Fixed Income

The outlook for fixed-income returns remains modest. Bonds won’t offer much upside over the medium term unless a slowdown or recession scenario unfolds. Overall, we forecast a 1.5% total fixed-income return for 2020.

Fixed-income markets have made a tentative move toward a “less bad” 2020 macro-economic scenario. Yields have been on an uptrend since the August lows. However, we currently don’t see fixed income being appropriately priced for the mild reflation we hold as our base case (see line chart below). Year-to-date moves of most asset classes may appear eye-popping and while most are a byproduct of the recovery from the deep declines of Q4 2018, this is not the case for fixed income. The strong 8.2% YTD return for fixed income (see bar chart below) reflects a structural shift to lower bond yields due to the abrupt early 2019 about-face on monetary policy by global central banks. That shift knocked yields down by about 0.5% and drove approximately half the YTD returns in 2019. 

Chart compares Government of Canada 2 and 10 year bond yields between 2006 and November 2019. The Canada 2-year yield is at 1.58%, above the Canadian 10-year at 1.46%. 2020 year-end targets are 1.75% for both the 2 and 10 year. : FTSE Canada Universe Bond Index Return chart showing calendar year total returns between 2006 to 2019. Current YTD total return of 8.2% is well above the average yield of 2.1%, which has dropped from an average of 2.7% at the beginning of the year.

We’ve been left with a Canadian bond yield trading range between 1.25% and 1.75% (for 10-year yields) that ebbs and flows primarily on trade news and central bank expectations, with macro-economic data having a periodic impact. Bond yields toward the mid-to-lower end of that range (where they sit currently) are pricing in a combination of trade disappointment, further central bank easing and no improvement in growth or inflation. We hold a constructive view on these issues and believe yields should be closer to the upper end of this range. Our view is bolstered by our belief that:

  1. Trade frictions will not escalate – while a phase one deal likely holds some disappointment, further escalation is too politically risky for the Trump administration in an election year.
  2. With trade no worse and economies showing signs of stabilization-to-improvement, central banks will not be required to cut rates.
  3. We see inflation ebbing in Canada by mid-2020 (see the Focus on the Bank of Canada for more) but expect the bank to hold the line on rate cuts through 2020.

If central banks remain on hold with a dovish bias for at least the first half of the year, we expect to see 2-year yields creep up toward the Bank of Canada overnight rate of 1.75%. A stabilizing global economy relieves some of the downward pressure on longer-term bond yields to allow the 10-year yield to rise to roughly the same level. The result will bring the Canadian 10s/2s yield curve out of inversion. These moves represent an increase of roughly 0.25%, which is a very small headwind that allows the broader investment-grade bond market to deliver a 12-month total return of 1.5%. Despite investing a good deal of time trying to figure out the Bank of Canada’s next move, the reality is if the Bank cut, it would only nudge our fixed income return forecasts higher by a smidge.

Our end of 2020 Canadian 2- and 10-year bond yield forecast is 1.75% for both (versus a 10-year yield of 1.46% and 2-year yield of 1.57% as at Nov. 30, 2019).

Bottom line: Our base-case scenario calls for a 2020 total bond market return of 1.5%. Fixed income’s risk-mitigating qualities remain a significant attraction. Canadian bond yields continue to offer enough income that they will deliver a small positive return given the small yield increases we forecast. The majority of our fixed-income return scenarios continue to deliver a positive total return outcome for 2020. If yields move up by more than we expect (i.e., more than a 50-basis point parallel shift in the yield curve), then 2020 could deliver slightly negative returns. By contrast, a risk-off environment (a parallel shift down by 50 basis points) in turn could deliver returns in the 7% range.

Sector insights

  1. Government bonds – Attractive for their superior risk-mitigation qualities, sovereign bond yields have re-rated lower on the 180-degree pivot by central banks from a tightening to an easing bias. Their attraction lies in their ability to deliver the highest level of upside in the event of a risk-off scenario. We maintain our government bond recommendation at neutral.
  2. Investment-grade corporate bonds – We continue to see these as most attractive given their mix of yield pick-up and modest safety. Investment-grade corporate bond spreads remain narrow (see line chart below) and we see little on offer in terms of further appreciation. The overall low yield environment continues to keep demand for the incremental yield of corporate bonds high (both investment grade and high yield). We prefer the risk-reward tradeoff of investment-grade corporate bonds over high yield bonds, given the greater degree of safety we generally desire from our fixed-income positions. We have a bias toward shorter-duration corporate bonds given the tight spread environment and our expectation for modestly higher yields. We continue to favour the higher credit-quality spectrum at the expense of the lowest BBB tranche. We maintain our investment-grade corporate bond recommendation at the highest overweight. 
Investment-grade corporate bond spreads of various risk ratings are compared in a historical line chart. As at Nov. 30, 2019, Province of Ontario bond yields are 44 basis points, while BBB are 141 bps. BBB has potential as future trouble to investors.

3. High-yield bonds – Given the narrow-spread levels in high-yield bonds in aggregate (see line chart below), and their lack of risk-mitigation characteristics as an asset class (see table below), we see their risk/reward tradeoff as unattractive. High-yield bonds should not be relied upon for risk-mitigation because they generally experience negative returns in ‘risk-off’ environments. Their main benefit lies in the higher yield and greater potential for capital appreciation they provide as spreads decline. At the asset class level, neither of these metrics (yield offered nor capital-appreciation potential) appear very attractive to us at present. High-yield bond issuers are not a homogeneous group and our active fixed-income managers continue to uncover select unique opportunities through individual security selection where the risk/return tradeoffs are appealing. We maintain our high-yield bond recommendation at underweight.

Very narrow spread levels and lack of risk-mitigation characteristics makes high-yield bonds unattractive, as seen in a line chart showing Canadian high yield bond yield spreads from 2014 to Nov. 30, 2019. The Bloomberg Canadian high yield bond index now sits at 355 basis points, well below the historical average of approximately 550. A table compares periods of steep declines for Canadian equities over the last 20 years to the performance for various fixed income assets. Investment grade bonds provide a positive offset in these periods of equity weakness. The FTSE Canadian High Yield Bond Index in the four most recent episodes between 2008-2018 did not provide any safety, posting negative returns along side equities. High quality bonds, not high yield bonds, should form the core component of a fixed income portfolio.

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This commentary represents GLC’s views at the date of publication, which are subject to change without notice. Furthermore, there can be no assurance that any trends described in this material will continue or that forecasts will occur; economic and market conditions change frequently. This commentary is intended as a general source of information and is not intended to be a solicitation to buy or sell specific investments, nor tax or legal advice. Before making any investment decision, prospective investors should carefully review the relevant offering documents and seek input from their advisor.