Fixed Income Viewpoint
Outlook – April 2014
Credit Cycle
Current View: We maintain our position that with a backdrop of range-bound yields, corporate bonds in Canada represent a sensible investment vehicle and we expect money to continue flowing into the asset class. Since GoC rates remain at paltry levels, we believe the incentive to add spread and juice returns is quite a palpable goal. In the current environment, we advise investors to improve credit quality when possible. That is not to say we are suggesting investors avoid higher-beta sectors; quite the contrary, we currently have both REITs and Tele- com rated Outperform. Within sectors, however, we believe investors should focus on their preferred issuers and look for opportunities where they can pick up bonds from those enti- ties by trading out of issuers perceived to be less desirable. Of course, this strategy is almost of the “no-brainer” ilk, but with many investors indiscriminately throwing cash at corporates and spreads at multi-year lows, the opportunity to upgrade should be pursued. Similarly, trades that reduce duration at flat or modest gives in spread, or that reduce duration and improve quality should be considered. Again, the above suggestions are not the most sophisticated, but rather ideas that we believe are being overlooked in the race to add bonds, any bonds.
Economic Growth: BMO Capital Markets expects moderate GDP growth of 1.2% for Canada in Q1/14, modestly softer on weaker-than-expected data to start the year. The estimate for full-year 2014 growth of 2.3% is up from 2.0% in 2013 and suggests economic activity is expected to rise a touch throughout the year.
Equity Markets: The heightened spectre of geopolitical risk so far this year, along with questions about U.S. economic strength and concerns about growth in China, has weighed on equity market performance. In addition, after posting a decent rally during 2013, there is lingering caution about possible over- valuation and further corrective activity. Although the equity markets managed to charge through a temporary pull-back in late January, conviction remains tepid as building tensions in Europe and mixed economic data in the U.S. have left investors looking for more concrete signs of forward direction.
Default Rates: According to Moody’s, the global speculative grade default rate was 2.4% at the end of February 2014, down from 2.6% in January. These levels compare with the historical average of 4.7% since 1983. Moody’s expects the global speculative-grade default rate to be 2.1% by the end of 2014.
New Issuance: We believe that last year’s total of $106 billion represents the recent high-water mark, with levels expected to slip modestly in 2014. At present, we fore- cast new issuance of $90–95 billion for full-year 2014, although the primary market started slower than we expect- ed largely due to the funding activities of the Big 6 Banks outside of Canada.
GoC Yields: Softening yields
to start the year gave way to
a consistent bid on the emergence of geopolitical risks and economic concerns, keeping yields range-bound, which is consistent with our expectation. Mixed messages from the U.S. Fed during March about the duration of its accommodative monetary policies placed some upward pressure on yields, but geopolitical tensions in Europe and mixed U.S. economic signals have kept traders reasonably disciplined. We expect modest credit curve flattening to continue as spreads remain range-bound and the long end remains a viable option to add duration risk and increase returns.
Relative Value
Sector View: We believe Telecom will outperform due to im- proved clarity over regulatory and competitive risks. We also rate the REIT sector Outperform, based on our view that the sector’s solid fundamentals will remain intact in 2014 and offset another likely year of active new issuance. At the same time, we believe Retail will underperform due to heightened risks for competition and shareholder-friendly management decisions. In terms of the Utility sector, the basis for our Underperform rating is two-fold: 1) in a rising interest environment (even moderately) it will be very difficult for the total return of the utility sector to match the broader market given the sector’s naturally long duration; and 2) we do not believe Utility spreads will tighten more than the broad market index, especially given long Utility spreads are beginning to break through their recent trading floor. We refer readers to each sector comment for a more detailed description of the recommendations and top picks.
Jason Parker, CFA
BMO Nesbitt Burns Inc. jason.parker@bmo.com (416) 359-5410