Monthly commentary discusses recent developments across the Diversified Bond, Alternative Credit Opportunities and Credit Income Opportunities Funds.
What a difference a month makes. In January, risk assets were rallying on the back of the “peak inflation and interest rates” story, with odds of a soft landing seemingly higher and even rate cuts later this year. Then in February, we saw a complete unwind of the prior month’s narrative. Stronger than expected payrolls and revisions to inflation made it less likely in investors’ minds that we would achieve the 2% inflation target any time soon. Result: higher interest rates across the curve, weaker equities market, and no more expected rate cuts in the back half of 2023. Perhaps even a higher terminal rate (futures pricing currently show a peak of 5.5% Fed Funds Rate this summer).
As we discussed in last month’s commentary, the road back to 2% inflation will be long and treacherous. For the next several months, every monthly inflation release will be scrutinized for signs that all the categories are heading in the right direction. Similarly, payrolls and wage numbers will be analyzed for hints of a long-awaited deceleration. And as it always does, economic data will no doubt surprise us all, positively and negatively, shifting around the narrative on any given day. Unfortunately, this volatility in economic indicators will be reflected in the markets but may create interesting opportunities down the road.
Our role, as stewards of our clients’ savings, is to navigate these swings, keeping an eye on the big picture and position the portfolios appropriately. No one can perfectly time every swing in market sentiment, but one must aim to be directionally accurate.
So far, 2023 continues to be similar to last year, we have an overheating economy, demand is too high, supply must catch up, and central bankers are tapping the brakes to tamper demand and reduce inflation. As shown in Figure 1 below, this U.S. rate hike cycle has been the fastest and largest on record since the double-dip recession of the early 1980s. And with a further 50-75bps of tightening in the US, (we expect maybe 1 hike here in Canada if things do not slow down enough) this hike cycle will rival the Volker years at the Fed. Monetary policy has a history of working, it is simply a matter of time before demand finally wanes. And there hasn’t been much time since those rates hikes began.
Banks have started to reduce credit availability (Figure 2), another reliable signal that the economy will soften going forward. We chose to show lending standards for firms, but the same applies to almost all categories of loans, from commercial real estate to mortgages and cards. We are also seeing the same in Canada, but time series aren’t as long, so we prefer to show U.S. data for better historical perspective.
So, it is going to take time, and economic data releases will swing market narratives back and forth, but from our perspective the direction of travel remains clear: the economy will decelerate, and, if history is any guide, enter recession at some point in the foreseeable future. That is the only way to bring inflation back to target in a sustainable fashion.
To prepare our portfolios for the inevitability of a recession, we are increasing government bond duration, improving credit quality and liquidity, reducing our allocation to High Yield, and layering in credit hedges. All our funds have yields-to-maturity ranging from 7.3% to 10.5%, not a bad place to be invested going into recession.
Canadian credit continued to perform well in February, with the Bloomberg Barclays Canada Aggregate Index tightening by 5bps, far better than the 9bps of widening in the US. The resilient tone in Canadian credit can be attributed to strong inflows into fixed income, a relatively slow month for new issuance and still extremely attractive all-in yields. Turning to sector performance, higher-beta sectors outperformed (e.g. autos, REITs, subordinated bank debt), while lower-beta sectors were the underperformers (e.g. utilities, pipelines, and telcos). Credit curves continued to steepen as the demand for front-end corporate paper remains very strong given that is where investors find the highest all-in yields (i.e. courtesy of a deeply inverted government bond yield curve).
February was a relatively slow month in terms of new issues in Canada, especially when compared to prior years. For the deals that did come to market, the order books remained very healthy, despite very slim new issue concessions (i.e. issuers are not being asked to pay-up to get a new issue across the finish line).
We continue to opportunistically high-grade the portfolios by increasing credit quality, increasing liquidity, reducing term, moving into lower-priced bonds, and reducing high-yield exposure. We outline some examples of this below across the funds which should serve as a helpful reminder on our active management approach.
We increased our exposure to long Government of Canada bonds while adding upside option exposure to the TLT ETF (which tracks long-dated US Government bonds). As a result of this, our duration moved up to 4 years (from 3.5 years one month prior). We also continued to prudently reduce credit risk with the fund’s spread duration moving down 0.3 years to 2.7 years during the month. As of month-end, the portfolio’s yield-to maturity was 7.3% (up slightly from 7.2% in January).
To help showcase just one of the many opportunities we are unable to uncover, the following trade was executed this month. We sold a Laurentian Bank subordinated bond callable in 2027 at a $96 price to move into a Ford bond with a 2026 maturity. We liked this trade for numerous reasons including picking up 21bps in yield, taking out $7 in price, retracting term by one year while maintaining credit quality (both bonds are rated BB+). We continue to scour secondary markets to find opportunities like these.
We increased duration to 2.7 years, from 2.2 years one month ago, by adding upside option exposure to the TLT ETF (which tracks long-dated US Government bonds). We also brought our credit risk down, with spread duration now down to 6.2 years (from 6.6 years one month prior). Leverage was unchanged month-over-month at 1.0x which we feel comfortable with at this juncture.
We also took profits on a Metro 10-year bond as the spread compressed materially since the January 30, 2023 issue date. We also fully exited our position in 7-year Choice Properties as it materially tightened following the 10-year Choice Properties new issue. As a replacement, we moved into a National Bank subordinated bond callable in 2027, increasing yield and liquidity while also reducing term.
We increased duration in the portfolio to 2.8 years from 2.2 years one month ago via adding upside option exposure to the TLT ETF (which tracks long-dated US Government bonds). We also brought our credit risk down during the month with the funds spread duration now at 6.5 years (from 7.1 years one month prior). Leverage was unchanged month-over-month at 1.1x.
We executed numerous switch trades to take advantage of various market dislocations. For example, we sold a Penske bond maturing in December 2025 to buy a Wells Fargo bond maturing in May 2025. We moved into an A- credit from a BBB credit, picked 19bps in all-in yield, reduced price by $3 and reduced term by 0.5 years. We also sold a VW bond maturing in November 2025 to buy a Manulife bond callable in August 2024. We reduced term by over a year, picked up 30bps in yield, reduced price by ~$5 and moved into an A- credit from a BBB+ credit.
We believe having lower credit duration, higher government bond duration, better liquidity and credit hedges are the best way to prepare for the coming recession. You can expect us to continue to move in that direction. The good news is that all these defensive actions don’t sacrifice the funds’ yields, which still range from 7.3% to 10.5%.
Mark, Etienne & Nick
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 February 28, 2023 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 February 28, 2023. 1 All Ninepoint Alternative Credit 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 February 28, 2023.
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