The golden age of security selection in fixed income

Less than two years since the onset of an historical global monetary tightening campaign, the fixed-income environment has changed dramatically. Interest rates across the yield curve rose rapidly, as witnessed by a trough-to-peak move in the 10-year U.S. Treasury of over 325 basis points (bps), to levels not seen since 2007. But as sharp as the rise has been, it hasn’t been a straight line—the 10-year Treasury yield has also declined more than 75bps over four separate occasions since the beginning of March 2022.¹ We believe the combination of higher yields and extreme rate volatility is presenting bond managers with a rare opportunity for both yield carry and active trading.

Granted, volatility can be particularly difficult to stomach for bond investors, especially when Treasuries exhibit more volatility than stocks, as was the case throughout 2023. Nevertheless, looking through the noise, we believe that active managers can help investors better navigate, and even benefit from, the turbulence experienced in today’s market environment. 

Picking the low-hanging fruit

The three pillars of our investment philosophy are valuation, volatility, and flexibility. We follow valuations very closely, we wait for periods of market volatility, and we use the flexibility of our strategies to take advantage of market dislocations.

For example, Canadian investment-grade (IG) bonds have historically traded at narrower credit spreads than their U.S. counterparts, or at least in line. This can be explained by the fact that the Canadian market is less fragmented and composed of fewer companies that are generally more resilient through economic cycles, as they benefit from high barriers to entry. Due to this market structure, about three-quarters of the Canadian IG corporate market is made up of banks, insurers, energy companies, telecoms, and utilities.

Yet in 2023, Canadian corporate IG spreads traded, on average, 30bps wider¹ than U.S. corporate IG spreads, a relationship we view as a market dislocation. While current spread levels suggest that an economic slowdown is priced in for Canada, our forecast is for the United States to also experience an economic slowdown in the near term; therefore, from a risk/reward perspective, favoring Canadian IG bonds within our credit risk budget is an appealing trade-off, as having an additional cushion of 30bps ahead of a potential recession may ultimately boost total returns.

Executing on our investment philosophy requires us to be conscientious, but it doesn’t always require abnormal creativity, as sometimes it can be as simple as rotating out of the United States into Canada.

High-quality carry

Part of an active manager’s value proposition involves the ability to build a well-diversified portfolio that will generate a higher yield than the benchmark (called carry) for a similar level of risk. Carry is achievable under any yield environment, but with rates being elevated and volatile, we believe it can be much more sizable today than during the previous zero interest-rate policy era; however, it’s important to not become complacent and to be selective, as not all carry is created equal.

For example, U.S. leveraged loans and high-yield bonds are both yielding more than 9%, providing investors with some of the best carry opportunities. But these two asset classes have very different risk/return profiles: In an environment in which the U.S. Federal Reserve (Fed) is cutting rates, the income (coupon) generated by the leveraged loans will decrease. With markets pricing in about five Fed rate cuts by the end of 2024,¹ we prefer high-yield bonds over leveraged loans.

Within high yield, it’s also important to be selective and look for high-quality carry. This is particularly true in the current environment, with an economic landscape that’s uncertain and corporate defaults that will most likely trend higher in the coming quarters. A passive strategy tracks an index and, by construction, the high-yield index is more exposed to issuers that have more debt on their balance sheet. In fact, issuers ranking in the top quartile of the ICE BofA U.S. High Yield Index (in terms of weights) have, on average, a debt-to-equity ratio about 1.2 times higher than lower-weighted issuers in the bottom quartile. This doesn’t necessarily mean that issuers in the bottom quartile are of better quality, but issuers with more leverage are usually more sensitive to higher interest rates and slowing economic conditions, and it’s important to thoroughly analyze every issuer’s fundamentals and assess whether it can face adversity before buying its bonds.

A prime example of getting high-quality carry within high yield is a hybrid issue we hold from a Canadian telecommunications company. Being a hybrid security and lower in the capital structure than some other debt, the credit risk is higher since in the event of bankruptcy, the repayment could be lower. That’s why this particular issue is rated high yield even though the issuer itself is rated as IG. We believe, however, that investors are being well compensated from a yield perspective for that modestly higher credit risk and, equally important, we believe its default risk is lower than most high-yield issuers given the company’s strong fundamentals and market position.

With rates and spreads offering very appealing levels, we believe investors are realizing handsome carry in today’s fixed-income market; however, it’s important to not offset (partially or completely) this compelling income with potential capital losses. Security selection and sector allocation are therefore crucial to generating high-quality carry in an environment in which uncertainty around the direction of the economy and interest rates remains.

Be ready to answer the call

The fixed-income market is deep and diverse, and there will always be pockets of opportunity for astute active managers to seize, regardless of the underlying economic environment. We believe, however, that due to current conditions (elevated and volatile interest rates), these opportunities are multiplied and amplified, favoring active management even more.

Markets evolve rapidly, and it’s critical to remain nimble and adapt to new circumstances. Today, we like duration, Canadian IG corporate bonds, Canadian hybrid bonds, and high-quality high-yield issues. But should rates come down further and credit spreads widen due to a more severe recession than market participants are anticipating, we stay ready to adapt and position our strategies so they can continue to deliver strong risk-adjusted returns. Limited recourse capital notes and fixed-reset preferred shares, for example, are asset classes that tend to perform well when interest rates bottom and credit spreads are wide—especially new issuance, as prevailing credit conditions at issuance usually dictate long-term performance for those types of securities.

No matter the scenario, we’re always ready to answer the call by following valuations very closely, taking advantage of volatility, and using the flexibility of our strategies to adapt to and benefit from any economic and market environments.

1 Manulife Investment Management, Bloomberg, as of December 31, 2023.