“Cry havoc, and let slip the dogs of war.” Marc Anthony (Shakespeare)
Every war has costs: the casualties of battle, the broken eggs required to make an omelette. Leaders must weigh these against the potential benefits and price of inaction. And once the war is waged, this cost/benefit analysis must be continuously recalibrated.
In their fight against inflation, central bankers aggressively hiked rates, knowing this would have negative consequences, intended and unintended. They were counting on restrictive policy inevitably leading to a weaker economy and labour market.
These costs were deemed necessary evils in pursuing low and stable inflation. But now, with CPI under 3%, the battleground appears to have shifted.
The costs of war.
So far, the costs of the war on inflation have been slower economic growth and a rise in unemployment. Over the past 18 months, the unemployment rates in Canada and the US have gone from 5% and 3.4% to 6.4% and 4.3%, respectively.
Central banks accepted this trade-off to avoid the perils of price increases getting ingrained. After all, persistently high inflation threatens economic stability and living standards for all.
Simply put, 6% inflation impacts almost everyone, whereas 6% unemployment affects around 6% of people. For the Trekkies, it is like Mr. Spock sacrificing himself because ‘the needs of the many outweigh the needs of the few.’
Assessing the damage.
But now that inflation is within striking distance of the 2% target, central bankers have the latitude to assess the fallout wrought by higher rates. Some of the damage is in the form of lower disposable cash for people and businesses, but a more significant concern is the fall in employment.
Current levels are not overly alarming, but the downward trend in job creation is causing concern. There is evidence that sharp increases in unemployment are a harbinger of recessions. Accordingly, central bankers seem to be shifting their focus from inflation to avoiding a hard landing.
The next battle.
At the recent Jackson Hole symposium, Federal Reserve (Fed) Chairman Powell acknowledged this shift, signalling that priorities have shifted from fighting inflation to protecting jobs. He went so far as to say that further cooling in the labour market would be ‘unwelcome.’
Thus, unless inflation reaccelerates and central bankers have to wage a war on two fronts, employment and economic growth will determine the path of the cutting cycle. As such, labour data will likely be the dominant driver of market volatility for the remainder of this year and into the next.
The Month of August
Credit.
Typically, August sees very little activity in corporate bonds. That was not the case this year. Several companies came to market with domestic issuance totalling an August record of $8.7 bn.
Enbridge ($1.8 bn) and SouthBow ($1.45 bn) did three tranche deals.
Hydro One, Capital Power, Telus, Smart Centres, Canadian Western Bank, Primaris, HomeEquity Bank, Volkswagon and Manulife rounded out the investment grade names.
A few high-yield issuers also tapped the market, as Chemtrade ($250 mm), ATS ($400 mm), and Surge Energy ($175 mm) completed successful transactions.
Demand remains robust for the new deals, but the supply volume and market volatility saw domestic credit spreads push modestly wider.
In other news, there was the potential acquisition of Seven Eleven by Couche Tard. If completed, this would lead to a significant increase in leverage and potential rating downgrade. Despite this, Couche Tard’s spread only widened 10 bps. From our perspective, this muted reaction underprices the downside risk in the credit.
Lastly, the long-awaited downgrade of Bell Canada to BBB-mid had no meaningful spread impact.
Investment grade credit spreads:
Canadian spreads widened 3 bps to 123 bps
US spreads were unchanged at 93 bps
Interest Rates.
After several months of speculation, the Fed acknowledged it was time to adjust interest rate policy, fueling a nice drop in yields. US treasuries are priced for 100 bps of rate cuts over the next three meetings, meaning investors expect at least one 50 bps move.
Although the Bank of Canada has already embarked on its rate-cutting cycle, the potential for aggressive moves south of the border prompted domestic bond traders to push short-end yields slightly lower.
Sovereign yields:
Canadian 2y finished at 3.33% (-12 bps), and the 10y at 3.16% (unchanged)
US 2y finished at 3.92% (-34 bps), and the 10y at 3.90% (-13 bps)
The Funds.
Algonquin Debt Strategies Fund.
The widening in domestic credit spreads was more than offset by the carry and active trading, leading to a slight gain over the month.
