The world’s financial markets continue to grapple with elevated inflation and a regime shift toward higher interest rates. Financial market sentiment has also been affected by the Russia and Ukraine crisis, which seems to go from better to worse and back again on a day-to-day basis. The latter crisis represents an ongoing risk to investment sentiment, and may also have longer-lasting implications for the geopolitical landscape.

 

Investors will need to remain patient with inflation and interest rates. Some clarity may emerge by mid- March, when major central banks deliver their next policy updates. More likely, it is 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 be volatile.

 

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

 

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

 

In our view, it is important to focus on the future and how to position portfolios appropriately. While the longer-term return prospects for fixed income remain challenging and yields are still below long-term averages, in our view there are pockets within the bond universe that are attractive. 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 become more interesting because of the sell-off. The pendulum of expectations regarding future 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. in 2022. If inflationary pressures recede through the second half of the year, or central banks approach their rate hiking cycles more gradually than is currently expected, the environment could shift 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 that such an occasion has begun to emerge for investors, particularly in higher credit quality fixed income, given the broad pressure that the bond market has experienced. We would not characterize the opportunities as compelling, but they are deserving of ongoing consideration.

 

Should you have any questions, please feel free to contact us.

 

 

 

Drew M. Pallett LL.B. CFP

Senior Portfolio Manager and Investment Advisor 

RBC Dominion Securities

Email: drew.pallett@rbc.com

Website: www.pallett.ca