Ninepoint Fixed Income Strategy

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

Summary

• The Fed and BoC hiked rates in July, very possibly their last hikes for this cycle
• The labour market continues to slowly soften, reducing the pressure on Central Banks to do more
• A confluence of factors drove a large sell-off in long-term government bonds in July, we expect a reversal in the coming weeks
• Risk assets continue to behave as if a soft landing is the likely outcome. We aren’t convinced of this and continue to remain cautious in our positioning

Macro

As widely anticipated, the BoC and Fed both hiked interest rates at their July meetings. Messaging about future actions is becoming increasingly two-sided, trying to balance the risks of doing too much versus a bit more. This means that central banks are now data dependent; that is, stronger data means a slight upward adjustment to rates, and weaker data, for now, means they can hold rates steady. As we have said all along, given the recent experience with inflation, they will error on the side of caution, and wait for as long as possible before even considering rate cuts.

That leaves us playing a waiting game. We (and everyone else) continue to watch the data and hope it is heading in the right direction. For now, it is confirming a slowdown in economic activity, but not a recession. For example, global PMIs (Figure 1 below) are softening.

Manufacturing has been in a lull for the greater part of the year and is showing no sign of picking up. Services was on the bright side in early 2023 but has since also turned down. Geographically, Europe and China have been the weakest (e.g. recession in Germany, China on the verge of deflation), while spending in the services sector in the U.S. has continued to buck the trend surprising to the upside. Nonetheless, for the past several months, the trend has clearly shifted to a slowing global economy.

With regard to employment, things are also starting to normalize. In Canada, after reaching a cycle low of 4.9% in 2022, the unemployment rate is now at 5.5%, and we have seen net job losses in two of the past three employment reports. In the U.S., non-farm payrolls have surprised market expectations to the downside for the past few months, and past numbers have also been revised down. So overall, the fight against inflation seems to be in the last innings; goods prices are declining, shelter has stabilized, and now the labour market, the last piece of the inflation puzzle, is finally starting to cool down. That is why we are confident enough to suggest that both the Fed and BoC are pretty much done raising rates.

Now, the end of the rate hike cycle doesn’t necessarily mean the end of interest rate volatility. Towards the end of July and the first week of August, the global bond market, and particularly the U.S. treasury market, saw a lot of volatility. Obviously, the middle of summer isn’t the most liquid time of year or well attended, so price action tends to be a bit more volatile. Nonetheless, a ~40bps selloff in 10-year treasuries in about 2 weeks is noteworthy enough in itself. So, what happened?

First off, the Bank of Japan (BoJ) surprised markets by widening the band around their 10-year JGB yield curve control policy. Since last December, the BoJ held a hard cap of 50bps on 10-year government bonds. Recognizing the distortions created by such a policy, the new Governor was widely expected to make adjustments to this policy, but most expected those to be made later this year. In a surprise leak to the press, the BoJ widened the range all the way to 100bps, taking 10-year bond yield 15bps higher overnight and sending shockwaves around the world.

A few days later, the U.S. treasury released its estimate of future borrowing, raising the estimated deficit for 2023 by $300bn, much larger than expected, and then the next day announced large increases in expected issuance of 10 and 30-year bonds, further fuelling the selloff.

Finally, to top it off, Fitch, one of the major rating agencies, decided to downgrade the U.S. government’s rating from AAA to AA+. While it is no secret that the current U.S. fiscal situation is far from enviable (largest post-war budget deficit outside of recessions), the downgrade came as a surprise, and coupled with all the action of the previous few days, contributed further to the sell-off.

This most recent episode should serve as a reminder to fiscal authorities in the developed world that the pandemic is over, and unsustainable deficits, even in the world's reserve currency, can lead to rapidly increasing funding costs and financial instability. Following the pandemic and energy shock last year, government around the world have now exhausted their fiscal space. With the global economy softening, their ability to stimulate during the next downturn will be limited. As we have seen with the UK in October 2022 and the U.S. downgrade this year, the Bond Vigilantes are alive and well.

And while it certainly creates unwanted volatility, the price action of the past few weeks in global government bond markets is, in our view, overdone. Given the continued softness in global economic data and inflation, it is a matter of when, not if, global bond markets rally to reflect impending rate cuts.

Credit

Coming off a strong June, Canadian investment grade credit performed well last month. At the benchmark level, credit tightened 8 basis points and now hovers around the yearly tights, retracing all the widening following the U.S. regional banking stress in March. At this juncture, our credit exposure is concentrated in short term corporate bonds (average quality BBB, term to maturity under 3 years). As such, we expect our funds to be less sensitive to credit spreads. Subordinated bank bonds were the top performing sector in July which helped drive performance across the funds given our overweight exposure. We also trimmed some autos since they are the best performing sector year-to-date and screen quite rich on a relative value basis.

July issuance was light as expected given the summer slowdown, with many issuers in blackout periods prior to their Q2 earnings releases. Across all funds, we participated in the CIBC new issue given its short tenor, attractive coupon, and high credit quality. Broadly speaking, new issue concessions were fair, and all deals were very well absorbed by investors with strong books.

Ninepoint Diversified Bond Fund (DBF)

Given our macroeconomic outlook, the portfolio remains defensively positioned, while still offering a very attractive yield-to-maturity of 7.8%, down slightly from 8.0% as of June month-end. Duration moved down 0.1 years and now sits at 4.2 years. Additionally, spread duration continued to edge lower and ended the month at 1.7 years, a function of the inverse yield curve and our desire to insulate the portfolio from potentially wider credit spreads. In terms of liquidity, ~30% of the portfolio matures within the next 12 months. We expect our High Yield exposure to continue to gradually drift lower as our very short dated HY bonds mature. Our short position in HYG (used for credit hedging purposes) remains at our target of -5% (subtracting from duration and spread duration).

Ninepoint Alternative Credit Opportunities Fund (NACO)

Given our macroeconomic outlook, the portfolio remains defensively positioned but still offers a very attractive yield-to-maturity of 9.7% (down slightly from last month at 9.9%). Duration remained unchanged at 2.8 years month over month while leverage was also unchanged and conservatively sits at 0.7x. Expect duration to drift a little higher as we add to our TLT options position given the big back up in yields experienced recently. Spread duration edged slightly lower as we continue to find attractive retractions given the inverted yield curve. In terms of liquidity, ~30% of the portfolio matures within the next 12 months. Our short HYG position (used for credit hedging purposes) remains at our target of -10% (subtracting from duration and spread duration).

Ninepoint Credit Income Opportunities Fund (Credit Ops)

Given our macroeconomic outlook, the portfolio remains defensively positioned but still offers a very attractive yield-to-maturity of 10.5% (down slightly from last month at 10.8%). Duration edged slightly up over the month and now sits at 2.7 years while leverage remained unchanged conservatively sitting at 0.7x. Expect duration to drift a little higher as we add to our TLT options position given the big back up in yields experienced recently. Spread duration edged slightly lower as we continue to find attractive retractions given the inverted yield curve. In terms of liquidity, ~30% of the portfolio matures within the next 12 months. Our short HYG position (used for credit hedging purposes) remains at our target of 10% (subtracting from duration and spread duration).

Until next month, 

Mark, Etienne & Nick
Ninepoint Partners