The fundamental fact of Canadian bonds these days is the flatness of the yield curve. For a five-year Government of Canada bond, the payoff is 1.91%; for 10 years, the figure is 1.97%; and, for 30 years, it’s 2.20%. Deciding to go long on a government bond may be a move to safety of principal, but it’s no way to make a living. Instead, for yield and security, bond buyers are shopping for corporate investment-grade debt.
Corporate bond spreads over government bonds have widened, explains Edward Jong, vice president for business development at T.I.P. Wealth Manager Inc. in Toronto. “The risk environment is driven by volatility in equities markets. By default, corporate bond spreads over government bonds have gotten a lot wider.”
A 10-year Canada due June 1, 2029 was recently priced at $134.61, to yield 2.03% to maturity. In comparison, the Bell Canada 6.55% bond, due May 1, 2029, was recently priced at $122.06 to yield 3.92% to maturity. That is almost twice the return of the government bond for a senior issue from a familiar issuer with a solid investment grade rating from DBRS.
Until the Bank of Canada (BoC) lifts the overnight rate, which was at 1.75% at the time of writing, the yield curve for government bonds will remain flat and be an incentive to move money to corporate bonds as an alternative to volatile stocks. The BoC said in a statement on Jan. 12, 2019 that it would like to push its overnight rate to between 2.5% and 3.5%. That would mean between three and seven more quarter-point rate hikes. But that rate migration is likely to be slow in light of the negative economic drag created by Canada’s energy and trade issues.
Just how soft Canadian debt markets are right now can be judged from the move on Jan. 16, 2019 by Royal Bank of Canada (RBC) to lower its five-year, fixed-rate mortgage to 3.74% from 3.89%. As the largest mortgage lender in Canada, RBC tends to lead other chartered banks’ mortgage rates, says James Laird, president of mortgage broker CanWise Financial and co-founder of Toronto-based data service provider Ratehub.ca Inc., which owns Canwise.
For home buyers, the flattening yield curve is a good thing. “There is less rate premium associated with locking in a mortgage for a longer period of time,” Laird says. The spread between variable and fixed mortgage rates has narrowed. For five years, the fixed rate decreased by 15 basis points. On a $400,000 mortgage, that is a cut of $32 per month.
Some might say that a $32 cut is just lunch once a month, but the implication of low rates is that seven- and 10-year mortgage rates are now close to the five-year rate. Indeed, the Canadian mortgage market could be headed to a situation where someone could lock in a 10-year mortgage note for close to the five-year rate. “For peace of mind and good deals, we expect to see a lot of borrowers lock in those long rates,” Laird says.
The decisive issue now in credit markets is whether to accept low long rates on government debt at the end of a rather flat curve or to take default risk in corporate bonds. The term premium is low, notes Chris Kresic, head of fixed-income and asset allocation at Jarislowsky Fraser Ltd. in Toronto.
The result is two-fold. Paying a small premium for going long amounts to buying insurance on your principal at relatively low cost or, from another point of view, accepting a low return to avoid all default risk. In terms of the alternative yield in investment-grade corporates, that is a high price to pay or a lot of yield to sacrifice.
Fixed-income investors seeking yield can, of course, take on more default risk with high yield debt. In this market, risk is up. As Kresic sees it, increased volatility in the stock market has migrated to the bond market, where the perception of more volatility in corporate cash flows has raised the risk premium in corporate bonds, cut their prices and raised their yields.
Indeed, data show precisely that. The Bloomberg Barclays U.S. corporate high yield total return index spread over 10-year U.S. Treasuries stands at 436. The number is an abstraction but is meaningful in the context of recent events. The index stood at 316 for September 2018 – before recent political events in the U.S., such as the shutdown of many federal government services.
“Corporate yield spreads, even on investment-grade issues, have widened over government issues,” agrees Charles Marleau, president of fund portfolio manager Palos Management Inc. in Montreal. “That’s the risk premium. Non-investment grade bonds are looking more attractive, but we don’t like this class as much as we did when the spreads were wider. However, to avoid trying to guess spreads, we prefer to ladder our bonds, not so much for the income but for the ability to trade once and pay one spread over the dealer’s cost and then let the market pay us back at maturity, then roll it and do it for another bond in the ladder. We avoid over-trading and its costs. It lets us keep up with returns in the bond class we are holding, and we preserve portfolio balance by not taking a bet on one maturity.”
Through laddering, the portfolio gets defined-term risk, which sets duration and rate sensitivity, Marleau adds. His strategy minimizes time bets along the curve and substitutes one average yield in the ladder.
That works out to a long-bond premium on what amounts to shorter bonds. It is a safe strategy with an option on future bond issues and rates. Given that rapid rate rises in the Canadian fixed-income market are not in sight, the tactical play of keeping trading costs down adds to low returns in all bond classes.