Semi-monthly Update February 18th 2022

February 18, 2022 | Thomas Donnelly


We discuss the bond market woes and why some opportunities at the margin to reposition portfolios are starting to emerge.

Not much has changed in recent weeks as many of the world’s financial markets continue to grapple with elevated inflation and a regime shift towards higher interest rates. Investors have also been on edge due to the Russia and Ukraine crisis, which seems to go from better to worse and back again by the day. The latter presents an ongoing risk to broader sentiment, but we believe it may have longer lasting implications for the geopolitical landscape rather than the investment outlook.


On the inflation and interest rate front, investors will have to remain patient. Some potential clarity may emerge by the middle of March when major central banks deliver their next policy updates. More likely, it’s going to take until the spring, if not longer, for investors to get a sense of whether inflation is peaking and has the potential to moderate, or whether it will remain stubbornly high due to more sustainable forces. Until then, markets may continue to consolidate. One area that has been vulnerable of late has been fixed income. We discuss this more below.


The bond market has been particularly noteworthy this year given its struggles. For perspective, the Canadian bond universe is down nearly 5% year-to-date, representing one of its worst starts to a year. That compares to the Canadian equity market which is nearly flat. It has been an abnormally weak start for an asset class that typically offers less volatility and downside risk than equities.


There have been two factors at play. Bonds have sold off (and yields have moved aggressively higher) due to aforementioned concerns over inflation and expectations of higher interest rates. Moreover, there has been a sharp move in credit spreads, which represents the extra compensation that investors demand to own corporate bonds. While spreads remain low relative to their long-term average, they have moved higher since the start of the year, reflecting some growing concern that investors have over the ability of companies to repay their debts in the future. The combination of higher bond yields and credit spreads has led to the broad selloff we have seen to date across much of the bond market.


Rather than dwell on the recent past, it is more important to focus on the future prospects and how to position accordingly. And, while the longer-term return prospects for fixed income remain challenging and yields are still unremarkable, there are some pockets within the bond universe that may arguably be more attractive than they have been in recent history. For example, short and longer-term government bond yields have not been this high since before the pandemic. The yields are still far from being outright attractive, but have undoubtedly become more interesting because of the sell-off. Moreover, one could argue the pendulum of expectations around rate hikes may have swung too far in one direction with markets now expecting close to six interest rate increases in Canada and the U.S. this year. Should inflationary pressures recede through the second half or central banks approach its rate hiking cycle more gradually than is currently expected, the environment could shift yet again, and this time, in favour of the bond market.


It is our responsibility to be on guard and identify opportunities that arise to reposition portfolios, even if changes are incremental and at the margin. We believe such an occasion has started to emerge for investors, particularly in higher credit quality fixed income given the broad pressure the bond market has experienced. We wouldn’t characterize the opportunities as compelling by any means, but they are noteworthy and deserving of some consideration.


Should you have any questions, please feel free to reach out.