(Bloomberg) -- Franklin Templeton Canada’s fund managers are betting that the credit spreads rally in the country’s corporate bond market has little room to run, so bargains will surface in the coming months.

Risk premiums in the C$500 billion ($372 billion) market have tightened by almost 40 basis points since late October and are around 11 basis points from the level held before Russia invaded Ukraine, according to Bloomberg indexes. Yet the Canadian unit of the giant asset manager has reduced its exposure to corporate credit — mostly during the first half of 2022 — and has put cash into highly liquid provincial debt, short-term securities or US dollar offerings by industrial companies. 

That’s based on the expectation that spreads will widen later this year, said Adrienne Young, senior vice president and director of credit research at Franklin Templeton Canada. 

“Generally the market right now seems to be a little bit expensive to us,” Young said in an interview. “We anticipate that spreads will continue to tighten for a little while, but we think that the market has gotten ahead of itself.”

Instead of joining the rally at full steam, Franklin Templeton is monitoring metrics such as the yield gap between the US three-month bill over the 10-year Treasury, which is running at close to its biggest inversion since the 1980s - in what a several market observers see as an indicator of a looming recession.

“That’s pointing to a rather difficult recession in the US,” said Young. “And whatever recession they get in the US we’ll get it worse here,” due to factors such as the potential knock-on effects in Canada of the cooling of its housing markets in the wider economy, she said.

Read more: Hedge Fund That Dodged Pain Says Credit Still Too Expensive

The yield investors require to hold investment-grade corporate bonds in loonies were at 142 basis points over government securities on Monday, less than one basis point from the narrowest gap in almost 10 months touched on Friday, according to a Bloomberg index. They have been mostly tightening since late October as worries about a potentially harsh recession are easing amid stronger-than-expected economic data and slowing inflation, prompting swaps traders to bet on rate cuts in US and Canada as soon as late this year.

“It’s pricing in a pretty good probability of a modest recession or even a soft landing as compared to a bumpier landing with some surprises,” said Young, adding that the Franklin Templeton Canada’s remaining exposure to the loonie denominated corporate bond market is focused on recession resilient sectors such as telecoms.

Before deciding to significantly increase Franklin Templeton’s exposure to the Canadian dollar corporate bond market, Young is also tracking other indicators such as the yield gap between the different layers of credit quality, as well as the share of risk spreads within all-in yields of corporate bonds. Even as indicators such as the strong demand of the recent new issues show that there is still appetite for corporate bonds, the credit spreads rally could already be in a late phase.

“We fear that the economic risks of realized rate hikes haven’t been fully incorporated into valuations,” National Bank Financial analysts including Taylor Schleich and Warren Lovely wrote in a Feb 2 report. “We judge that tighter spreads are still ahead but much of the juice has already been squeezed.”

The extra yield between higher-rated investment grade over lower-rated high-grade corporate bonds is around 37 basis points compared to over 90 basis points in March 2020 when central banks cut rates and put asset purchase programs in place to shore up financial markets amid the Covid-19 crisis, according to Bloomberg indexes. Also in early 2020, credit spreads accounted as much as 79% of corporate bond yields compared to around 30% currently. 

“When we begin to hear about the housing market in the summer and we begin to understand that pivot is not quite as likely as the market currently prices in, I think if we’re right on that, spreads will begin to widen out again,” said Young. “And that’s what I’m holding fire for.”

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