Ninepoint Fixed Income Strategy

Monthly commentary discusses recent developments across the Diversified Bond, Alternative Credit Opportunities and Credit Income Opportunities Funds.

In this commentary we are referencing US data because the availability of historical data is much more extensive, and the same analysis and conclusions can be drawn for Canada as well.

What a year it’s been so far; there is simply nowhere in fixed income or equities to hide; bond yields are up, credit spreads are wider and equities are now in bear market territory. Over the past 6 months, bond yields have marched higher at the fastest pace since 1994, resulting in significant mark-to-market losses for bond investors. Outside of the 1980s where Paul Volcker was fighting 15% US inflation, it is very rare for yields to move so rapidly or extensively. (Figure 1).

Of course, one could argue that, with US CPI Inflation at 8.6% in May, the comparison is certainly worth considering. The one caveat we would offer to this view is that Consumer Inflation Expectations are still modest versus what they were in the 1980s, following a decade of elevated inflation (Figure 2).

Looking more closely at consumer behavior, Figure 3 below shows the University of Michigan’s Survey on purchasing attitudes for large durable goods and vehicles. If households expected prices to keep marching higher, as they did in the 1980s when inflation expectations were unanchored, then the time series below wouldn’t be close to all time lows. In other words, yes inflation is problematic right now, but we are not seeing the kind of behavior that would lead to persistently escalating prices (wage/price spirals and frontloading of purchases in anticipation of higher prices).

From the perspective of Central Banks this is the whole point of this expeditious rate hike cycle: reduce inflation to make sure that long term inflation expectations do not get out of control!

The June FOMC meeting, where the Fed surprised the market with a leak to the press ahead of the formal meeting, resulted in a 75bp hike in addition to delivering a new set of forecasts and dot plots. While the Fed does not itself forecast recession over the coming months, the market narrative has quickly shifted to its inevitability. Contrasting the bond market pricing with the Fed’s own intentions is striking. While the Fed was, for most of 2021 and 2022, behind the curve (and market pricing) with regards to the path of rate hikes, we now find ourselves with a Fed that appears too aggressive vs. market expectations. In Figure 4 below, we show the realized (dark blue line) and expected (dotted line) Fed Funds Rate path from the start of the hiking cycle, along with two stars representing the median FOMC dot for December 2022 and 2023.

As discussed last month, the Fed is utterly focused on having a credible inflation fighting message, even though their policies have very little impact on many components of the headline inflation construct (food and energy), and that their tools works with a 6–18-month lag. So that explains their extreme hawkishness through their main messaging tool: the dot plot. We believe that, should inflation come down, the Fed would be happy to pivot to a less hawkish stance. But for the time being, they need to send a very strong message, and this latest dot plot does just that.

Interestingly, the market now expects the Fed to stop hiking below the 3.4% implied by the June FOMC dot plot, and while the Fed has communicated that it would keep hiking through 2023 (all the way to 3.75%), the bond market is now pricing a series of rate cuts starting in 2023.

We see two ways to interpret this shift in market pricing: either the Fed hikes us into a recession as they fight inflation and try to prevent inflation expectations from getting out of control, which then necessitates rates cuts down the line, or the Fed engineers a soft landing, where we avoid a recession, and they can loosen policy again.

The 1994 rate hike cycle is an interesting comparison to current times, since it is both the last time the Fed hiked as fast as it is now, and the only time in recent Fed history where they engineered such a soft landing. The 1994 hike path is shown in grey on Figure 4 above. Both the 1994 and 2022 (market implied) hiking cycles seem to peak after a 12-month period, followed by some rate cuts in the following year. In terms of magnitude, the total increase from start to finish in the Fed Funds Rate is quite similar (~3%). The main difference is the pace at which the market is currently expecting the Fed to hike, which is much faster than in the 1990s, and could bring unintended consequences for the economic backdrop.

Looking at leading economic indicators (Figure 5 below shows the US ISM Manufacturing PMI), the economy is clearly decelerating, following the sugar rush induced by the pandemic policy response. We have overlaid past US recessions in yellow in the chart below. Typically, the ISM goes through or bottoms around 40 during recessions, whereas mid-cycle slowdowns such as 2015-2016 or soft landings like 1994, stay between 45 and 50, mildly contractionary, but not enough to be classified as recessions. In reality, we won’t know the severity of the downturn until we get there, taking clues from financial conditions (rates, credit and equities) and the incoming economic data.

For now, market participants seem to have already made up their minds: we are heading into a recession. If that is the case, expect the yield curve to continue to flatten and then invert shortly (i.e. 5 to 30 year yields will go down while the front end will remain elevated). In this environment, we would expect credit spreads to keep drifting wider. At almost 170bps now at the index level, Canadian corporate spreads have already discounted a lot of bad news but based on prior recessions we should expect another 30bps of widening if a recession were to occur.

