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At half time, there remains a prevailing headwind of higher benchmark bond yields and a consensus view of core “sticky” inflation. Is a soft landing still feasible? Only time will tell, but there are reasons enough to be generally cautious and selectively optimistic.
First, the general caution. We see elements in the environment that warrant caution on credit. These include an inverted yield curve, a persistently negative trend in the Conference Board U.S. Leading Ten Economic Indicators, a rapidly decelerating U.S. Personal Consumption Expenditure Price Index, and tightening credit standards from surveyed lenders. Given that these factors have historically led recessions, we have tempered our expectations for issuer earnings and have taken a careful stance in considering both existing portfolio companies and prospective investments.
Certain underlying factors that buoyed consumer spending and the economy, such as excess household savings accumulated during the pandemic period, are now weakening. Household delinquency rates are rising due to the lagged impact of tighter monetary policies and restrained bank lending. Small business bankruptcy rates are also trending higher. Further rate hikes may be on the horizon over the short term, which bodes ill for both households and small businesses.
However, at some point policy rates will come down. Hence, our caution on credit is offset by a growing optimism regarding other areas of the fixed-income universe that do well when policy rates come down. We like higher-rated investment-grade securities that are now offering yields that are close to 13-year highs. We also have become increasingly constructive on a group of yield-curve-affiliated positions that we believe have been punished by rising North American policy rates.
Looking to past cycles, we note that an end to tightening in North America has resulted in strong returns in precious metals and higher-grade emerging markets (EM) debt. Given that there are extraordinary yield premiums available in the debt of some gold and silver miners and large discounts for higher quality EM credit issuers, we consider these ideas to be likely beneficiaries in the event there is an end to rising policy rates.
Against a general strategic backdrop of defensiveness, it is worthwhile to scour the credit markets for line-item opportunities. Individual names get beaten up, sectors go in and out of favour, and refinancing challenges all regularly create opportunities that do not fit neatly into the broad narrative of a market cycle. In fact, we have often succeeded in spite of our strategic positioning as opposed to because of it.
On a bottom-up basis, we see interesting opportunity in several market niches. The Canadian preferred share market is one attractive corner. Take, for example, the Fairfax 5-year rate-reset preferred series M. Sporting a current dividend yield of 6.25%, the shares are scheduled to reset 21 months from now at a yield of over 9.5%, assuming Canada 5-year benchmark yield remains at its current level of 3.68%. That would amount to a tax-equivalent yield of 12.4% from Fairfax M’s, a level more than double this issuer’s 5-year bond yield.
As we head into the latter half of 2023, we believe investment-grade credit offers interesting value, as do a number of individual lines in the high-yield spectrum where prices have become detached from strong fundamentals.
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 2023. Used with permission.
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