What’s in store for fixed income?

Historic upwards rate reset setting stage for bond rebound

The historic upwards reset of interest rates in 2022 has resulted in widespread fallout across capital markets. Amidst this volatile and fast-changing market, there are more questions than answers, but we will attempt to provide our thoughts on a few key questions.

What is going on in 2022?

We see the Fed and other central banks reacting to inflation readings that are, frankly, much higher and much less transitory than anticipated. Fed Chairman, Jerome Powell’s, guidance regarding a quickly rising Fed funds rate, combined with plans to reverse much of the bond purchasing from the emergency pandemic market support, has caused rates to reset higher all along the curve as investors respond to this new reality. For example, a sudden yield increase of 2% creates a price decline of over 8% in a 5-year bond and a decline of over 16% in a 10-year bond. Yield increases in government bonds can raise the discount rate across equities and other risk assets too, which is why the typical diversified portfolio is showing a lot of red ink in 2022.

When will the correction in bond prices be over?

Clearly, there is no way of knowing this answer, but we can share our thoughts about the possible events and prices that might prove to be turning points. If rising inflation is the problem, then inflation stabilization or decline may be signs of a turning point. The most recent series of consumer price inflation numbers is still hitting new highs. However, we are starting to see some price series (steel, lumber, and wheat, for instance) retreat significantly from recent highs. Slowing activity in housing markets, and a sudden reduction in new debt financings and IPO activity are also the sort of indicators that suggest the path of consumer inflation may slow in coming months.

Another signal could be a spike in market volatility…known less politely as a crash. While we don’t necessarily expect a crash, we remain cognizant that sometimes these things happen. The critical factor about a crash is that one might expect, in those circumstances, that the Fed could pivot from its inflation-fighting toolkit to its market-stabilizing toolkit. And that, of course, would be the sort of event that might provide an unequivocal bottom.

A common experience in capital markets is that of the investor who loses more money flinching in the anticipation of a crash that doesn’t materialize than they make from pivots back and forth to cash. While we ourselves have moved to the brick house from the stick house, we are not huddling in the bunker twelve feet below.

Our base case assumption is that a slow, rounding bottom in bond prices is likely to occur sometime this year. Following such a turn, we believe that some pretty interesting pockets of black ink may emerge in a bond market that has been printing red all year.

What is the upside for staying the course?

We all know the difference between believing in the theoretical upside on one hand and sitting across from a client experiencing actual cash losses on the other. The humble 1-year GIC, once considered a disregarded wallflower at the investment dance, is now the belle of the ball. To cash in a GIC in favour of any sort of risk asset in May of 2022 is not the kind of move that today’s shell-shocked client is likely to suggest. But for the intrepid few who dare to consider such a move, let us provide some intellectual ammunition.

In our view, rebounds follow drawdowns as surely as summer follows spring. As we look at the history of rebounds in the investment grade category, we see some interesting turns. Following a decline that ended in October 2008, we saw a rebound over the following 12 months that provided investment grade bond investors with a 17.8% return that dwarfed prevailing GIC rates of approximately 1.8%. In September 2013, a drawdown ended and investors of that vintage enjoyed a high grade rebound of 9.2% versus a prevailing GIC rate of 0.8%. And more recently in March 2020, a drawdown ended that saw a rebound in high grade of 14.6% against a prevailing GIC rate of 0.8%.¹ High-yield rebounds have been even more significant.

We don’t know the future, but our experience has been that past markets have paid investors a significant premium over GIC rates for participating in recovering bond markets.

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

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