Monthly commentary discusses recent developments across both the Diversified Bond Fund and Credit Income Opportunities Funds
2020 started on a bullish tone, with equities making new highs and credit rallying strongly. Economic data for December came in better than expected, with strong PMIs in the US and Europe stabilizing, albeit at low levels of activity. In short, the positive tone from late 2019 seemed to be at last vindicated. However, the Coronavirus epidemic that started late January and quickly spread through China has now put the cyclical recovery on pause.
The Chinese authorities have reacted promptly and forcefully to this threat, shutting down entire cities in the hope of controlling the spread of the virus. Unfortunately, we now know that the virus is transmissible even in patients that exhibit no symptoms at all, making it very difficult to stop its progression. This probably means that the containment efforts will last a lot longer than previous epidemics. The economic costs of these efforts will be important; the entire country is in a state of lockdown and several nations have announced travel restrictions to and from China. This has resulted in important supply chain disruptions, flights cancellations and store closings. For example, Starbucks and McDonalds have announced temporary restaurant closures in China, and Hyundai has suspended operation at a plant in South Korea for lack of parts coming from China. Because of the size and interconnectedness of China in the world economy, we should expect the economic impact of this virus to be global.
Initially, the market reaction to these events was as expected, with a risk off tone in credit and equities, and a flight to safety in government bonds. However, while the daily number of cases continues to grow (delaying a return to normal), we have seen a rapid snap back of risk assets to all time highs. While we are by no means infectious disease experts, it seems a bit early to celebrate victory. Government bonds are taking a more cautious approach., with both real and nominal yields drifting back to their August/September 2019 lows, appropriately reflecting the economic uncertainty stemming from the virus outbreak.
So, while the US/China trade deal and the monetary impulses of 2019 were starting to push global growth higher, we now find ourselves with the Coronavirus containment efforts gumming up the engine. We thus expect data for the first quarter of 2020 to come in weaker than was originally anticipated. No one know how long that weakness will last, but it certainly doesn’t feel like its all over already.
While credit spreads have widened modestly due to the Coronavirus fears, they remain near or at cycle lows. Figure 1 below shows credit spreads, normalized for duration, for US and Canadian BBB corporates; in the post crisis world, credit is at its most expensive point, completely ignoring the macroeconomic risks mentioned above. So, at the risk of sounding like a broken record, we do not feel like we are being properly compensated to take a lot of credit risk right now, so we prefer to stay up in quality and wait for a better entry point.
As discussed last month, the green shoots in the global economy led us to gradually reduce our government bond exposure (and duration). Of course, little did we know that the US would strike Iran and assassinate one of its leaders and that the Coronavirus would appear in China. Since then global rates have declined significantly, benefiting high duration exposure. While our duration was pared back ahead of these events, we still benefited somewhat from the rally in government bonds. Once it became apparent that the epidemic in China would have potentially grave economic consequences, we initiated a long position in US 30-year government bonds through the TLT ETF along with an option overlay. Given all the uncertainty, we think that exposure to government bonds in this manner offers a better risk/reward.
Astute readers will also notice that our allocation to investment grade corporate bonds increased to 73%, from 58% at year end 2019. This is primarily due to us redeploying the proceeds from the sale of our government bonds into short dated corporate bonds.
There were a few minor changes to the portfolio in January. First, several maturities at year end and proceeds from a commercial paper issue that was not rolled were reinvested into short term corporate bonds. Leverage also declined, as we took profits on some 2019Q4 new issues that performed particularly well in the past few months.
Second, we participated in a new private loan, taking our overall weight to this asset class to 4%, still well within our risk appetite. This new, one-year loan is to a small, public natural resource company. It carries an expected total return of 14% and is secured by substantially all the assets of the company.
This new year has already surprised everyone with geopolitics/war (Iran) and public health issues (Wuhan Coronavirus). With credit valuations as high as they currently are, staying defensive is an easier decision than usual.
Until next month,
The Bond Team: Mark, Etienne and Chris
1 All Ninepoint Diversified Bond Fund returns and fund details are a) based on Series F units; b) net of fees; c) annualized if period is greater than one year; d) as at January 31, 2020 1 All Ninepoint Credit Income Opportunities Fund returns and fund details are a) based on Class F units; b) net of fees; c) annualized if period is greater than one year; d) as at January 31, 2020.
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