Portfolio Metrics:
6-8% yield
Average credit rating: A-
Average maturity: 3y
IR Duration: 1y
1M
3M
6M
YTD
1Y
3Y
5Y
SI
X Class
0.09%
2.04%
4.54%
7.81%
13.07%
5.64%
5.48%
8.30%
F Class
0.05%
1.76%
3.99%
6.95%
11.67%
4.78%
4.64%
NA
* As of August 31st , 2024
The Algonquin Debt Strategies Fund LP was launched on February 2, 2015. Returns are shown on ‘Series 1 X Founder’s Class’ since inception and for ‘Series 1 F Class’ since May 1st, 2016, and are based on NAVs in Canadian dollars as calculated by SGGG Fund Services Inc. net of all fees and expenses. For periods greater than one year, returns are annualized.
Algonquin Fixed Income 2.0
The returns earned through portfolio yield and rate positioning were enough to compensate for the sell-off in Canadian credit, leading to a monthly gain of 0.50%.
Portfolio Metrics:
6-7% yield
Average credit rating: A-
Average maturity: 3.5y
IR Duration: 2.6y
1M
3M
6M
YTD
1Y
2023
2022
2021
2020
F Class
0.50%
3.57%
5.07%
5.68%
10.93%
9.75%
-6.15%
2.42%
10.53%
* As of August 31st , 2024
Algonquin Fixed Income 2.0 Fund is an Alternative Mutual Fund and was launched on December 9, 2019. Returns are shown for Class F since inception and are based on NAVs in Canadian dollars as calculated by SGGG Fund Services Inc., net of all fees and expenses. Investors should read the Simpli?ed Prospectus, Annual Information Form, and Fund Facts Documents and consult their registered investment dealer before making an investment decision. Commissions, trailing commissions, management fees, and operating expenses all may be associated with mutual fund investments. An Alternative Mutual Fund is not guaranteed, its value changes frequently and its past performance is not indicative of future performance and may not be repeated. Payment of quarterly distributions is not guaranteed and paid at the discretion of the manager; therefore, it may vary from period to period and does not infer fund performance or rate of return.
Looking Ahead.
Corporate issuance has been robust so far this year. Fortunately, the tailwind of a cutting cycle has fueled a steady demand for bonds, allowing spreads to remain well contained. The window for issuance in the fall is a little smaller than usual, as we suspect most companies would prefer to avoid the period around the US election.
As such, September ought to be quite busy. The wild card is domestic supply from the banks, as raising debt in the US or Europe is cheaper. Given how much supply has already come, we expect new issue activity to be muted for the rest of the year. The lack of new deals should be another factor limiting how far credit spreads can widen.
Bond markets are now priced for the BoC to cut rates to 2.5-2.75% in 2025 and for the Fed to lower its policy rate to around 3%. While we cannot rule this out, there is scope for disappointment should economic growth accelerate and labour conditions improve.
Overall, we remain comfortable with the value in domestic credit spreads, but given the optimism in rate cuts, we are cautious with duration exposure.
An individual who, alone or together with a spouse, owns financial assets worth more than $1,000,000 before taxes but net of related liabilities or An individual, who alone or together with a spouse, has net assets of at least $5,000,000
An individual whose net income before taxes exceeded $200,000 in both of the last two years and who expects to maintain at least the same level of income this year or An individual whose net income before taxes, combined with that of a spouse, exceeded $300,000 in both of the last two years and who expects to maintain at least the same level of income this year
An individual who currently is, or once was, a registered adviser or dealer, other than a limited market dealer
Financial institutions
Governments and governmental agencies
Insurance companies
Pension funds
Registered charities
Certain mutual funds, pooled funds and managed accounts
Companies with net assets of at least $5,000,000
Persons or companies recognized by the OSC as an accredited investor
Shifting Battlegrounds| August 2024
Every war has costs: the casualties of battle, the broken eggs required to make an omelette. Leaders must weigh these against the potential benefits and price of inaction. And once the war is waged, this cost/benefit analysis must be continuously recalibrated.
In their fight against inflation, central bankers aggressively hiked rates, knowing this would have negative consequences, intended and unintended. They were counting on restrictive policy inevitably leading to a weaker economy and labour market.
These costs were deemed necessary evils in pursuing low and stable inflation. But now, with CPI under 3%, the battleground appears to have shifted.
The costs of war.
So far, the costs of the war on inflation have been slower economic growth and a rise in unemployment. Over the past 18 months, the unemployment rates in Canada and the US have gone from 5% and 3.4% to 6.4% and 4.3%, respectively.
Central banks accepted this trade-off to avoid the perils of price increases getting ingrained. After all, persistently high inflation threatens economic stability and living standards for all.
Simply put, 6% inflation impacts almost everyone, whereas 6% unemployment affects around 6% of people. For the Trekkies, it is like Mr. Spock sacrificing himself because ‘the needs of the many outweigh the needs of the few.’
