Stronger long-term performance, fading fear around credit risk, and frustration with government-heavy portfolios are pushing institutional capital deeper into corporate bonds
If you were to ask Derek Brown, head of fixed income at Beutel, Goodman and Company to describe the current fixed income environment, he describes it as one that’s “more nuanced or trickier than usual.”
After all, rate cutting cycles are wrapping up in Canada and the US, and Europe has already stopped. And with credit spreads tight, investors are left collecting coupon income rather than benefiting from capital gains through spread compression or falling yields.
“From a fixed income standpoint, you're much more in a carry environment than you would be," he said, adding geopolitical risks, including CUSMA renegotiations over the summer and instability in the Middle East, could shift the picture fast.
"I'd rather take this subordination risk and get paid for that because I believe in this company, rather than the leverage risk or the bad business risk that that you get in some non-investment grade companies," Brown said.
The problem, however, is structural, Brown noted. Because hybrids sit below senior debt in the capital structure, rating agencies assign them non-investment grade ratings – even when the issuer carries an investment grade rating. For example, Bell Canada is rated triple B, but its subordinated debt drops to double B. That dividing line between investment grade and high yield creates a barrier that many institutions refuse to cross.
"Some people just can't buy that. They're not allowed to buy it or for whatever reason they're afraid of it. They have an older, a 1990s view of what high yield was. It's a very different market," he noted.
Brown argues that hybrid bonds sit in an awkward spot in institutional portfolios. While they’re typically considered to be corporate bonds, because they are subordinated, they are usually rated below investment grade even when the issuing company itself is investment grade.
That rating gap can distort pricing, because many institutional investors either can't buy them under mandate rules or still view anything outside investment grade through an outdated lens. He believes that leaves room for opportunity as investors can access debt issued by large, established companies with deep capital structures, even though the bonds are often treated more like riskier high yield paper.
He suggests this segment was neglected for years, although it has started to gain traction in Canada as more telecom and energy issuers have come to market.
He makes a similar point about municipal bonds, which he sees as another overlooked corner of fixed income. In many institutional setups, they fall between categories. They’re not corporate bonds, so credit teams might not spend much time on them, but they are also not provincial bonds or pure interest rate trades, so government bond teams may not prioritize them either.
That can lead to odd pricing, where a long-dated municipal bond offers yields similar to infrastructure or utility names that appear less secure on paper. For pension funds and institutional investors in particular, Brown sees municipals as worth closer attention because they tend to be long-dated, liquid, and issued in large size.
“From a strategy perspective, what we're seeing is more clients, specifically who have long liabilities, are looking at what's called a long universe, or long bond portfolio, which includes government bonds, Canadian government, Ontario, provincial bonds and corporates and they're tweaking that allocation more towards corporate bonds,” said Brown. “So instead of having one third of the allocation, it's going around 50 per cent corporates and 50 per cent governments, or even 70 per cent corporates and 30 per cent governments. We're seeing a lot more movement to the corporate side of things as people become a little more familiar and comfortable with the risks out there.”
To that end, Brown sees two main reasons institutional investors are leaning more toward corporate bonds than government debt.
The first is performance. Over time, the return gap has been large enough to force a rethink among pension plans and other long-term investors as the extra gains available in corporate credit no longer look marginal.
The second is because concern about corporate bond risk has faded. Brown underscored how the shock of 2022 was important because bonds failed to protect portfolios when equities sold off, pushing investors to demand more return from fixed income rather than treating it only as a defensive holding.
He also points to how Canadian corporate bonds have held up through repeated crises, from the global credit crisis and the oil collapse to COVID and the inflation spike. That track record has made investors more comfortable with the asset class.
Additionally, the market itself limits risk. Companies issuing 30-year corporate bonds tend to be large, established names in sectors such as telecoms, pipelines, and utilities, rather than speculative borrowers. Brown believes the move into corporate credit reflects both stronger long-term returns and a broader belief that the risks are more manageable than many institutions once thought.
Meanwhile, he suggests most pensions funds and institutional investors still carry too much government bond exposure relative to what their portfolios require. He doesn’t suggest chasing risk into private credit or speculative-grade names, but notes that investment grade credit, select double B paper, and hybrids all offer value that pension plans are leaving on the table.
"A lot of pension plans are overweight in fixed income on the government side, and they don't need to be," he said, adding timing ultimately matters as last month, credit spreads were near 20-year tights, which made the short-term return outlook for corporate credit weak.
Looking ahead, Brown favours conservative positioning and underweighting long credit, with flat credit curves and valuations stretched.
“You should be ensuring that you're getting that active management, whether it's interest rate management, whether it's curve management, whether it's credit management. So structurally hold more credit, but in the near term, be very conservative and be ready to go. We think spreads will be more attractive, I'd say in the next six to 12 months or so,” noted Brown.
