Where are the opportunities in volatile fixed-income market?

Bonds expert says rate hikes and impact of conflict in Ukraine offers chance to put money to work

Where are the opportunities in volatile fixed-income market?

These are volatile times with the war in Ukraine, drop in Russian bonds, and now the Bank of Canada finally starting to hike interest rates, but Picton Mahoney sees some opportunities in this volatility.

When the bank announced it was starting to raise rates yesterday, Phil Mesman, Partner and Head of Fixed Income for Picton Mahoney Asset Management in Toronto, told Wealth Professional that Canada’s 6.7% economic growth was stronger than the bank expected in the last quarter of 2021, but the former economic slack had been “somewhat absorbed”. He added that the bank is also positive on the reopening and expecting stronger than anticipated growth in the first quarter of 2022, even though the housing market is elevated, which he said is “a bit of a warning comment”.

After the bank said it is increasing its target for the overnight rate by 25 basis point to ½%, with the bank rate at ¾% and the deposit rate at ½%, Mesman said he is anticipating four to five interest rate hikes this year, which the market has already priced in. But he’s concerned that may not be enough to bring the consumer price index into the 2.5% target range the bank desires.

“The other change on the margin, which the Bank of Canada discussed in its announcement, is the concerns in Europe and the fact that the unprovoked invasion of Ukraine is a major new source of uncertainty,” he added. “So that change may cause the banks to be more dovish and perhaps slow down the aggressiveness of the rate hiking.”

The bank said, “the invasion of Ukraine is putting further upward pressure on prices for both energy and food-related commodities,” so “inflation is now expected to be higher in the near term than projected in January.”

Mesman said: “I’ve been talking to investors and the main message is that financial assets really need to adjust to going from a near zero rate environment to 2.5%. It’s that transition that’s causing the volatility in financial assets. So, for financial assets, equities, and corporate bonds, it’s a transitional period.”

He noted that all fixed income had been hurt by the sell-off of government bonds. Investment grade was down 5%, while high yield was down 3-4%, but the credit spreads between the corporate bond yield and government bond yields hadn’t changed. Although it’s been down on the year, he said it’s been very stable from a flow perspective

In all this, Mesman said the credit class looks good as the leverage and balance sheets are good.

“Credit has been surprisingly resilient through this sell-off and that compares starkly to the taper tantrum in 2013,” he said, when there was a sharp sell-off and big outflows. “So, it looks like the credit market has absorbed the volatility very well.”

“I believe what we’re going to see now is more differentiation or bifurcation of good and bad credit,” he said. “I think investors will be more discerning. So, credit really matters now. I always say that credit doesn’t matter until it does. When it does, you want to listen, and now is one of those times.”

Mesman is not keen on the reopening sectors yet because he doesn’t think the credits are priced properly. But, he likes some bank investments that Picton has been adding to the finance sector.  

Russian bonds are also down considerably and, he said “some of the largest portfolios in Canada have been materially impacted by that over the last couple of days, so that’s another kind of risk that have impacted some of the core investment grade bond funds that own Russian debt.”

Mesman recommended that advisors debrief on what’s happened and rebalance their fixed income.

“This certainly gives a business case for alternative income,” he said. “Alternative income has more flexibility and more tools to navigate these kinds of markets.”

Given all the volatility, Mesman said corporate bonds are starting to look interesting.

“We would like to see credit spreads widen a little bit, but they still remain fairly tight,” he said. “It is starting to get interesting on an absolute yield basis. So, corporate bonds being high yield and investment grade corporates are starting to look interesting.”

“We, in our portfolios, remain defensively positioned,” said Mesman. “We are taking profits on some of our hedges, and we’re starting to add some names in defensive sectors. I like the healthcare sector. I like to own resilient company bonds, and these are great opportunities and periods to get your hands on them. So, we’re gingerly putting money to work through the volatility.”

Mesman encouraged advisors to “spend time to understand the process of those that they’re empowering with their capital” and “really make sure they understand the risks of the strategies that they’re getting involved in.

“It’s important to spend their time understanding the process of fixed income managers that they’re empowering. Their due diligence is really important,” he said, adding that Picton is also there to help. “It’s always good to have a bond person in your pocket.”