‘The $25-B question: should money-market investors pivot into longer-duration bonds?’

With rate cuts coming, investors who piled into money markets could go on ‘quest for higher yield’ this year

Reprinted with permission of Wealth Professional | Original feature
Authored by: Leo Almazora | January 23, 2024


With fixed-income markets expected to undergo a patch of volatility as investors anticipate several interest rate cuts from central bankers, Canadian investment-grade bonds may be an interesting asset class for advisors and their clients this year, argues one investment industry leader.

“There’s potential for more inflows and interest in this category from advisors, simply because the economic environment seems reasonably strong, and there’s a broad expectation that interest rates will decline,” says Mark Noble, senior vice president of Retail Strategy at Guardian Capital LP.

“That’s sort of a sweet spot for corporate credit, because, historically, it’s meant that corporate yields tend to have that higher spread, which results in a higher yield.”

From ‘cash is king’ to ‘a quest for higher yield’

Looking at analysts’ data, Noble says the consensus view for interest rates calls for three to six rate cuts from central banks going into 2025. The timeline of those cuts has been the subject of much discourse, with analysts diverging on whether the Bank of Canada and the Fed will start cutting this spring or later in 2024.

“What’s important to highlight is that we’re probably at or near a top in interest rates rather than a bottom,” he says. “Investors are really having to take a hard look at their fixed-income portfolios, to see if they’d want to potentially lock in interest rates from here on out. … If we start to see interest rates decline, income levels on fixed-income holdings will obviously start to decline.”

In 2022 and through to 2023, cash was king among Canada’s retail investor crowd, with flows into money-market ETFs totalling $25 billion last year according to National Bank Financial. As central bankers navigate a pivotal interest-rate transition and the risks of cash investments become clearer, investors must now consider when and how to rotate into other fixed-income options.

“Money-market instruments come with reinvestment risk, which is not a risk of loss, but a risk of declining income … They have short maturities, so they roll over very quickly,” Noble says. “We could see yields on high-interest savings account (HISA) ETFs, T-bills, money-market funds start to potentially decline dramatically, so we could expect a quest for higher yield in 2024 as investors look at other things like GICs or longer-duration corporate bonds.”

Disappointing Goldilocks

Following the Office of the Superintendent for Financial Institution’s (OSFI) decision to stiffen liquidity requirements for HISAs, Noble says the HISA ETFs’ competitive edge has been blunted somewhat, with some of those products paying 5% or less.

Recently, Guardian Capital launched its GuardBonds suite of defined-maturity bond funds, which each hold a portfolio of corporate bonds set to mature on a specific year. Noble says the GuardBonds 2024 maturity bond fund holds bonds with a current weighted-average yield to maturity of 5.25%.

“You’re already generating a higher yield than a cash alternatives product with the same risk characteristics,” he says. “The difference is you’re not having to worry month to month about interest rates declining.”

From his vantage point, Noble sees markets currently pricing in a Goldilocks scenario for bonds in 2024, which includes six interest rate cuts within the year. Noble argues those expecting a quick barrage of rate cuts could be disappointed, which could drive some near-term volatility in bond markets.

Despite the recent market rally in the last quarter of 2023, Noble says the majority of corporate and investment-grade bond issuances in Canada are currently trading at a discount. For investors who are able to buy such bond issuances and hold them to maturity, that creates a fairly high certainty of a capital gain, making their return profile relatively more tax-efficient than products like GICs that pay out as pure income.

“If you’re holding bonds to maturity, you don’t really care what the daily NAV of the bonds is. You don’t really care about volatility in investment-grade bonds,” he says. “All you care about is that you’re being paid a certain level of income, and that these bonds are going to mature at their par value.”