Active management key as bond markets reprice risk

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Adam Ditkofsky, senior portfolio manager, global fixed income at CIBC Global Asset Management 

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The most relevant question on bond investors minds’ today is how to position portfolios against the backdrop of elevated energy prices, ongoing geopolitical tensions — particularly what’s going on in Iran— and risks surrounding the re-accelerating inflation and weakening economic conditions as the Strait of Hormuz stays effectively closed. I think it’s important that I provide some context as to where our portfolios were positioned ahead of the conflict before I get to what we’ve changed. 

Our team typically thinks about positioning through three key lenses: the first being interest-rate risk or duration; the second being curve positioning, or how short-term and long-term yields are priced relative to one another; and the third is sector: credit risk or our exposure to corporate risk. 

First, from the context of duration, our portfolios have been fairly neutral relative to our benchmarks going into the month of March, as yields have moved lower in February on fears of weaker labour conditions, both in Canada and the U.S. attributed to the tariff uncertainty and soft employment statistics. 

When yields moved higher in March, as energy prices spiked, we were less impacted. 

Second, yield curve exposures — or how much incremental yield investors are being paid to extend maturity — we had a modest bias towards longer maturities because we viewed the curve as offering reasonable compensation beyond the front end. As a result, we had relatively less exposure to the very short maturities, which are most directly impacted when markets repriced the expected path of central banks. 

As the conflict escalated, expectations for near-term rate cuts were reduced in the futures markets, and the probability of additional tightening was discussed. This led to short-term yields rising more than long-term yields. So, we saw what was effectively a yield curve flattener, as short-term rates moved higher, and the move was more pronounced in shorter-dated bonds than longer-dated bonds. So, we were well positioned from that perspective as well. 

And then lastly, our positioning in corporate bonds had been defensive. And while we were still overweight in our portfolios, our positionings reflected our lowest active overweight in years, as both investment-grade and high-yield credit was facing the tightest credit spreads they had seen since the great financial crisis. 

We also started to see cracks in the private debt market and questions surrounding the viability of AI investments being funded in the bond market as well. So, we had mainly been focused on high-quality credit with shorter tenures to minimize our exposure to a potential credit spread widening event. And we also added credit protection, where permitted, to reduce our overall credit exposures, as the U.S. military started moving ships into the Middle East region. Overall, this all worked very well for our portfolios ahead of the conflict starting. 

Since then, we’ve taken a lot of actions in our portfolio. But the main aspect is that we’ve stayed extremely disciplined, taking advantage of the market volatility and credit spread widening.  

So, we had increased credit exposure where we saw corporate bonds being cheap, and positioned the portfolios to account for the fact that perhaps too many rate hikes have been priced into the market. 

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In terms of how we expect central banks to respond if energy prices stay elevated, I think the context is important. The starting point today is materially different from what we saw in 2022. 

Back then, energy was a major driver of inflation, especially after the Russia invasion of Ukraine. But it wasn’t just energy. Inflation was broad based, and well above 2% targets, consumers still had excess savings from stimulus and lockdowns, and the labour markets were very tight, pushing wages up. 

Today is very different. Household savings have come down significantly, labour markets have loosened, and policy rates are already far higher than where they were during the pandemic. Inflation has cooled meaningfully from its peak as well. And there’s also far less political and economic tolerance for aggressive hikes that could tip the economy into a recession. 

If energy prices do stay elevated because of the Iran situation, I don’t expect that we’re going to see a repeat of 2022-style rate shock, unless inflation re-accelerates and becomes much more broad based. More realistically, central banks are likely going to hold rates higher for longer and push back on any near-term rate cut expectations, rather than launch into a new hiking cycle. 

From a policy perspective, central banks tend to focus less on the initial energy-driven price shock, and more on the second-round effects, whether higher energy prices costs spill into wages, does it spill into service inflation and, of course, do medium-term inflation expectations change? If those measures remain contained alongside moderating growth, central banks can be patient. But if they become unanchored, the probability of additional tightening rises. 

For fixed-income investors, that is a more navigable outcome. It supports remaining invested and harvesting income. We continue to favour mid-term bonds, roughly in that five to seven year, where yields remain attractive, and interest-rate sensitivity is typically more balanced than at the long end. 

In our 12-month outlook, we still see room for about one Fed cut, and we also see a small chance that the Bank of Canada could do an insurance hike — call it a modest extra hike meant to keep inflation expectations anchored. That said, we think Canada has more downside growth risk, especially with trade uncertainty, including the upcoming USMCA renegotiation, and ongoing softness in Canadian real estate. 

