A study in scarlet: examining bond duration

Four suggestive points in favor of quality, longer-duration credit

In midsummer 2020, fear reigned. Investment-grade credit, a magnet for the risk-averse investor, was hot. And hottest of all were long-duration investment grade. But now, splattered all over the statements of then-defensive investors, are splashes of bright red ink. From the early August highs, the ETF tracking the duration-heavy Canadian bond universe has delivered a total loss in excess of 5%.* The triple-A-rated 30-year Canada bond has delivered a loss of over 20%. With such blood already spilled, is it finally time to look at longer duration bonds?

We believe that after a long period of answering “of course not,” we are seeing enough price movement to offer a qualified “yes.” We may not be at the point of maximum longer bond yields in this cycle, but we may be close enough to start shifting a bit of weight rightwards along the curve.

There are, of course, arguments for making the opposite trade. As we ourselves have noted, inflation is rising, yields are still historically low, and the Fed has been slowly backing away from its emergency programs designed to hammer down bond yields. All true. But as the U.S. 10-year Treasury yield closes in on 2.0%, the case for buying quality longer-duration credit strengthens. Consider the following:

1. Higher Treasury yields, if sustained, may cap some asset values and slow economic activity: As market action has shown in the through March weeks, it is not just long bonds that suffer from rising rates. A host of “long duration assets” are vulnerable. For instance, in a world where you can earn back the cost of buying a house from 10 years of rental income, home prices are not particularly sensitive to 10-year interest rates that move from 1% to 2%.

But when it takes 50 years of rental income to recoup your cost, a move in longer-term yields to 2% is big. And 3% rates in that situation are a disaster. So, the knock-on effects of higher rates may be lower prices for some properties and businesses, and that may ultimately limit the scope for yields to rise.

2. Sentiment has gotten pretty lopsided: Sentiment surveys are hardly foolproof, but we do tend to see market turns close to extreme readings. And, in the case of investor sentiment towards U.S. Treasury yields, recent readings are lopsidedly bearish. There are almost no bond bulls left. The hedgers have hedged. With such a consensus in place, the market may be primed for a result its participants do not currently expect.

3. The term premium has turned positive: After years of negative term premiums, the instantaneous forward term premium 10 years hence, a key measure tracked by the U.S. Federal Reserve, recently hit 0.3%, its highest level since 2018. In short, investors are getting paid something again for duration risk.

4. Many of the deflation drivers that existed before Covid are still in place or have further intensified: We acknowledge that there are certain markets that are experiencing cyclically rising prices, particularly in the commodity area. However, other deflation drivers, more secular in nature, are still in place. Demographics still favour deflation. Some weaker balance sheets have added debt in the crisis. And many of the creative solutions to the pandemic, like Zoom, presage a future deflation in disrupted industries like office space, retail stores, and business travel.

We haven’t taken our Pender Corporate Bond Fund to an extra-long duration positioning by any means. But, considering the favourable moves in prices, and the shifting fundamentals of the duration trade, there have been a number of situations where we have picked up 1%-2% in yield extending into the 7- to 10-year tenors in issuers like Canadian Pacific, Fairfax, Gartner, and MSCI.

* iShares Core Canadian Universe Bond Index ETF (TSX: XBB)

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – March 2021. Used with permission.

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