in fact, the biggest move the bond market has experienced since the Volker-era in the late 1970s/early 1980s (Chart 4). Even after the recent strong rally in the bond markets, the 3-year yield change is still approximately 300 bps, again much larger than any previous move over the past 4 decades! And when you put this move in the context of how low yields were at their starting point 3-years ago, the magnitude of the rise is truly historic.

Chart 4:

Source: Bloomberg

In addition to the obviously income benefits, higher yields also increase the margin of safety that investors have to potential further increases in yields. Simply put, the higher amount of income provides a bigger cushion to absorb price depreciation if yields rise. We refer to that margin of safety or the size of that cushion as a “break even” yield – how much do yields need to rise before your income is eroded by price declines, leaving you with an overall flat return. The higher your starting yield or income, the more yields need to rise to reach that break even point. Currently, the UST 10-year yield would need to rise approximately 50 bps to offset your earned income. This is the highest margin of safety since the GFC (Chart 5). As highlighted, given the yield has already risen by 300 bps over the past 3-years, we view the additional 50 bps break even yield rise as providing investors with an attractive level of downside protection. The margin of safety is even more attractive at the shorter end of the yield curve given less sensitivity to rising yields. At present, the break even yield rise for the UST 5-year is a little under 100 bps – again an attractive margin of safety for investors.

Chart 5:

Source: Bloomberg

IG Credit – Playing the Percentages

We have been and continue to be, constructive on investment grade credit. There are a few reasons, including (i) resilient if not improving credit fundamentals; (ii) a stronger than expected macro-economic environment and (iii) strong investor demand.

Another important rationale is valuations. As Mr. Burns from The Simpsons famously put it, “It’s called playing the percentages. It’s what smart managers do to win ballgames.” In analyzing credit yield spreads for Canadian IG corporate bonds over the past 20 years, we found some interesting statistics about credit risk premiums. We looked at what percentage of the time risk premiums spent in different yield spread ranges (Chart 6). Some of the interesting findings are as follows:

• An average corporate bond yield spread or risk premium of 175bps and higher is typically considered what to expect during a recession. Over the past 2 decades, Canadian IG risk premiums have spent less than 10% of time at those levels. And while risk premiums have spiked considerable higher than that during periods such as the GFC and the pandemic, they don’t stay at those levels for long. Therefore, trying to position a portfolio to mitigate against recession risk in credit, for anything other than a short-term tactical time horizon, is betting against the odds.
• As pointed out, Canadian IG corporate bonds have generated material excess returns over government bonds this year. Given yield spreads are now tighter than the +175bps recession threshold, some have argued that credit is expensive. While I agree that if we do enter a recession, risk premiums will likely increase, as we have shown above, that will likely be a short-term situation. Further, again looking back over the past two decades, risk premiums have trading at levels lower than current levels approximately three-quarters of the time. Therefore, while credit has outperformed meaningfully this year, valuations don’t appear to me to be overly expensive in the absence of a significant economic slowdown (not our base case).

Chart 6:

Source: Bloomberg

Rates positioning: (i) neutral duration following the recent rally; (ii) yield curve neutral; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) overweight Canada but reducing that position on opportunity.

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