Now, what would change our view? If we saw a re-acceleration in core inflation, especially services, or if inflation expectations move sharply higher. Then the whole scenario could quickly turn into a more tightening risk, and that’s going to be very data dependent. 

In Canada, there’s one specific nuisance as well. The economy generally is more rate sensitive, given our household leverage and the frequency of our mortgage resets, and as a result, restrictive policy tends to transmit into activity with less lag than in the U.S., which is one reason we view the hurdle for additional hikes as relatively high if growth continues to soften. 

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In terms of positioning for potential stagflation scenarios, stagflation really refers to the regime of below-trend growth alongside persistent elevated inflation. However, I think it’s important to distinguish today’s set up versus past examples. 

In 2022, we briefly experienced stagflation-like conditions, and bonds offered limited protection because starting yields were exceptionally low. Back then, 10-year bond yields were yielding roughly 1.5%, and provided very little cushion when inflation accelerated towards 8% to 9%. 

Today, the starting point is much better. In Canada, 10-year yields are around the mid-3% range, and long bonds are closer to 4%, while in the U.S., investors can lock in roughly mid-4% yields on 10-year bonds, and around 5% on 30-year bonds. 

Those levels give investors real income to work with, and in many shorter maturities, you can still find positive real yields, meaning yields are higher than inflation. Now, if we do drift towards a more stagflation outcome, portfolios are better insulated today than they were a few years ago. 

In addition, a meaningful portion of inflation risk is already embedded into the short-term rates, which is most directly linked to expectations for central bank policy. That said, higher starting yields do not eliminate credit risk. And in a stagflation environment, corporate fundamentals can be pressured as demand slows, while input costs remain elevated. 

Credit spreads do not always compensate for that risk early in the cycle, which is why we emphasize higher-quality issuers, shorter maturities and limited exposure to longer-dated corporate credit. So, we’ve been upgrading our portfolios overall, leaning towards investment-grade and focusing on sectors with stronger pricing power, like energy, banking and infrastructure. We also like businesses tied to government spending, and there are parts of the AI buildout where revenues are very durable. 

Overall, this is my takeaway: caution in credit isn’t pessimism; it’s discipline. In a stagflation-type scenario, security selection and issuer quality matter a lot more. So, when we talk about positioning for stagflation, it’s less about predicting the 1970s, and more about building a portfolio that can survive sticky inflation without taking unnecessary credit risk. 

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In terms of where we’re seeing opportunities in fixed income today, again, this isn’t a 2022 story. In fact, I’d make the argument today [that] it actually becomes generally positive for investors. In 2022, there was almost really nowhere to hide in fixed income. Rising rates hit everything—short and long bonds, government and credit. It was really a reset of the entire fixed-income market, and a very painful one. 

But what that reset did was restore income to the asset class, and in a way that we haven’t seen since before the global financial crisis. For the first time in over a decade, bonds are actually doing what they’re supposed to: They’re paying you to own them. 

So, where are we putting our money to work? Again, investment-grade corporate bonds in the five- to seven-year range are compelling. You’re getting real yield from high-quality companies without taking excessive duration risk. We’re also selectively adding to high yield, but very deliberately—companies with strong cash flow generators that can weather elevated energy price environments. 

And we still like high-quality hybrid securities that offer attractive yields and spreads relative to traditional investment-grade securities. And these securities are also partially insulated from rising yields, as their structure includes a reset, in many cases, every five years at a fixed spread plus the prevailing five-year rate. And in many cases, these issues also include yield floors in the event that yields drop at the time of reset. So, we think there’s good protection, and investors are getting good compensation for these structures. 

But I think the message for retail investors is this: the Iran conflict creates a lot of volatility. And although volatility can be uncomfortable, today is not like 2022. You’re not fighting the entire rate architecture being rebuilt beneath your feet. The foundation is already there. 

The question now is how disciplined and selective investors are in terms of building on top of it. And that’s exactly what we’re doing by being selective, by adding credit when spreads widen, positioning our portfolios to maximize returns without taking excessive risks. Also, our view is for central banks to be on the sidelines over the near term, which should act as the stabilizing factor for the bond market. 

Now, I’d argue that this backdrop brings back the traditional concept of an appropriately balanced portfolio because we’re not in a high-inflation, zero-interest-rate environment like we were in 2022. 

The message is this: get exposure to fixed income because the income is real, the opportunity is real, and sitting on cash while yields on high-quality bonds are close to decades highs is a decision with a real cost. 

But investors need to recognize that risks to the downside are also very real. We’d argue portfolio precision is very critical, and professional active management can be far more rewarding than passive management in this environment.

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