Fears of inflation and recession are weighing on fixed income securities



The continued threat of higher inflation and rising interest rates has made some investors cautious about the prospects for bonds and other corporate bonds. Greg Bonnell talks to Benjamin Chim, Senior Portfolio Manager TD Asset Management, about his prospects for steady income.


Gregory Bonnell: The aggressive central bank tightening has sent shockwaves through markets while raising fears of a recession on the horizon. So what does this mean for the health of companies and investors holding their debt? Benjamin Chim, Senior Fixed Income Portfolio Manager at TD Asset Management, joins us for the discussion. Benjamin, welcome to the show. Fascinating topic. Here, let’s talk about the outlook for corporate health and what that means, particularly when you’re talking about fixed income and corporate debt.

Benjamin Chim: Thank you for the invitation, Greg. Glad to be here. The short answer in terms of how badly recession fears and rising interest rates are affecting the health of corporate debt is a lot. It affects it a lot. And it’s a big driver of why we’ve seen these big year-to-date drawdowns in corporate credit, both investment grade and high yield. The market has essentially re-rated bonds on the prospect that interest rates will continue to rise and the fact that we could potentially see a recession – if not by the end of this year then possibly by the end of next year. And so spreads and yields adjust accordingly.

But when we think about what the future will hold and how things will develop in the future, we still think about investing in corporate bonds with some caution. We expect there to be decent volatility into the end of the year and possibly into next year. And the reason we’re quite concerned is that, as you know, inflation rates are still persistently high, right? The July number was encouraging because inflation has eased off a bit, but we’re still talking about central banks trying to bring inflation down from this 7.5%, 8% level to their target of 3% to 4% – 2% to 3% – to lower. , Yes, really. And there are several elements related to the inflation metrics that are still pretty sticky. You have wages and rent, of course. So there is a good chance or reasonable potential for inflation to roll over but stagnate in that 4% to 5% range. And if it stays there for an extended period of time, that’s going to be a pretty challenging backdrop for corporate bond funding — of course, they’re likely to experience a recession over that period, so credit quality could be affected. And that scenario is really not being priced into the markets right now, so we see a little caution here. And we think you can expect reasonable volatility in corporate bonds going forward.

Gregory Bonnell: So let’s talk about that caution when someone gets into the corporate bond space. Will the quality of the company, the quality of the issuer, matter when there is a challenging economic environment that also brings with it higher interest rates?

Benjamin Chim: Yes. I mean, the only bright spot or salvation for corporate bonds at this time is that we’re coming from a pretty unique situation in that the credit quality is pretty good. And it’s a lot better than we’ve typically seen when the market heads into a recession. And that’s just because it really hasn’t been that long since we had that last wash, right? It was the COVID pandemic where there were lockdowns. The economy was really struggling. Businesses were obviously struggling to get by with business closures. The high yield bond market had a 10% default rate in 2020. So many of the weaker companies were wiped out. You have restructured. And since then, the last two years, they’ve really focused — most companies have really focused on rebuilding the liquidity war chest and terming their debt maturity profiles. And that has put them in a position today where they have a lot of flexibility to wait and see when dealing with what is now a much more volatile and much more difficult funding market. They have a lot of flexibility to take different avenues to fund their growth, so they’re in a good position. And that gives us confidence that even if we start to see some dislocations in credit markets, we probably won’t experience what we saw in 2008 or 2020.

Gregory Bonnell: When we think of all the challenges we’re facing right now – and there’s no shortage of challenges or things to worry about – it makes sense to tread cautiously. If we were bullish on space, what could be going right in terms of corporate bond investing given the broader economic backdrop? What could actually unravel in the world where we’d start to say, hey, I’m feeling a little more excited about the space?

Benjamin Chim: Well I think if central banks handle inflation better than we expect and what the market is expecting right now that would certainly be hugely positive for spreads and risk and risk premia because that could potentially lead to a soft landing which they are going to have a hard time have to meet could come to fruition. And when that happens, we’re sure to see a rally in all risk markets, including corporate bonds. And the potential corporate bond yields are actually pretty decent considering the all-in yields, right? You’re set for some pretty decent long-term returns, as the yield in the investment-grade market is currently 4.7%. The yield in the high-yield market is currently around 8%. That’s a lot higher than we’ve seen this year.

Of course, the concern we have overall with the corporate bond market is that if you look closely at this yield number, the risk premium, the spread for owning corporate bonds is not as attractive as you typically see in a recessionary period. So the investment grade spread is currently 145 basis points or 1.45% versus government bonds. And in high yield, it’s 480 basis points, or 4.8%. And typically in recessions you see the spread is much wider. For example, in COVID, the high yield spread hit 1,000 basis points, or 10% more. And investment grade, we saw 400 basis points. So at 145, at 480 we’re not even half of that. And we’d like to see more of that concern in relation to the downside scenario that we talked about, which is priced into the markets a little more.

So if you’re investing in corporate bonds, yes, there’s pretty good potential for long-term returns based on the yields. However, because of the spreads, you need to be prepared for reasonable volatility.

Gregory Bonnell: Well, the risk, of course, and the reward, you’re trying to balance that in terms of what kind of investment decisions you want to make. It’s interesting when you talk about making that headline return, and it can look attractive. But you have to go below the surface to find out what exactly is happening. It sounds even more important. I’m thinking of dividend payers and someone who, if they are — if they’re investing in high-yield companies. And they say, oh, look at the size of that dividend. Then you have to ask the question, OK, that’s a nice number. Why is the number there? What is happening beneath the surface of this number?

Benjamin Chim: Yes. The same could be said for credit, right? What’s happening beneath the surface is that things can level out – yields can go even higher and spreads can go even higher because we’re not in a market gone haywire right now, right? We are not in a situation where credit quality is a major concern. It’s more about tariffs. It’s more about inflation. And if concerns shift in that direction, there could be more volatility.

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