The third quarter ushered in a broad-based selloff as central bank projections of a higher-for-longer interest rate environment, fiscal deficit concerns, and unfavorable supply-demand dynamics reignited interest rate volatility. While this may make fixed income investors weary of what's to come, in a series of charts, we highlight why we believe high-quality credit is more attractive than it has been in a long time.
1. Investment Grade Bonds are Trading at an Incredible Discount
Investment grade corporate bonds are trading at price discounts representing 20-year lows. This market dynamic allows investors to participate in very attractive tax-efficient returns through capital gains when these resilient bonds pull back to their $100 par value.
2. Maximizing After-Tax Yield Can Lead to Surprisingly High Returns
GIC returns are sourced 100% from coupon payments, which are taxed in non-registered accounts at the investor’s full marginal tax rate. In comparison, total returns for bonds include coupon payments as well as capital gains, which are taxed at only
50% of the investor’s marginal tax rate. This makes after-tax bond returns far more tax-efficient when they are trading at discounts to par value – like we are seeing in the current environment.
3. The End of a Hiking Cycle May Be the Worst Time to Choose a GIC Over Bonds
Over the past 40 years, bond returns have exceeded those of one-year GICs in 33 out of 40 years; in other words, 83% of the time.
Historical data demonstrates that following periods of interest rate hikes that led to losses, bond returns have experienced a significant recovery in subsequent years – most notably in 1995, 2000, and 2014, when the FTSE Canada Universe Bond Index
generated more than twice the return as one-year GICs.
4. Bonds Provided Significant Protection During Previous Market Downturns
Bonds have acted as an important ballast for portfolios during periods of market stress. A weak economy often leads to a “flight to safety” response and a sudden decline in bond yields, which leads to significant bond returns.
At current yield levels of ~6%, we believe bonds offer an exceedingly attractive opportunity and can be a material return diversifier and enhancer if equity markets deteriorate faster than expected.
5. Investors Can Generate Better Yields from Securities Higher in the Capital Structure
Equity valuations remain potentially lofty and are beginning to feel the adverse effects of rising real rates, whereas all-in yields on investment grade bonds are attractive in both absolute and relative terms. This environment makes the case for greater
fixed income exposure as a compliment to equities or cash in a portfolio as they sit higher on a company’s capital structure.