Bonds in a cutting cycle

With the Bank of Canada now cutting rates for the second consecutive meeting — and signalling that more cuts may come soon — we appear to finally be in the interest rate cutting cycle that so many analysts predicted would come this year. Softening economic data in Canada, as well as cooling inflation, has motivated cuts by the Bank of Canada. The United States is showing signs of a slowdown as well. Though cuts from the US Federal Reserve have not come yet, the expectation is that they will begin as early as September.

The onset of cuts spells opportunity in the fixed income market. Institutions, however, have to balance these short-term opportunities with the length of their liabilities and their allocations to other asset classes. Grant Connor, vice president and portfolio manager at CI Global Asset Management, shared some of his outlook for fixed income markets now and offered an idea of where Canadian institutions can find opportunity.

“When you’re looking forward and seeing where our rates are tat today, people probably say that it takes a lot of rate cuts to generate a good return, but I think we’re set up for a lot of rate cuts,” Connor says. “I certainly think there can be a lot of benefit to being in the middle of the curve, because if the bank lowers rates they’ll probably pull on yields in the middle of the curve. If you get a big recession, even long-ended 30-year bonds could generate quite a good return.”

Connor, speaking primarily about the Canadian bond market, says that signs point to a potentially more intense weakening in the Canadian economy than many might expect. In that environment he expects that the Bank of Canada may have to cut faster than they’d like, which could create meaningful price movements in Canadian bonds.

The debate for institutional managers right now is about duration. While the yield curve remains inverted and the room for price appreciation appears greater at the shorter end, the question is how anchored the long end of the yield curve is if we get a slew of interest rate cuts.

That’s some of why Connor prefers the middle end of the yield curve, which has historically done well in a falling rate environment. Even if the BoC doesn’t lower as much as he predicts, the total returns from that segment should still be attractive for institutions.

Asset managers who are more bullish on duration may want to pick up bonds in the 20-year part of the curve, an area that Connor says tends to get less activity. In both provincial and Canadian government bonds he thinks that there’s a real opportunity if the expectation is that more cuts will come.

Canada Mortgage Bonds could also be an opportunity to pick up spread, Conor says. Spreads are tight on these products but he expects they should perform well in a recession because even if they widen, they never widen so much that the pull of lower rates can’t generate a return.

Currently, the opportunity set looks better in the Canadian bond market than the US bond market, because of the relative weakness in the Canadian economy. However, as the US economy also shows more signs of a slowdown and the US Federal Reserve moves towards a cut, there may be a pivot point where US fixed income allocations offer more promise.

On a more fundamental level, the cutting cycle now underway in Canada and set to begin in the United States should offer institutions an opportunity to reconsider their fixed income allocations and consider new asset classes that can deliver for them. His view is that we may be headed for a worse recession than many previously predicted in Canada. While that is broadly bad news, it should spur some meaningful movement in the bond market.

“What I’ve seen that might make people miss things is that equity markets have generally done well, and the US market specifically,” Connor says. “We often see equity markets do really well before a recession, until it’s clear we’re going into that recession. I think the miss could be if you don’t have enough duration in your portfolio with core long-term bonds that will perform well and offer some protection.”