Investors have been increasingly dipping their toes into the corporate bond market as demand for higher quality credit grows. Benjamin Chim, Vice President, Director and Lead of the High Yield Fixed Income team at TD Asset Management, looks at potential opportunities for investors.
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* Well, the US Federal Reserve is still signaling that it expects three rate cuts this year. And while that's been a boon to equities, what does it mean for the corporate bond market? Joining us now to discuss is Ben Chim, VP, director, and lead of the High Yield Fixed Income team at TD Asset Management. Ben, great to have you back on the show. * Thanks a lot, Greg. Great to be here. Thanks for having me. Appreciate it. * All right, so-- * Go ahead. * I was going to say, we do have rate cuts on the table. What does it mean for corporates? * Yeah. I mean, I think last time I was on with you guys was the fall of last year, so October of 2023. Then, I was talking a lot about the resilience of the corporate bond market in light of what was quite a bit of volatility, quite a bit of weak bit of weakness in the government bond space. And of course, since then, as you know, we've had the mother of all government-bond rallies at the end of 2023. And that has dramatically changed investor perception around investing in bonds overall. And corporate bonds have definitely benefited from that. And so the demand for corporates has continued to improved from that period. * We've seen demand increase to the extent that it has well offset the supply that we've seen so far this year, which has been pretty meaningful, as well. And so spreads have continued to tighten. They're at pretty tight levels right now and one of the tightest we've seen in the last 15, 20 years or so. And the bond market, corporate fund fundamentals remain fairly healthy. * So when you step back and think about it, it's pretty easy to see why the bond market is so popular right now and there's so much demand for corporates. We're kind of in this place right now where the really challenging component of the Fed hike cycle is behind us. We had a lot of rate hikes in the last couple of years. But inflation is coming down fairly comfortably, sometimes not as quickly as what the market would like, but overall, in a very steady trajectory. * And then wage increases are actually coming off, as well. And that's really a key metric that the central banks are watching to think about what their next move is. And think their next move is pretty clearly going to be something on the easing side, so likely a rate cut, maybe something in terms of reducing quantitative tightening. And that, of course, is going to be very positive for bonds overall, including corporate bonds, as you asked about. One of the reasons why corporate bonds specifically look pretty good in this kind of backdrop is the Fed hasn't made their next move yet. They haven't cut rates. And the reason why there's been this delay is because the global economic backdrop remains quite strong and very resilient. * Strong global economy, obviously, is very good for company fundamentals, good for credit metrics. And so corporate bond investors can feel pretty confident, at least in the near term, that spreads are not going to move much wider. Corporate bond market is going to trade fairly healthy, despite how tight spreads are today. * And so when you take that back and think about why corporate bonds are compelling, you've got this situation where you're earning higher potential returns. The yields in corporate bonds are about 5% in Canadian investment-grade space, 5.4% US investment grade, 7.5% for US high yield. And they are benefiting also from this strong economic backdrop. So you're kind of getting better compensation as you wait for the Fed's next move. And you still will benefit if we do see rate cuts and bonds rally from that. * I do want to caveat by saying a lot depends on how these rate cuts play out. Right now, the base case is, and our base case, as well, from the market, that we'll see rate cuts, because the central banks feel that the current policy rate is very high and quite restrictive, given where the trajectory of inflation is right now. If they're cutting rates because of that and the economy is fairly solid, that's the Goldilocks scenario for corporate bonds. And corporate bonds will do very well in that backdrop. * If, however, they're cutting rates because of something else, because let's say there's some exogenous shock to the economy causing us to rerate growth expectations lower, a big sharp decline there, that would be much more negative for corporate bonds, because of where spreads are. They're not really compensating investors for that kind of scenario. And spreads could widen to the extent that they offset a lot of the price gain that we expect to get with rate cuts and offset a lot of the carry that you get. * So that's kind of your worst-case scenario. And we should watch out for that. And we are continuing to be aware of that tracks, the probability of that happening. I will say right now, as we look at things going forward, we don't see the potential for an exogenous shock of any kind or a big downgrade to growth. So our base case is that former scenario where the rate cuts happened because of a normal course of central-bank policy. The economy remains fairly healthy. And that is very constructive for corporate bonds. * Well, that is our technical backdrop. And that's some of the important caveats that you laid out. People will gravitate naturally when they think about the Fed. And when that first rate cut comes, they'll gravitate towards the 10-year yield. They always think about governments. How should we be thinking about corporates against governments, vice versa, when that day comes? * Yeah. I mean, I would say right now, there's good reasons to own both corporate bonds and government bonds. For corporate bonds, of course, you're getting more yield. But you're getting a lot more potential volatility if the economy-- there becomes changes to the global economic backdrop, things slow down more than what it's currently expected right now. And I think that's particularly true, like I said, given where spreads are. * On the other hand, government bonds will give you more protection in that scenario. And they will perform fairly well if the Goldilocks scenario doesn't play out. And I think we do have to consider that going forward. * I would say right now, with how we're seeing the economy, how corporate fundamentals are performing, company earnings, it's better to have more carry. And credit corporate bonds are probably a slightly better place to be. But we could see a situation not too far down in the future, maybe even sometime this year, where it makes more sense to have government bonds. So I think both make a lot of sense in your portfolio. And both should be owned to some extent. * You mentioned some of the caveats earlier, Ben. What are some of the biggest risks to all of this? Is it simply the economy, valuations? * Yeah, I think both of those are big concerns that we have, big factors that we're constantly watching out for as we think about how do we position within the bond space in our portfolios. In terms of the economy, the big question still remains, in our opinion, inflation. Does inflation continue to move in this current trajectory? Or do we see something in terms of, maybe animal spirits, as a result of strong risk appetite that causes inflation to start to move back higher? Or do we see a policy error where maybe the central banks start to loosen monetary policy too soon? And that causes a resurgence of spending, and causes the economy to overheat. * In either of those cases, if we start to see inflation start to rear its ugly head and get a lot worse, we could start to see the market start to price out some of those rate cuts that we expect. We expect three this year. We expect another three next year, both in Canada and the US. And that would cause volatility in the bond market overall, cause corporate funding to continue to be challenged as interest rates remain high. And I think that would be a pretty negative scenario. * The other thing that we're thinking about is valuations, as you said. They are quite tight, and to us, really not really not compensating you for some of the landmines that you can have in the credit market today. While the economy remains fairly strong and funding remains solid, there are a number of companies that are struggling. The default rate has risen over the last few years. It was close to zero, significantly under 1% from 2021 and 2022. * Last year in high yields, it rose to about 3.5%. It's not alarming. It's right around long-term average. But it certainly is not zero. And we expect that to continue to be the case, to be around 3.5%, maybe even be a little bit higher for this year. And it's the small concentrated companies that don't have a lot of avenues for flexibility in terms of funding needs that are seeing-- running into trouble, particularly the ones that are in the sectors that are under pressure-- advertising, et cetera. And it's the large-capital structures, companies that have had-- took on too much debt at a period where debt was cheap and are struggling to make positive cash flows as a result of that and now face refinancing where interest rates are even higher. And that's going to eat into their cash flows more. They still have capital spending needs that they can't fund. Those companies are the ones that are defaulting. And they're going to continue to be a risk to the market going forward and a risk to stability.
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