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  • Writer's pictureChris Bolton

Look What You Made Me Do (To Bond Yields) - Taylor’s Version

With apologies to Taylor Swift, it has been a “Cruel Summer” for bond investors (particularly those with longer durations). For example, the price of the five-year Government of Canada bond has dropped as yields increased from 2.87% in early May 2023 to 4.26% as of September 21, 2023. As shown in Figure 1, interest rates have moved higher across the Government of Canada yield curve. If this pattern continues, when we reflect on the prior year on “New Year’s Day” 2024, 2023 could be another “Picture to Burn” for many bond investors. Somewhat like when we look “Back to December” 2022.

Figure 1: Government of Canada Yield Curve May 3, 2023 to September 21, 2023

Source: Bloomberg

In the spring, there was optimism among many market participants that year-over-year inflation rates were declining and central banks would soon be starting to reduce short-term interest rates. These investors expected a bull market in bonds to “Begin Again” and told longer duration bonds that “You Belong with Me” and are “Mine”. But bonds investors “Should’ve Said No” when it came to extending duration in the spring. Inflation has been “stickier” than many market participants were expecting in the spring and central banks have generally continued to increase interest rates. The Bank of Canada sent the message regarding inflation and by extension the bond market that “You Need to Calm Down” when they raised the overnight interest rate by 0.25% on June 7 and again on July 12. This is a pattern bond investors know “All Too Well” since the Bank of Canada began raising interest rates in March 2022. We believe the “End Game” for the Bank of Canada is and should be to control inflation above all other considerations.

The Bank of Canada did hold the overnight interest rate steady on September 6. However, many economists described this as a “hawkish hold” as the Bank of Canada noted that “measures of core inflation are still elevated”. As is typical recently, the last sentence of the Bank of Canada’s announcement was “The Bank remains resolute in its commitment to restoring price stability for Canadians.”. While overnight index swaps are far from perfect predictors, these swaps are currently pricing in an additional 0.25% increase in the overnight rate in the next six months and no cuts for at least a year. Recently, multiple Canadian politicians have written letters to the Bank of Canada urging the Bank to stop raising interest rates. We think there is the potential that “Sparks Fly” between these groups if politicians expect the Bank of Canada to ride in on a “White Horse” and loosen monetary policy in the near term. Doing so could badly damage its “Reputation” when it comes to controlling inflation.

The labour market (particularly in the U.S.) remains strong and is in a “Lavender Haze”. Organized labour is trying (and in many cases succeeding) to negotiate significant compensation increases for their members as labour contracts come due. For example, more than “Fifteen” thousand pilots at American Airlines received immediate raises of 21% with compensation increasing more than 46% over the duration of a new four-year contract that was ratified in August. Anecdotally, a brief internet search brings up headlines such as “Salesforce to hire 3,300 people following layoffs earlier this year: report”, “Meta revives happy hours, t-shirts following layoffs”, “Public-sector jobs at the federal, state and local level have risen by 327,000 positions so far in 2023, according to the Bureau of Labor Statistics.”, “Target’s hiring numbers for 2023 match its plans to hire 100,000 employees over the last two years.”. Given the strength of the labour market, we believe inflation is likely to be stickier than the optimists initially expected. We are not sure it is safe to conclude that central banks have raised interest rates for “The Last Time”.

As managers of the Kipling Strategic Income Fund, our investment “Style” has been to focus on shorter dated corporate bonds. When it comes to the yield curve, we have generally been in the “higher for longer” camp. Consequently, the duration of our portfolio has remained below 2 throughout 2023. With the yield curve inverted, we often see the highest yield-to-maturities available in sub-two year bonds. In addition, all else equal, the prices of longer duration bonds should be more volatile as they are more sensitive to changes in interest rates. All else equal, focusing on higher yield-to-maturities and lower volatility should be a recipe to deliver better risk adjusted returns. We are definitely ”Eyes Open” when we see 7%+ yields in what we consider to be higher quality, shorter-term paper. While we remain selective, these types of bonds are generally attractive for “Me!” and our unitholders.

