Half-time break from the grind

Where to after this long, difficult trek for bonds?

A few minutes by car heading out of Vancouver in a northerly direction, one comes across a popular hiking trail leading up Grouse Mountain. “The Grind,” as it is known, is a steep and punishing trail populated by sweaty hikers and the occasional bear. On a tree at about 450 metres of elevation into the climb is a blue “1/2” marker, and beside that tree is a makeshift bench, which can serve as a nice spot to rest and reflect before pushing on towards the summit.

Six months into one of the most challenging years in bond market history, we recognize that 2022 has turned into investing’s version of “The Grind” – long and difficult, and occasionally sweaty – and so the holiday weekend that arrived at the end of June does evoke that quiet wooden bench and the reflective pause that comes with it. A few thoughts emerge as we rest at the half-way point of the year.

Inflation is weakening: You can see the signs everywhere. Look at the commodity complex. Steel and lumber, for instance, are both down more than 50% from their recent highs. Financial conditions are tightening. Consumer confidence has plummeted. And so, it is not surprising to see sovereign bonds and higher-grade credit catching a bid.

Profit margins are under pressure: It stands to reason that if wages are up, if cost of goods are up, and if interest charges are up, then earnings, generically speaking, must be lower. And so, despite the buoyant expectations of the early post-Covid rebound, we expect a challenging earnings picture for many companies. The relative winners in such an environment should be companies that can pass along cost increases easily and/or companies that benefit from relatively stable underlying demand.

Lower tiers of credit are more challenged than higher-grade: As the economic weather has turned from sunshine to rain, we are witnessing a speedy reversal of relative performance in credit markets. Over the past 12 months, higher-yielding but lower-rated credit was more able to withstand the impact of rising risk-free rates. But recently that trend has reversed as default risk replaces duration as the biggest potential drag on returns. Unlike duration, default risk is less homogenously priced into the market, so the key is really to avoid unpriced default risk.

Central banks are still in tightening mode: What makes the current downturn a bit different from 2020 and even 2016 is that despite an evident market drop and rapidly decelerating economy, the Federal Reserve and other central banks continue to raise rates. The Fed’s fear of allowing an entrenched inflationary cycle to take hold, for the moment at least, seems to be taking priority over maintaining economic expansion or promoting full employment.

Now, thinking can be useful, but it is doing that tends to drive results. So, given this picture, what are we looking to do?

First, we are continuing to allocate towards the investment-grade end of our spectrum, as we anticipate this area will be first to benefit from a waning inflation picture and should also be most resilient to risks of recession.
Second, within the high-yield part of the portfolio, we are pushing increasing weight into the most economically resilient issuers with strong coverage factors.
Third, we are extending slightly more duration than we have recently as we believe longer-term bonds, at least in the higher grades, stand to generate a higher total return should rates subside.

But while these are all directions that we believe are sensible in the current context, we never want to let top-down strategy prevent us from capitalizing on an excellent bottom-up idea. And so we continue to turn over rocks, particularly in the deeply discounted segment of the market, to see if we can find situations where market pricing has moved too far. As always, we remain on the lookout for a great risk-adjusted return opportunity in a very low-priced bond.

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – June 2022. Used with permission.

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