Fundamentals vs Prices vs Inflation

October 2021

The fundamental credit backdrop continues to be supported by improvements in both operating and balance sheet metrics. Through the third quarter, corporations were able to deliver above forecast revenue and earnings performance, supported by continued macroeconomic gains. To date, we continue to see broad leverage metrics continue to decline. The absence of aggressive acquisitions, equity buybacks and dividend increases have, for the time being, maintained the focus on balance sheet repair. Combined, the operational and balance sheet trends are expected to support more ratings upgrades over the coming quarters, especially for companies aiming to regain pre-pandemic rating thresholds.

Buoyed by the fundamental improvements, investment grade risk premiums have remained within in a narrow range since early in the second quarter. On a historical basis, valuations are near their tights. Yet, we do not expect periods of material widening of credit premiums to persist, if they were to occur at all, in the near term. The Canadian credit market has outperformed the US over the past month after remaining silent for most of the year. We continue to search for opportunities most related to changing credit profiles, as the absence of volatility has limited the relative value opportunity set.

Our portfolios are positioned with an overweight to areas we still believe can provide outperformance in the near term as the economy continues to reopen. We have an emphasis on financials, telecommunications and real estate, and BBB rated issuers in general. Term wise, we are emphasizing 5 to 7 year maturities, as they represent better value and improved roll-down benefits. Where deemed appropriate, we continue to harvest profits on securities believed to reside near their valuation high.

We continue to view the risk of rising government yields as a real possibility through the end of the year and into next year. As such, we have kept portfolio duration low in absolute and relative to benchmark duration. While inflation concerns will likely pressure government yields and continuing an upward trajectory as economic reopening continues, there will be periods in which we believe the market moves are aggressive. At the time of this writing, the latest yield moves are reflecting over five rate hikes by the Bank of Canada through September 2022. On balance, in our opinion, this is aggressive, especially when compared to rate hike expectations in the United States.

A Final Thought

Following the move in government yields, the opportunity for fixed income investors is more attractive today. In response, we continue to witness buying of investment grade credit, especially in shorter dated securities, at all-in yield levels not seen in Canada since well before the pandemic. We expect that any pause in growth/inflation expectations will be met by aggressive buying of short-term corporate securities.