Bonds have been beaten this year, but that’s good news for anyone betting that today’s obsession with inflation and rising interest rates will subside.
Hanif Mamdani, the lead manager of Royal Bank of Canada’s giant PH&N High Yield Bond Fund, offers a high-profile example of an investor looking to take advantage of eye-popping bond yields.
He is now on the lookout for corporate bonds that he believes could generate double-digit annualized returns – eye-popping gains in the normally stuffy world of bonds – within a few years.
“I wouldn’t call it a once-in-a-generation buying opportunity. But it’s starting to look awfully beautiful,” Mr. Mamdani said.
Of course, making the case for bonds is not easy right now.
The asset class in the first half of this year suffered its worst losses for decades, and a few economic developments this week haven’t really bolstered the case.
The US Department of Labor reported that inflation in June jumped to 9.1%, at an annualized rate. This will surely push the Federal Reserve to raise interest rates aggressively, even at the risk of pushing the economy into recession.
The Bank of Canada may have led the way: the central bank raised its key interest rate by one percentage point this week in its effort to combat rising Canadian inflation.
“These are relatively uncharted waters. The twin threat of inflation and recession is very dangerous, and one that most investors have not seen in their lifetime,” Mamdani said.
But danger can also offer rewards. He reopened his fund to new investors this week – only existing investors have been able to add positions in the past two years – underscoring his belief that a promising opportunity has arrived.
Mr. Mamdani’s views carry some weight.
The PH&N fund has $7.1 billion in assets under management, giving it considerable leverage. Its performance regularly ranks in the first quartile of bond funds.
And Mr. Mamdani’s timing may be good: the last time the fund reopened to new investors, in 2020, it sought to profit from the fall in corporate bonds at the start of the COVID-19 pandemic. 19, finding that companies with good credit ratings were unduly punished. He was right.
Now, he believes one of the most promising areas of the market is Canadian corporate bonds with investment grade ratings now trading at unusually high yields.
He cited a few examples.
He bought CIBC’s Limited Recourse Capital Notes – or LRCN, a five-year subordinated debt instrument – with yields as high as 7.4%.
Similarly, Manulife Financial Corp. recently issued the same type of security with a coupon of 7.1%.
Within a year or two, he estimates, if the Fed has beaten inflation and bond yields decline, the yield on CIBC’s debt instrument could drop to 5%. This would drive up the price of the stock and reward investors with a total annualized return of 9-10%, all based on the attractive credit risk of a Canadian bank.
“This is not a bet on Canadian bank stocks. This is just a bet on the survival of Canadian banks over the next two years. To me, that’s compelling,” he said.
The risks? Inflation could remain stubbornly high, causing central banks to raise rates more than expected, which would not be good for bonds.
But there are several encouraging signs that this will not be the case.
Commodity prices are falling, removing a key source of inflation. The so-called equilibrium rate – an indication of bond market inflation expectations – peaked several months ago.
Bonds barely reacted to this week’s alarming US inflation reading for June: the yield on 10-year US Treasury bonds ended the week at 2.93%, down from the recent high of around 3.5% last month.
And, the inverted yield curve – long-term bonds yield less than short-term bonds – suggests that bond traders expect the Fed to cut interest rates next year.
“The market seems to be telling us that while last month wasn’t the worst, we are getting closer to the peak of inflation here,” Mamdani said.
The open question is whether the inflation rate quickly returns to the Fed’s 2% target or lingers, say, above 4%.
But for Mr. Mamdani, it simply marks the difference between a good environment for bonds and a great one.
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