We continue to generally focus on corporate credit and bonds. While fears of a recession are almost always present, growth in the third quarter has generally exceeded the initial expectations of analysts. According to the Federal Reserve Bank of Atlanta’s “GDPNow” forecast model, third-quarter real GDP growth is expected to be approximately 4.9%. Meanwhile, when the quarter began most economists thought Q3 real GDP growth would be a “Blank Space” near zero. In their “Wildest Dreams”, most economists would not have forecast 4.9% Q3/23 real GDP growth when the quarter began. They were definitely not “…Ready for it”. While only one data point, this does not indicate a weak economy in need of immediate interest rates cuts.

Figure 2: Third Quarter GDP Now Forecast from the Federal Reserve Bank of Atlanta

Source: Federal Reserve Bank of Atlanta

Looking forward, National Bank Financial publishes a “Weekly U.S. Recession Dashboard”. This dashboard highlights 16 leading economic indicators that could foretell a recession. Red indicates that the current reading is worse than any historical episodes. Both yellow and orange are in the historical range, with yellow indicating a better situation compared to the median and orange showing the opposite. As you can see, only 2 of the 16 indicators are red; 6 are in the orange range, while 8 are yellow (within the historic range and better than median). While this is something to monitor, the relative lack of “Red” on the page does not imply that a recession is imminent. That does not guarantee that we are “Out of the Woods” forever, but it would indicate that a recession is less likely in the near term. As an aside, one advantage of focusing on shorter-term corporate bonds is that there is less time for the economy (or something company specific) to go wrong before the bonds mature.

Figure 3: National Bank Financial’s “Weekly U.S. Recession Dashboard”

Source: National Bank Financial, Inc. “Weekly U.S. Recession Dashboard”. Published September 18, 2023

One area we remain cautious on is unsecured consumer lending. The rapid increase in interest rates and higher than normal inflation is creating financial stress for certain consumer borrowers. In addition, many borrowers who took out fixed rate mortgages in 2020 or 2021 could be facing interest rates that have doubled or even tripled when they seek to renew their mortgages (a 5 year fixed mortgage is somewhat common in Canada). Indeed, “Everything Has Changed” when it comes to interest rates for these borrowers.

BMO Capital Markets publishes a quarterly “Residential Mortgage ‘Survival Guide’” highlighting the residential mortgage exposure of Canadian banks. BMO’s analysis indicates that “the percentage of total mortgages in negative amortization ranges from 18-“22”% at TD, CM, and BMO as a result of the recent rate hike cycle. BNS, NA, and RY do not have any due to their mortgage payment rules”. As seen in Figure 4, four of the banks also have more than 20% of their residential mortgages with amortizations greater than 30 years. To be clear, we are not being the “Anti-Hero” and calling into question the solvency of Canadian banks, but simply stating that we are not “Fearless” and would prefer secured consumer lending over unsecured consumer lending at this point in the cycle (even if that “Mean”s giving up some yield).

Figure 4: BMO Capital Markets 

Over the long term, we do expect bond yields to ultimately decline from current levels and for the yield curve to become upward sloping. We simply think it will take longer for that to happen than some market participants suggest. Maybe then the “Bad Blood” will end and bond investors will “Shake it Off” and renew a “Love Story” with bonds. As always, we thank-you for your trusting us with your capital. Wishing you all good “Karma”.

*Cumberland and Cumberland Private Wealth refer to Cumberland Private Wealth Management Inc. (CPWM) and Cumberland Investment Counsel Inc. (CIC). NCM Asset Management Ltd. (NCM) is the Investment Fund Manager and CIC is the sub-advisor to the Kipling and NCM Funds. CIC is also the sub-advisor to certain CPWM investment mandates. This communication is for informational purposes only and is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. The communication may contain forward-looking statements which are not guarantees of future performance. Forward-looking statements involve inherent risk and uncertainties, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. All opinions in forward-looking statements are subject to change without notice. Past performance does not guarantee future results. CPWM and CIC may engage in trading strategies or hold long or short positions in any of the securities discussed in this communication and may alter such trading strategies or unwind such positions at any time without notice or liability. CPWM, CIC and NCM are under the common ownership of Cumberland Partners Ltd. Please contact your Portfolio Manager and refer to the offering documents for additional information.


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