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The continued threat of higher inflation and rising interest rates has made some investors cautious about the outlook for bonds and other corporate credit. Greg Bonnell speaks with Benjamin Chim, Senior Portfolio Manager TD Asset Management about his outlook for fixed income.
Transcript
Greg Bonnell: Aggressive central bank tightening has sent shockwaves through the markets while stoking fears of a recession on the horizon. So what does this mean for the health of corporations and investors that hold their debt? Joining us now to discuss is Benjamin Chim, senior portfolio manager for fixed income at TD Asset Management. Benjamin, welcome to the show. Fascinating topic. Let’s talk about the outlook here for corporate health and what it particularly means when you talk about fixed income and corporate debt.
Benjamin Chim: Thanks a lot for having me, Greg. Happy to be here. The short answer in terms of how much the fears around recessions and rising rates impact corporate debt health is a lot. It impacts it a lot. And it’s a big driving force behind why we’ve seen these big drawdowns year to date in the corporate bond space, both in terms of investment grade and in terms of high yield. The market has really been essentially repricing bonds to the prospect that interest rates are going to continue to rise and the fact that we may potentially be seeing a recession — if not the end of this year, then possibly the end of next year. And so spreads and yields are adjusting to that.
But as we think through what the future is going to look like and how things will progress going forward, we’re still thinking about investing in corporate bonds with quite a bit of caution. We think there’s going to be a decent amount of volatility going forward into the end of the year and possibly into next year. And the reason why we’re fairly concerned is that inflation levels are still, as you know, persistently high, right? The July number was encouraging because inflation did fall a little bit, but we’re still talking about central banks trying to get inflation down from that 7.5%, 8% level to their target 3% to 4% — 2% to 3%, really. And there are several elements in terms of the inflation metrics that are still pretty sticky. You’ve got wages, of course, and you’ve got rent. So there’s a decent chance or decent potential for inflation to roll over but plateau in that 4% to 5% range. And if it stays there for an extended period of time, that’s going to be a pretty challenging backdrop for corporate bonds to fund as well as — of course, they’ll likely have a recession during that period, so credit quality could get compressed. And that scenario really isn’t being priced into markets right now, so that’s where we see a little bit of caution. And we think, with corporate bonds, you need to expect a decent amount of volatility going forward.
Greg Bonnell: Let’s talk about, then, that caution if anyone’s looking at the corporate bond space. Is it going to come down to the quality of the corporation, the quality of the issuer if there’s going to be a challenging economic environment that also involves higher interest rates?
Benjamin Chim: Yeah. I mean, the one bright spot or the one saving grace for corporate bonds going into this period is that we’re coming from a rather unique situation, in that credit quality is pretty good. And it’s much better than we’ve typically seen when the market heads into a recession. And that’s simply because it really hasn’t been that long since we’ve had that last washout, right? It was the COVID pandemic, where there were lockdowns. The economy was really struggling. Companies were obviously struggling to get by with businesses shut down. High yield debt market had a 10% default rate in 2020. So a lot of the weaker companies got wiped out. They restructured. And since then, in the last two years, they’ve really been focused — most companies have really been focused on rebuilding the liquidity war chest and terming out their debt maturity profiles. And so that’s put them in a position today where, when they’re dealing with what is now a much more volatile, much more difficult funding market, they have a lot of flexibility to wait it out. They have a lot of flexibility to pursue different avenues to fund their growth, so they’re in a good spot. And that gives us some confidence that, even if we do start to see some dislocation in the credit markets, we’re not likely to see what we saw in 2008 or 2020.
Greg Bonnell: When we think about all the challenges that we’re faced with right now — and there’s no shortage of challenges or things to worry about — it makes sense to tread cautiously. If we were going to be optimists about the space, what could go right in terms of investing in corporate bonds against the larger economic backdrop? What could actually resolve itself in the world where we would start saying, hey, I feel a little bit more enthusiastic about the space?
Benjamin Chim: Well, I think if central banks end up addressing inflation better than what we expect and what the market expects right now, that certainly would be extremely positive for spreads and risk and risk premiums because that could potentially mean that that soft landing that they’re going to have a hard time meeting could come to realization. And if that happens, we’ll certainly see all risk markets rally, including corporate bonds. And the potential returns for corporate bonds are actually, when you think about the all-in yields, pretty decent, right? You’re set up to actually have some pretty decent long-term returns because the yield on the investment-grade market right now is 4.7%. The yield on the high-yield market right now is around 8%. That’s a lot higher than we saw going into this year.
The concern that we have overall, of course, with the corporate bond market is that, when you drill down into that yield number, the risk premium, the spread for owning corporate bonds is not as attractive as you usually see in a recessionary period. So the spread right now in the investment grade is 145 basis points, or 1.45% over treasuries. And high-yield, it’s 480 basis points, or 4.8%. And typically in recessions, you see the spread be much higher than that. For example, in COVID, the high-yield spread hit 1,000 basis points, or 10% over. And investment-grade, we saw 400 basis points. So at 145, at 480, we’re not even half of that, right now. And we’d like to see more of that concern around the downside scenario that we talked about, being priced into the markets a little bit more.
And so if you are going to invest in corporate bonds, yes, there’s pretty good potential for long-term returns because of where yields are. But you need to be prepared for a decent amount of volatility because of where spreads are.
Greg Bonnell: Now, the risk, obviously, and the return, you try to weigh those out in terms of what kind of investment decisions you want to make. It’s interesting when you talk about the fact that, yeah, you’ll get that headline yield, and that can look attractive. But you need to go below the surface to figure out exactly what is happening. It sounds even more important. I think of in terms of dividend payers and someone, who if they’re — if they invest in high-yield companies. And they say oh, look at the size of that dividend. Then you have to ask the question, OK, well that’s a nice number. Why is the number there? What’s happening below the surface of that number?
Benjamin Chim: Yeah. The same thing you could say for credit, right? What’s happening below the surface is things can get even — yields can move even higher, and spreads can move even higher because, right now, we’re not in a dislocated market, right? We’re not in a situation where credit quality is a big concern. It’s more about rates. It’s more about inflation. And if the concern starts to shift towards that, there could be more volatility.
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