Assessing the damage.
But now that inflation is within striking distance of the 2% target, central bankers have the latitude to assess the fallout wrought by higher rates. Some of the damage is in the form of lower disposable cash for people and businesses, but a more significant concern is the fall in employment.
Current levels are not overly alarming, but the downward trend in job creation is causing concern. There is evidence that sharp increases in unemployment are a harbinger of recessions. Accordingly, central bankers seem to be shifting their focus from inflation to avoiding a hard landing.
The next battle.
At the recent Jackson Hole symposium, Federal Reserve (Fed) Chairman Powell acknowledged this shift, signalling that priorities have shifted from fighting inflation to protecting jobs. He went so far as to say that further cooling in the labour market would be ‘unwelcome.’
Thus, unless inflation reaccelerates and central bankers have to wage a war on two fronts, employment and economic growth will determine the path of the cutting cycle. As such, labour data will likely be the dominant driver of market volatility for the remainder of this year and into the next.
The Month of August
Credit.
Typically, August sees very little activity in corporate bonds. That was not the case this year. Several companies came to market with domestic issuance totalling an August record of $8.7 bn.
Demand remains robust for the new deals, but the supply volume and market volatility saw domestic credit spreads push modestly wider.
In other news, there was the potential acquisition of Seven Eleven by Couche Tard. If completed, this would lead to a significant increase in leverage and potential rating downgrade. Despite this, Couche Tard’s spread only widened 10 bps. From our perspective, this muted reaction underprices the downside risk in the credit.
Lastly, the long-awaited downgrade of Bell Canada to BBB-mid had no meaningful spread impact.
Investment grade credit spreads:
Interest Rates.
After several months of speculation, the Fed acknowledged it was time to adjust interest rate policy, fueling a nice drop in yields. US treasuries are priced for 100 bps of rate cuts over the next three meetings, meaning investors expect at least one 50 bps move.
Although the Bank of Canada has already embarked on its rate-cutting cycle, the potential for aggressive moves south of the border prompted domestic bond traders to push short-end yields slightly lower.
Sovereign yields:
The Funds.
Algonquin Debt Strategies Fund.
The widening in domestic credit spreads was more than offset by the carry and active trading, leading to a slight gain over the month.
Portfolio Metrics:
* As of August 31st , 2024
The Algonquin Debt Strategies Fund LP was launched on February 2, 2015. Returns are shown on ‘Series 1 X Founder’s Class’ since inception and for ‘Series 1 F Class’ since May 1st, 2016, and are based on NAVs in Canadian dollars as calculated by SGGG Fund Services Inc. net of all fees and expenses. For periods greater than one year, returns are annualized.
Algonquin Fixed Income 2.0
The returns earned through portfolio yield and rate positioning were enough to compensate for the sell-off in Canadian credit, leading to a monthly gain of 0.50%.
Portfolio Metrics:
* As of August 31st , 2024
Algonquin Fixed Income 2.0 Fund is an Alternative Mutual Fund and was launched on December 9, 2019. Returns are shown for Class F since inception and are based on NAVs in Canadian dollars as calculated by SGGG Fund Services Inc., net of all fees and expenses. Investors should read the Simpli?ed Prospectus, Annual Information Form, and Fund Facts Documents and consult their registered investment dealer before making an investment decision. Commissions, trailing commissions, management fees, and operating expenses all may be associated with mutual fund investments. An Alternative Mutual Fund is not guaranteed, its value changes frequently and its past performance is not indicative of future performance and may not be repeated. Payment of quarterly distributions is not guaranteed and paid at the discretion of the manager; therefore, it may vary from period to period and does not infer fund performance or rate of return.
Looking Ahead.
Corporate issuance has been robust so far this year. Fortunately, the tailwind of a cutting cycle has fueled a steady demand for bonds, allowing spreads to remain well contained. The window for issuance in the fall is a little smaller than usual, as we suspect most companies would prefer to avoid the period around the US election.
As such, September ought to be quite busy. The wild card is domestic supply from the banks, as raising debt in the US or Europe is cheaper. Given how much supply has already come, we expect new issue activity to be muted for the rest of the year. The lack of new deals should be another factor limiting how far credit spreads can widen.
Bond markets are now priced for the BoC to cut rates to 2.5-2.75% in 2025 and for the Fed to lower its policy rate to around 3%. While we cannot rule this out, there is scope for disappointment should economic growth accelerate and labour conditions improve.
Overall, we remain comfortable with the value in domestic credit spreads, but given the optimism in rate cuts, we are cautious with duration exposure.
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