In a market where 'everything trades well', PICTON Investments’ Phil Mesman explains why bond investors need to get selective
Fixed income investors face a strange contradiction this year, according to PICTON Investments’ recent fixed income outlook. The economic backdrop looks solid, labour markets are stable, inflation is trending in the right direction, and central banks remain accommodative.
Yet Phil Mesman, portfolio manager and co-head of fixed income at PICTON Investments, sees trouble brewing beneath the surface.
“The backdrop looks really attractive for risky assets for fixed income, particularly corporate bonds. But the problem is everything trades so well,” said Mesman. “And so, valuation is one of the biggest challenges for fixed income investors. That’s why we’re focusing on three things this year. Supply, valuations and the third would be divergence.”
The supply issue stems from ballooning government deficits. As Meman explained, G20 deficits, which represent roughly 80 per cent of global government spending, have averaged 5.7 per cent of GDP since COVID compared to 3 per cent historically. That cumulative excess means enormous amounts of new debt need to find buyers and the same pressure is building in corporate investment-grade markets.
He frames this as a headwind for government bonds. Short-term yields should decline as central banks remain supportive, but the long end faces a different dynamic.
"You could see a continued steepening of the yield curve of longer dated government bond yields going higher and that's just to clear that excess supply that has to get financed in the bond market," he said.
When asked whether deficits could trigger genuine credit concerns for sovereign borrowers, Mesman takes a pragmatic view. While he expects some spread widening among lower-quality governments as fiscal pressures mount globally, he doesn't foresee a broader credit crisis.
After all, US Treasuries remain the benchmark against which all other bonds are measured, and the 10-year yield serves as the starting point for valuation across fixed income markets. His expectation is that yields will rise to absorb the excess supply, and if markets become disorderly, central banks retain the option to deploy balance sheet to calm things down.
But that intervention won't come pre-emptively. Rates would need to climb substantially higher before policymakers decide to step in, he said.
Mesman ties the fiscal deficit story back to a practical question - who will step up as the incremental buyer? That’s why he sees well-funded pension plans and evolving dynamics among life insurance companies creating a solid base of demand. Credit yields remain attractive by historical standards, and despite tight spreads, there's a persistent technical bid supporting the market.
He believes supply will ultimately get absorbed but it just may require higher yields to clear.
He doesn't claim to know when deficits might trigger genuine credit concerns for sovereign borrowers, but he expects an iterative process rather than a sudden break. Governments can adjust the pace of issuance, and the market provides feedback.
"I think we'll probably course correct long before you have a credit concern," he said, pointing to recent AI-related corporate issuance as an example, because when the bond market pushed back on volume and terms, issuers adjusted.
That’s why he expects a similar dynamic to play out with government debt.
Still, Mesman underscored why institutional investors need to pay close attention to duration - the measure of how sensitive a bond portfolio is to interest rate movements. According to Mesman, the math has shifted considerably over the past two decades, noting that twenty years ago, a typical Canadian investment-grade portfolio might have offered around 6 per cent yield with six years of duration, giving investors one unit of yield for each unit of duration risk. That provided a meaningful cushion against rate volatility.
Today, that ratio has dropped to roughly half a unit of yield per unit of duration. It shows that markets have evolved, pushing duration longer just to maintain yields at similar levels, he said.
“Being mindful of that is really important, I think, and it also creates a business case for having a hedged approach,” noted Mesman.
To that end, Mesman sees compelling reasons to favor shorter-duration bonds, recommending investors position portfolios around five years or less. That part of the curve still offers attractive yields while avoiding exposure to potential steepening at the long end.
It’s the ten-year and beyond that presents a more complicated picture. While falling policy rates might tempt investors to extend duration, Mesman argues the supply overhang and lingering inflation uncertainty create asymmetric risk. He underscored that beyond seven years, portfolios become increasingly vulnerable to yield curve steepening and when yields rise, bond prices fall. Without the threat of steepening, he concedes ten-year bonds would look appealing at current levels.
He describes the current setup as "a coupon clipping at best kind of market with potential spread widening given supply," he said. While that's not necessarily a bad outcome given attractive starting yields in investment grade and high yield, it means investors shouldn't expect gains from further spread compression, he noted.
On the long side, he favours event-driven opportunities where a bond might benefit from a specific catalyst, such as an early redemption tied to M&A activity or other corporate actions. This approach requires more creativity than simply buying and holding for yield.
The current environment also presents an unusual opportunity on the hedging front. With volatility suppressed and complacency widespread, options are cheap, making it inexpensive to protect portfolios against the two primary risks in fixed income: rate risk from rising interest rates and credit risk from widening spreads or corporate defaults.
For him, the key signal isn't the absolute level of yields but market psychology. Mesman emphasized the 5 per cent threshold on the US 10-year carries weight as the 200-year historical average, and he expects both bond and equity markets to become more sensitive as yields approach that level.
Ultimately, with valuations stretched across much of the market, Mesman argues investors need to be more selective in finding attractive risk-reward opportunities. He acknowledged his preferred hierarchy, noting corporate credit over government bonds, active management over passive strategies, and hedged exposure over unhedged positions - all while keeping duration at reasonable levels.
"Bonds don't matter until they do and when they do you want to listen," he said.
