Santa Claus has come early for bond investors. November 2023 was a strong month for fixed income and that has continued into early December. When we speak with bond dealers, comment s like “gap tighter,” “relentless bid,” and “buyer, buyer pants
on fire!” permeate the conversations.
It seems clear that we are in a period of transition. We are at or very close to the end
of a hiking cycle that began in March 2022 for the Bank of Canada. The debate is now focused on when rate cuts begin, how quickly central banks will cut short-term interest rates, and how many cuts will ultimately occur.
Since the start of November, most economic data in North America has been tepid at best. This weaker data has helped spur on the rally in bonds as investors begin to conclude that rate cuts are closer than previously thought.
Tighter corporate spreads
Corporate credit spreads in Canada have tightened materially since the start of November and are at or near the tightest levels of 2023. As shown in Figure 1, money has generally been flowing into Canadian corporate bond funds, particularly in the last few weeks. In addition, December has two of the top four and four of the top ten days in terms of cash flows for one of the largest indexes in Canada (as shown in Figure 2).
Figure 1
Figure 2
Largest projected FTSE Canada Universe Bond Index cash flow days: 2023
At the same time, supply in Canadian dollars may have underwhelmed the market. Canadian banks are generally some of the largest issuers of corporate credit in Canada. The “Big 6” Canadian banks all reported fourth quarter results in late November. Often, shortly after reporting quarterly results, the banks will issue new debt instruments to shore up their liquidity and capital positions. It is worth noting that four of the Big 6 six issued new debt in the U.S. dollar market, and only two have issued debt in Canadian dollars so far. Economics 101 holds that more demand for credit and less supply of credit leads to tighter credit spreads.
Does money on the sidelines end up in bonds?
Despite the recent increase in the bond and stock markets, there is still plenty of money on the sidelines. According to the Investment Company Institute, total money market fund assets increased by $72.98 billion to an all-time record of $5.84 trillion for the eight-day period ended November 29th.
Meanwhile, the yield on 10-year U.S. Treasuries is greater than the earnings yield for the S&P 500 for the first time in over 20 years. It seems plausible that if some of the cash currently in money market funds is allocated to longer-term assets, bonds
could be an attractive home for this money.
Figure 3
S&P earnings yield vs. 10 year Treasury yield
Bonds haven't been this attractive vs stocks since 2001
Our current outlook
While the bond market is euphoric, we remain disciplined. We believe central banks will reduce short-term interest rates in 2024, but we also think the market may be overly optimistic about the number of cuts. One of the "Big 6" banks has forecast
six rate cuts by the Bank of Canada in 2024(1). While we would never make a big bet with unitholder capital on a specific outcome one way or the other, we do think the
risk skews towards fewer than six rate cuts in 2024.
Inflation could be stickier than some are expecting. For example, wage growth has been strong, and unionized wage settlements are often backwards-looking in terms of
inflation. In addition, the supply of new housing will likely remain inadequate to materially reduce housing prices and rents in 2024. We think it would take a more severe economic slowdown before the Bank of Canada would cut rates six times in 2024.
Similarly, in the United States, futures markets are pricing in six rate cuts between now and January 2025. We think that, barring a substantial economic slowdown, six rate cuts is unlikely. U.S. economic data has generally been stronger than many other countries, including Canada. It is also an election year, and we suspect that the U.S. Federal Reserve will try not to make changes to monetary policy in the lead up to the
election in an effort to avoid accusations of partisanship.
We believe that with the yield curve still inverted, shorter dated corporate credit remains the best area from a risk-reward perspective. If yields continue to fall and/or credit spreads narrow, we will still participate in the upside to some extent.
However, if government yields increase and/or credit spreads widen, our shorter duration and higher average coupon should insulate us from the downside. We can always hold a shorter duration bond to maturity if necessary. While greater gains
are possible further out the curve, greater volatility is almost guaranteed further out the curve.
As always, we thank you for trusting us with your capital
NCM Asset Management Ltd. provides this commentary for informational purposes only.
Chris Bolton is a Portfolio Manager, with Cumberland Investment Counsel Inc. (CIC). CIC is the sub-advisor to its affiliate, NCM Asset Management Ltd. The information in this document is current as of December 7, 2023 but is subject to change. The Kipling Funds are only available for sale to investors who meet the definition of “accredited investor” as set forth in National Instrument 45-106 Prospectus and Registration Exemptions, or non-individuals who will be investing a minimum of $150,000. Please contact your advisor to determine your qualification status. Investors should take note that certain statements in this report about a fund or strategy, including expected future performance, are forward-looking. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the forward-looking statements. Although the forward-looking statements contained herein are based upon what the portfolio manager believes are reasonable assumptions, the portfolio manager cannot assure that actual results will be consistent with these forward-looking statements. Due to ongoing portfolio transactions, the positions discussed in this communication may no longer be held in the Fund. The information contained herein is based on sources that we believe to be reliable, but may change without notice. The comments included in this document are general in nature, and professional legal, accounting, tax and investment advice regarding an individual’s particular investment needs and circumstances should be obtained. This presentation does not constitute an offer to sell or solicitation of an offer to buy a security in any jurisdiction. Past performance is not indicative of future results. NCM Asset Management Ltd. as manager and portfolio manager of the Kipling Funds may engage one or more sub advisors to provide investment management services to certain Funds, including its affiliate, Cumberland Investment Counsel Inc. Cumberland Private Wealth Management Inc., Cumberland Investment Counsel and NCM Asset Management Ltd. are affiliate companies under the common ownership of Cumberland Partners Ltd.