Bond strategy for cooling inflation

Analyzing duration and credit exposure for clues to opportunity

After a volatile October, we are generally constructive on the bond market heading into the end of the year. There is a great deal of evidence that the economy is slowing down. We hear many local anecdotes. We see the bank layoffs and hear of the troubles brewing in condo markets. And we also observe some broader indicators. For instance, the Conference Board U.S. Leading Index has declined in each of the past 18 monthly readings. So, the question we ask ourselves is whether the slowing economy is good for bonds.

We believe the answer is a resounding “yes.” If a rising economic tide in the context of Covid-constrained capacity led to high inflation, then a falling demand picture in an environment where productive capacity has essentially rebounded should do the opposite. And if higher inflation led to higher yields across the curve, then falling inflation should lead to lower yields.

The turn in inflation is no longer something about which we need to speculate. It has clearly happened. The Fed’s preferred measure, Core Inflation, peaked at 6.6% in September 2022 and has declined in a steady fashion over the past 12 months, to 4.1% at the end of September 2023. Given the continuing weak economic outlook, we would expect the decline in inflation to continue unabated for some time.

Which bonds to focus on?

So, if inflation has been conquered, at least for now, and bond yields are set to decline, which bonds should we focus on? The two dimensions to consider are duration and credit exposure.

Duration, after being a negative factor for ages, seems to be worth looking at again. It is true that the term premium is not massive. But, with the prospect of a falling curve in front of us, we believe it is worth exposing ourselves to a degree of volatility to take advantage of the levered gains that could come from lower long-term rates. There are plenty of longer-dated bonds down more than 40% over the past three years. Even a 1% decline in a 30-year bond’s yield can offer the prospect of a one-year total return in excess of 15%.

While credit is not wholly attractive in a slowing economy, we do see bright spots. Cinemas, where the Covid recovery is still fairly nascent, is an area where enterprise values are still tiny, and credit is cheap. Likewise, oil which has suffered from capital starvation over the past five years. Healthcare and pharma, which lost margin dollars from the divergence of resources to Covid, also are still in rebound phase.

And there are other random cheap pockets in credit markets because credit quality, ultimately, is situational. Businesses that can de-lever by selling hidden assets or businesses with implicit credit support from deep pocketed owners are a couple of classes of situation that have served us well over the years.

On the other hand, there are quite a few areas of expanding credit risks. Banking and real estate, as general categories, garner a pass from us for now.

All in all, we are very optimistic about our market and the prospect for a rebound. But we see perhaps, a different kind of rebound than previous episodes such as 2016 and 2020. Those were credit- and commodity-driven rebounds. In the current market, it is the risk-free rate itself that is the source of significant opportunity. And we view a rates-led, high-quality rally as the most likely near-term opportunity, with potential kickers to be provided by the above-noted pockets of cheap credit.

Geoff Castle is Lead Portfolio Manager of PenderFund Capital Management’s Fixed Income Portfolios, including the Pender Corporate Bond Fund. Excerpted from the Pender Fixed Income Manager’s Commentary, October 2023. Used with permission.

Disclaimer

Securities mentioned in this article are for illustrative purposes only and do not constitute an investment recommendation. Always consult your financial advisor before investing in any security.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

Image: iStock.com/AndreyPopov