Q3 2016 Commentary

Mackenzie Fixed Income Team

Market Review

While the effects of central banks’ efforts have varied somewhat in 2016, there had been a general trend to flatter yield curves, lower government bond yields and tighter credit spreads over the last 8 months. After a difficult environment for “risky” assets over the first six weeks of the year, anticipated and realized stimulus programs drove equities, corporate credit, and sovereign bond prices all higher.

Brexit was a major feature of the fixed income landscape in the market focus as we went from Q2 to Q3. In the immediate aftermath, there was a flight to quality trade which pushed yields lower in most developed markets. In fact, we hit the low yields for the year in early July, in most cases. As we've gone through the summer, yields have traded in a very low volatile range: about 20 basis points for the Government of Canada 10-year yield, for example, as we've gone through the end of August.

For interest rate markets, one thing that changed in September was the emergence of a little bit more volatility, in particular, around the long-end of the yield curve. This is occurring as some markets are starting to reconsider some of the monetary policy effects on the yield curve including things like zero interest rate or negative interest rate policy as well as the quantitative easing programs underway by major Central Banks. First out of the gate was the Japanese yield curve which steepened quite sharply in late August and early September. That's been followed on by other developed markets seeing curve steepening affecting, particularly the long end of the market. For most markets, the front end of the yield curve remains relatively anchored by central bank policies aimed at low or negative policy rates.

Credit has actually remained pretty robust throughout the summer months. Coming into the summer, we had good strong returns of around 10%, for example, for U.S. high-yield. And, that's really continued quarter-to-date through the second half of September. High-yield markets in the U.S. have produced just over a 4% total return this quarter, which has pushed the total return for the year-to-date period, up to about 14½%.  Over the quarter, we've seen over 2½% returns from the loan market in the U.S. And, corporate credit in the investment grade side continues to perform well also.

While there has been strength in all corporate bond markets this year, in the high-yield bond market valuations have begun to appear expensive in some credits and sectors. Over the last three or four months, we have gradually been reducing our allocations, in particular, to high-yield debt. We have slightly increased our allocation to investment grade corporate debt, in the balance leaving our overall corporate allocation about the same. In general terms, among high yield sectors, we have a preference for loans over high yield bonds. However, credit selectivity has increased in importance once again, as tighter credit spreads have removed credit-event, or tail-risk, premiums from a larger number of issuers in both markets.

Outlook & Strategy

As we look forward, we think there's going to be increased volatility around some areas of credit. And, we're looking to avoid those areas that are most overpriced to avoid the dips that may come.

On the interest rate front, we see that the bond market is currently about two-thirds priced for a 0.25% rate hike from the Fed before the end of this year – more than enough, such that a hike at the December meeting accompanied by a “dovish” statement on the 2017 path for the Fed Funds rate is unlikely to cause a similar episode of FX market and yield volatility. There are some potential volatility-inducing events on the calendar over the next few quarters, starting with the US election in November. In 2017, we may also experience a slowing of some over-heated housing markets, including in China, and in Canada, as governments are trying to crack-down on rapid price appreciation by instituting macro-prudential policies. And, perhaps in the first half of next year, we should see the beginning of the Brexit process unfolding, into a politically-charged election season for Germany. Lastly, the Bank of Canada is likely to remain on hold into the first half of 2017, with a small dovish tilt that could lead to a rate cut should the commodity price stability of late fade, or expectations of more robust global trade next year diminish. We believe that the Bank of Canada would favour a modest weakening of the CAD in this environment.

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