Rhythmic Reasoning_Full Report_Final_EN - Flipbook - Page 59
THE DRUMMER'S EAR | RHYTHMIC REASONING
yields continue to provide attractive all-in compensation for
investors. Credit fundamentals have largely remained stable
as corporations prudently manage capital expenditures and
expansion plans while waiting for greater clarity on the tariff front.
messaging to the bond market. U.S. bank deregulation that is being
proposed would potentially improve liquidity in the bond market
and likely prevent volatility spikes such as the April episode earlier
this year.
The mid-part of the Canadian yield curve has outperformed year to
date as the government curve continues to steepen with investors
still cautious on how both the federal and provincial governments
will fund increasing deficits. Our portfolio positioning continues to
favour the short to medium term parts of the curve and higherquality credit. The longer end of the curve is increasingly screening
as attractive but until we receive more information on funding
plans by both the federal and provincial governments as well as the
broader economy, we maintain our current positioning.
Corporate new issue bond supply has been running in line with the
previous year’s volumes and there are likely no material changes
to the sales for the rest of the year, supported by the maturity
calendar which remains light into 2026 for both investment grade
and high yield. High yield borrowers have also managed to reduce
their refinancing burden this year and pushed back the maturity
wall into 2028. Refinancing costs have been trending lower this
year, mainly at the front- and mid-term maturities with the fiveyear average new coupon declining to the lowest levels since
2022. Long-term maturity coupons remain relatively elevated,
likely driven by inflation concerns.
Amid emerging concerns of an economic slowdown, and with
inflation apparently in check, the FOMC (Fed) shifted its focus to
the U.S. labour market and resumed its monetary policy easing
cycle in September. With the FOMC expecting the tariffs impact on
consumer prices to be relatively short-lived and a one-time shift
in the price level, the market anticipates that the Fed will cut rates
well into 2026. The impact of easing policy on the U.S. yield curve
is uncertain, given last year’s U.S. Treasuries selloff as the central
bank lowered rates. Nevertheless, history suggests that the yield
curve would tend to move lower during periods of easy monetary
policy.
The U.S. employment picture has notably shifted to the downside
with job growth hitting the weakest levels in two years. Inflationary
pressures have dissipated to a large extent as headline and core
measures of CPI, PCE and PPI are close to the lows of the last 24
months. The Fed shifting its focus to the other side of its
mandate to begin the next easing cycle is somewhat
understandable. As the U.S. tariffs impact fades, other economic
indicators may command more attention such as U.S. money
supply hitting new highs after bottoming in 2023 and financial
conditions as measured by the Chicago Fed that is at its loosest
since 2022.
This backdrop supports risky assets – including credit – that
are very close to or at all-time highs indicating that there is
likely no shortage of liquidity. Economic growth is still moving at a
healthy pace, with average Q3 projections calling for a ~1.7%
quarter-on-quarter annualized expansion (based on median
estimate among economists polled by Bloomberg). There is
no doubt that the labour market is flashing warning signs –
be it from a slowing economy and possible AI adoption –
and while there are still inflationary risks, the slowing growth
scenario is gaining traction.
One concern of the fixed income market remains U.S.
Treasury supply which remains steady, averaging around
$315-$325 billion per month over the last 12 months. After
a slight dip during 2022-23, new issuance has slowly risen
close to 2020 levels. The management in sovereign issuance is
generally supportive of stable rates and the U.S. administration
has been acutely aware of their
Much like their Canadian counterparts, U.S. credit fundamentals
remain stable, though historically at relatively weak levels.
Investment grade leverage was generally unchanged in Q2 with
interest coverage (EBIT-to-interest) falling marginally and holding
close to 2009 and 2020 levels. High yield metrics tell a similar story,
with leverage nudging lower last quarter while interest coverage
remains close to 2020 lows. So, it is not surprising that rating
agencies have been leaning to the pessimistic side on credit
this year. Rating downgrades have been outpacing upgrades as
upgrade-to-downgrade ratios have been stuck in negative territory
since 2023.
With no surprises in U.S. Treasury supply, the as-expected
corporate issuance and maturity calendar combined with “ok”
fundamentals, is proving to be the perfect formula for steady
demand for credit. Negative credit rating trends, however, keep the
downside scenario for corporates alive.
Fig. 2: U.S. Investment Grade & High Yield
spreads (OAS) back through long-term averages
1600
1200
Bps.
FOMC SHIFTING FOCUS TO EMPLOYMENT PICTURE WITH
BELIEF INFLATION MAY BE IN-CHECK WITH ONE-OFF IMPACT
OF TARIFFS
800
400
0
2002
2008
2014
US High Yield
US Investment Grade
2019
2025
Source: Bloomberg Finance LP, Scotia Wealth Management
Option adjusted spread (OAS) represented by Bloomberg
U.S. Corporate TR Index & Bloomberg U.S. High Yield Index
There is more room for lower rates across the curve generally as
U.S. yields likely peaked in May and are potentially set to revisit last
year’s lows. Following the short-lived selloff in April, the demand
for credit regained momentum throughout the summer, driving
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