U.S. Treasuries have been facing increased volatility recently, while the investment environment for corporate bonds has been a bit more favourable. Benjamin Chim, Vice President and Director, Lead of the High Yield Team at TD Asset Management, discusses the outlook for fixed income.
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We've seen a lot of volatility in US treasuries recently, the yield on the 10-year sitting at levels we haven't seen since 2007. So how are the corporate credit markets holding up amid all this turmoil? Joining us now to discuss, Ben Shim, Vice President and Director and Head of High Yield Team at TD Asset Management. Ben, great to have you back on the show.
Great to see you, Greg. Thanks for having me.
So we know market participants keeping a very close eye on bond yields. I keep a close eye on them on a daily basis, too, cracking above levels we haven't seen since 2007. Talk to me about the credit markets. What does that look like in this environment?
Yeah, I mean, the volatility that we've seen in government bonds-- I say volatility probably is being easy in terms of how crazy things have been. It's really had a major impact across the bond market overall. We've seen corporate bond spreads widen a little bit as equity markets have weakened as a result of concerns around growth.
But, you know, I would say that, generally speaking, things have been quite calm in the corporate bond market, all things considered, particularly over the last two months or so. And spreads have remained sort of range bound, and liquidity continues to be quite solid.
And there really are two main reasons why the bond market has been so sanguine, despite all the volatility in government bonds. The first is the stronger economy, the resiliency of the US economy, and the global economy, for that matter, has given corporations a lot of time to adjust to what is a more challenging funding backdrop, a more challenging cost backdrop.
And so what that has meant is they've reduced their expenses. They've been able to adjust their spending profile accordingly and their debt profile accordingly. And they have situations now where their credit profile has really held up well despite weaker earnings going forward.
And so that's given the bond market a lot of confidence that there probably isn't going to be a blow up in the corporate bond space, probably isn't going to be a lot of dislocations, like what we've seen in previous downturns. So that's the first thing.
The second is the supply demand picture remains quite favorable, in favor of corporate bonds overall, and particularly investment grade. And so what I mean by that is, quite simply, there's still more buyers and sellers of corporate bonds. And flows have been fairly stable, especially considering that performance in the bond market has been pretty weak this year.
I think that's a bit of a testament to the attractiveness of corporate bond yields overall. You're getting 6% yield for investment grade. You're getting 9% for high yield, so the long-term return profile looks appealing to many investors.
Of course, having some exposure to interest rates for a diversified portfolio makes sense as well, and I think there's some value to that, being in the investment grade market specifically and having that in your portfolio. So that's helping demand.
And then institutionally, higher bond yields really gives a lot of the pension funds, a lot of the insurance companies the ability to immunize their cash flows going forward. And so there's demand from that. So the demand side of the equation is quite robust.
On supply side, things are actually getting more constructive for corporate bonds. And that's because yields have moved up so much. So a lot of corporate bond issuers, if they had been thinking about issuing debt two months ago, well, now it's going to cost them 50 basis points, 75 basis points more. If you're an issuer with good liquidity, you have good credit quality, you can afford to wait and see if there's a better opportunity down the road to do that.
And so the outlook for issuance going forward for the rest of this year is probably going to be lower, and that's going to be supportive for the corporate bond market as well. So those are the two main factors really keeping spreads relatively sanguine amidst all the volatility.
It's really interesting dynamics in the market. If that is our backdrop, what sectors in the corporate bond market start to look attractive here?
Yeah, I mean, a lot of the concern, of course, is that things are going to get weaker. And so because of that, there are sectors that have become quite interesting going forward.
We rely really heavily on the deep credit research that we do on the corporate bond space to find opportunities. And that often leads us to look for opportunities in sectors that may be a little bit out of favor, companies that have more headline risk that aren't particularly well understood.
One of those sectors that is quite out of favor right now is the real estate sector, the REIT sector specifically, where you've got higher interest rates really impacting the values of their underlying assets. You have an office property sector, a commercial real estate sector, that really is quite dislocated and quite a mess right now.
We've generally been avoiding the office property space. I think there's a lot more questions than answers there. But where that has created pockets of value is in areas like retail real estate, industrial REITs. Those are sectors where occupancies are still at very high levels. They're seeing good growth in terms of the rents.
