Last year, corporate bond issuance in Canada exceeded $100 billion for the first time. On the surface, this milestone would appear to signal the initial phase of crowding out by corporate issuers at this stage of the economic cycle. As an expansion becomes anchored, corporate issuance will dominate the capital markets as businesses look to fund capital expenditures in anticipation of growing demand.
On closer examination, investors anticipating another bumper crop of corporate issuance this year are likely to be disappointed. So far in 2014 corporate issuance is down 36% year over year, and, all else being equal, an annual issuance near $85 billion is projected, closer to the average of the three years prior to 2013. The combination of slowing growth early this year and giant pockets of excess capacity are likely forestalling spending plans.
Absent corporate issuance, governments typically tend to fill the void. However, with election season creeping around the corner, austerity is likely to factor more prominently in 2014. This suggests we likely won’t see much if any increase in issuance by the federal government and its agencies and maybe even a modest decrease by provincial governments.
What does this mean for investors? Given the significant improvement in the funded status of DB plans at the end of 2013, the motivation to de-risk or, at a minimum, rebalance to policy weights has the potential to create a supply/demand imbalance in the domestic bond market.
If so, interest rates will remain sticky around current levels suggesting another year of modest returns. Additionally, pervasive income needs at a time of lower corporate issuance makes it likely that the domestic corporate market will exhibit low dispersion and remain uniformly expensive.
At a time like this, investors should consider rethinking their fixed income allocation.
For some, the need to hedge within the domestic market is a constraint that does not afford much leeway to be creative. For others, the need for diversification in fixed income was driven home in 2013, when both the FTSE TMX Canada Bond Universe and Long Term indexes (formerly DEX) posted negative returns for the first time since 1999.
These indexes remain heavily exposed to interest rate risk, not a desirable trait in a climate of rising rates. Fortunately, the fixed income universe beyond Canada is large. Global fixed income opportunities such as structured credit, emerging market debt and high yield offer diversification benefits as well as the potential for higher total returns with less exposure to interest rates.
This is not to say these sectors don’t pose their own challenges; the recent volatility in emerging market debt is a case in point. But diversification isn’t about finding a perfect new tool. It’s about enlarging the toolset, and for Canadian investors this may mean looking beyond Canada’s borders to find more attractive fixed income opportunities elsewhere.