By contrast, if inflation does slow down materially this fall, allowing the Fed and BoC to walk back from their extremely hawkish stance, then the economy might slow enough to stop overheating, without having to go into a full-blown recession. Earlier this spring, this felt like the most likely outcome, given our expectation for a deceleration in goods inflation, which would have brought down core inflation (what central bankers tell us they care most about). But instead elevated and persistent headline inflation has brought forward the path of rate hikes to an unprecedented level, with the Fed and BoC now expected to hike by 75bps in July. As such, we now see the path to a soft-landing narrowing.

Over the past month, we have been busy making changes to the portfolios to help mitigate any potential adverse impacts. As we briefly discussed in our May commentary, we continue to high-grade the portfolios in numerous ways. Firstly, we have been able to slowly move out of more cyclical/consumer facing sectors into higher rated, more liquid sectors at very similar yields. For example, we have trimmed some REIT positions to move into Canadian bank positions. Secondly, when we deploy capital in the new issue market, we have focused on shorter maturities. As an example, we participated in the Home Trust new issue after gaining comfort with the company’s strategy and financials after we met the management team, the fact that it was a two-year bond was an added bonus. Lastly, we routinely ensure our positioning in lower rated credits remains prudent given the economic outlook. For example, our high yield exposure across all three funds is drastically skewed to the higher rated segments within the high yield complex (BB and BB+) and is focused on sectors that should do relatively well in a challenging macroeconomic environment (e.g., midstream and consumer staples).

Diversified Bond Fund (DBF)

As we did in May, we continue to trim our exposure to REIT/housing/consumer names to move into higher-rated banks at near flat yields. Additionally, we were able to sell our Shaw Communications bond to move into a Rogers Communication bond at a nearly flat yield. While most market participants believe Rogers’ acquisition of Shaw is likely to close, it is far from a slam dunk as numerous regulatory hurdles remain. The Rogers bond we purchased has a Special Mandatory Redemption (SMR) feature, meaning that if the deal fails to materialize by YE2022, Rogers is forced to buy back the bonds at $101, a large delta from where the bonds currently trade (~$93). To us, this risk/reward was very compelling. From a portfolio perspective, duration remains low at 2.4 years and the Yield-to-Maturity is now 6.6%.

Alternative Credit Opportunities Fund (NACO)

We executed very similar trades in NACO as we did in DBF. We trimmed REIT/housing/consumer names to purchase higher rated banks in addition to switching from Shaw to Rogers. We also participated in the Home Trust new issue after a robust meeting with the management team. A 5.317% coupon for a 2-year BBB rated bond with solid fundamentals was attractive to us. The portfolio’s duration remains unchanged from May month-end at 2 years while the Yield-to-Maturity ticked up 60bps to 8.9%.

Credit Income Opportunities Fund (Credit Ops)

We made similar portfolio moves in the Credit Ops as we did in DBF and NACO in terms of moving into higher rated, more liquid bonds. We also participated in the Home Trust new issue in this fund for the same reasons outlined in the NACO section. Duration remains essentially unchanged month-over-month at 1.4 years while the Yield-to-Maturity moved higher by 50bps vs May to 10.5%.

Conclusion

If we were to close the books on 2022 at the end of the first half, this would be the worst year on record for fixed income investors (ourselves included). The ICE US Broad Market Index is down over 11% year to date (Figure 6). As the yield or income is always a positive contributor (grey bars), this 11% decline is entirely due to higher interest rates and credit spreads (higher rates mean bond prices go down). While we have seen similar price declines in the past (1994 for example), the overall yield of the index was much higher then (~7% vs 1.7% when we entered 2022), providing investors with a larger cushion (the Index was “only” down 2% in 1994).

While the repricing of the bond market in the first half of 2022 has been excruciatingly painful, from this point onwards, the good news is, overall bond yields (and income) is much higher. At 3.6% (black horizontal line on Figure 6), the US bond index now generates more income than at any point since 2009 (except for a brief period in 2018). In Canada, the Corporate Bond Index is closer to 5%, again the highest level since 2009.

Bond total returns aren’t complicated its income plus price change. The higher the income, the bigger the negative price change required to end up with negative total return. Higher income (or yields) means more margin of safety for fixed income investors.

Its been a very long time since our funds have had this much yield and income, and while the return dynamics over the first half of the year will surely leave all of us with a lasting memory, we are optimistic about the future earning potential of our mandates (DBF, NACO, Credit Ops), which now yield 6.6%, 8.9% and 10.5% respectively.

Until next month,

Mark, Etienne & Nick
Ninepoint Partners