In situations where leases have come up, they've been able to renew them at levels that are at or above inflation, sometimes even in double-digit level. And so earnings have been solid, cash flows have been very steady, and the BBB, BBB-minus-type investment grade REITs in those two spaces have been able to steadily improve their balance sheets. And we think that will continue.
So we like the two to three-year bonds in that part of the market, because yes, there could be some volatility with the economy going forward. But being short really dampens that volatility a bit. So that's an opportunity that we see.
The pipeline space is pretty interesting as well. And we've talked about that a few times. But it's kind of like a tale of two markets, right? And where we see the sweet spot is in that BB, single B part of the market.
There you have management teams that are quite solid. You have assets that are fairly high quality, but companies that still need to invest in their business and grow and improve their balance sheets. And so we see steady improvement there, given the cash flows they're getting from strong oil prices.
And conversely, we're actually a little bit more nervous, a little bit more cautious on the higher quality pipes. So the BBB-pluses, the A-minuses, those companies have the balance sheet where they want it to be. And so there's going to be very little improvement there. They're using most of their cash flows towards shareholder returns, towards M&As, and so we're a little bit more nervous about that.
When you look at opportunities moving further down the spectrum deep into the high yield market, what we like is defensives over cyclicals. So sectors like hospitals, consumer products, utilities, TELCO, that's all underperformed versus cyclicals this year.
We've seen it on the stocks. We've seen it a bit on the credit as well. And I think that creates opportunities because, particularly on the bond side, stable and predictable cash flows are very important. And so we like the opportunities that the defensive sectors present.
And then on the metals and mining side, there are some interesting opportunities as well. Again, a sector that's disappointed a little bit because of the weaker growth in China than many had expected. But when you think about the long term, you know, copper specifically has some pretty good fundamentals behind it, limited amount of supply coming into play, very good demand long term because of energy transition.
So a lot of these B-plus, BB-minus copper issuers, they have bonds yielding between 8% to 10%. They're generating good free cash flow, and they're continuing to improve their balance sheet. So those, I would say, are some of the areas where we see the best value right now.
Right now. So obviously, there's some potential there. What would the risks be overall? It would just be the credit environment and this continued push higher in yield?
Yes, absolutely. As yields rise and as the economy slows down, most of the companies are strong enough that we're looking at to withstand that. But certainly, if things fall weaker than expected and something breaks, which often happens when financial conditions get tighter, you could see those kind of sectors underperform because of how cyclical they are.
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We've seen a lot of volatility in US treasuries recently, the yield on the 10-year sitting at levels we haven't seen since 2007. So how are the corporate credit markets holding up amid all this turmoil? Joining us now to discuss, Ben Shim, Vice President and Director and Head of High Yield Team at TD Asset Management. Ben, great to have you back on the show.
Great to see you, Greg. Thanks for having me.
So we know market participants keeping a very close eye on bond yields. I keep a close eye on them on a daily basis, too, cracking above levels we haven't seen since 2007. Talk to me about the credit markets. What does that look like in this environment?
Yeah, I mean, the volatility that we've seen in government bonds-- I say volatility probably is being easy in terms of how crazy things have been. It's really had a major impact across the bond market overall. We've seen corporate bond spreads widen a little bit as equity markets have weakened as a result of concerns around growth.
But, you know, I would say that, generally speaking, things have been quite calm in the corporate bond market, all things considered, particularly over the last two months or so. And spreads have remained sort of range bound, and liquidity continues to be quite solid.
And there really are two main reasons why the bond market has been so sanguine, despite all the volatility in government bonds. The first is the stronger economy, the resiliency of the US economy, and the global economy, for that matter, has given corporations a lot of time to adjust to what is a more challenging funding backdrop, a more challenging cost backdrop.
And so what that has meant is they've reduced their expenses. They've been able to adjust their spending profile accordingly and their debt profile accordingly. And they have situations now where their credit profile has really held up well despite weaker earnings going forward.
And so that's given the bond market a lot of confidence that there probably isn't going to be a blow up in the corporate bond space, probably isn't going to be a lot of dislocations, like what we've seen in previous downturns. So that's the first thing.
The second is the supply demand picture remains quite favorable, in favor of corporate bonds overall, and particularly investment grade. And so what I mean by that is, quite simply, there's still more buyers and sellers of corporate bonds. And flows have been fairly stable, especially considering that performance in the bond market has been pretty weak this year.
I think that's a bit of a testament to the attractiveness of corporate bond yields overall. You're getting 6% yield for investment grade. You're getting 9% for high yield, so the long-term return profile looks appealing to many investors.
Of course, having some exposure to interest rates for a diversified portfolio makes sense as well, and I think there's some value to that, being in the investment grade market specifically and having that in your portfolio. So that's helping demand.
And then institutionally, higher bond yields really gives a lot of the pension funds, a lot of the insurance companies the ability to immunize their cash flows going forward. And so there's demand from that. So the demand side of the equation is quite robust.
On supply side, things are actually getting more constructive for corporate bonds. And that's because yields have moved up so much. So a lot of corporate bond issuers, if they had been thinking about issuing debt two months ago, well, now it's going to cost them 50 basis points, 75 basis points more. If you're an issuer with good liquidity, you have good credit quality, you can afford to wait and see if there's a better opportunity down the road to do that.
And so the outlook for issuance going forward for the rest of this year is probably going to be lower, and that's going to be supportive for the corporate bond market as well. So those are the two main factors really keeping spreads relatively sanguine amidst all the volatility.
It's really interesting dynamics in the market. If that is our backdrop, what sectors in the corporate bond market start to look attractive here?
Yeah, I mean, a lot of the concern, of course, is that things are going to get weaker. And so because of that, there are sectors that have become quite interesting going forward.
We rely really heavily on the deep credit research that we do on the corporate bond space to find opportunities. And that often leads us to look for opportunities in sectors that may be a little bit out of favor, companies that have more headline risk that aren't particularly well understood.
One of those sectors that is quite out of favor right now is the real estate sector, the REIT sector specifically, where you've got higher interest rates really impacting the values of their underlying assets. You have an office property sector, a commercial real estate sector, that really is quite dislocated and quite a mess right now.
We've generally been avoiding the office property space. I think there's a lot more questions than answers there. But where that has created pockets of value is in areas like retail real estate, industrial REITs. Those are sectors where occupancies are still at very high levels. They're seeing good growth in terms of the rents.
In situations where leases have come up, they've been able to renew them at levels that are at or above inflation, sometimes even in double-digit level. And so earnings have been solid, cash flows have been very steady, and the BBB, BBB-minus-type investment grade REITs in those two spaces have been able to steadily improve their balance sheets. And we think that will continue.
So we like the two to three-year bonds in that part of the market, because yes, there could be some volatility with the economy going forward. But being short really dampens that volatility a bit. So that's an opportunity that we see.
The pipeline space is pretty interesting as well. And we've talked about that a few times. But it's kind of like a tale of two markets, right? And where we see the sweet spot is in that BB, single B part of the market.
There you have management teams that are quite solid. You have assets that are fairly high quality, but companies that still need to invest in their business and grow and improve their balance sheets. And so we see steady improvement there, given the cash flows they're getting from strong oil prices.
And conversely, we're actually a little bit more nervous, a little bit more cautious on the higher quality pipes. So the BBB-pluses, the A-minuses, those companies have the balance sheet where they want it to be. And so there's going to be very little improvement there. They're using most of their cash flows towards shareholder returns, towards M&As, and so we're a little bit more nervous about that.
When you look at opportunities moving further down the spectrum deep into the high yield market, what we like is defensives over cyclicals. So sectors like hospitals, consumer products, utilities, TELCO, that's all underperformed versus cyclicals this year.
We've seen it on the stocks. We've seen it a bit on the credit as well. And I think that creates opportunities because, particularly on the bond side, stable and predictable cash flows are very important. And so we like the opportunities that the defensive sectors present.
And then on the metals and mining side, there are some interesting opportunities as well. Again, a sector that's disappointed a little bit because of the weaker growth in China than many had expected. But when you think about the long term, you know, copper specifically has some pretty good fundamentals behind it, limited amount of supply coming into play, very good demand long term because of energy transition.
So a lot of these B-plus, BB-minus copper issuers, they have bonds yielding between 8% to 10%. They're generating good free cash flow, and they're continuing to improve their balance sheet. So those, I would say, are some of the areas where we see the best value right now.
Right now. So obviously, there's some potential there. What would the risks be overall? It would just be the credit environment and this continued push higher in yield?
Yes, absolutely. As yields rise and as the economy slows down, most of the companies are strong enough that we're looking at to withstand that. But certainly, if things fall weaker than expected and something breaks, which often happens when financial conditions get tighter, you could see those kind of sectors underperform because of how cyclical they are.
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