Monthly Commentaries
Are You a Bad Loser? | January 2016
“I hate to lose more than I like to win.”
Larry Bird
If you were watching your stock portfolio closely last month, you were reminded of just how much losing hurts. Behavioural economists postulate that the pain from loss is twice the joy of gain. While the magnitude can vary between individuals and situations, it seems fair to conclude that losing sucks.
The danger of this pain is that our emotions can take over. So rather than join the ‘chicken little’ parade and rehash all the negative news, we thought it more useful to remind our readers of a couple of the psychological pitfalls associated with losses.
By our very nature humans are averse to losing. For our survival this makes sense. It is more prudent to be aware of threats than opportunities, to protect what one has than take risks to gain more. This feeling is accentuated by the recent sting of falling markets. This can lead us to passing up on opportunities with attractive risk/return profiles, as we overemphasize the prospects of further loss.
On the flip side, losses can make some of us more aggressive in taking risk. Consider the following two scenarios:
- Receive $900 for sure OR take a 90% chance to get $1000 and 10% chance of getting nothing
- Lose $900 for sure OR take a 90% chance to lose $1000 and 10% chance of losing nothing
Despite being mathematically equivalent, most people would take the $900 in the first scenario but gamble in the second. This is because when presented with the opportunity to recoup our losses, we become inclined to take risks that would otherwise be unacceptable to us.
The simple point is that our emotions can sway us to the extremes of becoming overly loss averse or aggressive, to miss opportunities or go chasing them. The important thing is to recognize these influences within ourselves. As whether markets go up or down, it is better to proceed rationally rather than emotionally.
The Fund
When we launched our fund last February, we could not have guessed how strange the journey would be. After three or four months of robust credit markets, things got ugly. For the last half of 2015, credit spreads steadily widened, especially punishing anyone who dared to own 30 year corporate debt.
With equities dropping 10% in the first two weeks of 2016, the trend to wider credit spreads continued unabated. The Fund’s gain in January can be attributed to continuing our December strategy of holding very short dated securities and capitalizing on a few active trades.
After avoiding the oil sector for most of last year, the recent dip in crude and the ensuing carnage in the bonds of many Canadian investment grade issuers means we will re-evaluate the risk/reward trade-off in these securities.
Credit
The negative sentiment of global markets and the drop in oil pervaded domestic credit markets, taking spreads wider through the month. Bank NVCC debt struggled in the difficult environment, widening +25bp through January, while the oil and gas sector continued to get pounded as crude dipped below $30bbl. JP Morgan’s decision not to call their C$ sub-debt caught investors off-guard with an instant $3 dollar drop in the bonds leaving a mark. We have avoided holding callable fixed/floater subordinated bonds from foreign issuers for precisely this reason.
2016 is off to an exceptionally slow start as far as Canadian bond supply is concerned. With just C$5bn issued so far out of an expected C$100bn this year, the market is well behind schedule. Hopefully deal flow picks-up in February, particularly as redemptions and delayed transactions force corporate issuers to market. In the US, the AB InBev (US$46bn) transaction was one of the largest of all-time, which by amusing comparison amounts to more than half of the total expected C$ corporate supply for the year.
Rates
Amidst the equity volatility and deteriorating economic prospects, Canadians were bracing themselves for another rate cut. The Bank of Canada decided not to lower rates, choosing instead to allow the weak loonie and promised fiscal stimulus some time to work. Given that the low dollar has yet to benefit the struggling manufacturing sector, we believe that additional monetary accommodation may be required, although one shouldn’t expect to see any action until after the federal budget.
South of the border, the next hike has been pushed out like a carrot on a stick. US 10yr yields are significantly lower than where they were around the December rate hike, so bond investors clearly disagree with the Fed’s improbable outlook of 4 hikes in 2016. That said, we believe that yields have overshot to the downside, and the risk now is that they snap sharply higher on the slightest bit of good news.
Regards,
The Algonquin Team
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Happy New Year? | December 2015
“It is always wise to look ahead, but difficult to look further than you can see.”
Winston Churchill
After a difficult 2015, which saw the TSX down over 11% and jokes of the northern peso surfacing, Canadians are undoubtedly hoping for a sweeter 16. While we are not in possession of a crystal ball, we believe that the year ahead will be a challenging one for investors.
The ulcer inducing volatility that characterized the second half of 2015 is likely to persist for several more months. The uncertainty surrounding the Chinese economy, the pace of rate hikes by the Federal Reserve, the path of commodity prices and the gnawing suspicion that global growth has somehow been permanently impaired will conspire to send equities see-sawing in all directions.
By comparison, the bond markets ought to remain awfully dull. The Federal Reserve will likely sneak in one or two more rate hikes if they can, while the Bank of Canada will fret over the price of oil as they deliberate on whether another rate cut or other unconventional stimulus is required.
Corporates will need to raise about the same amount of money in the bond market this year as they did in 2015. A wild card will be how much issuance banks do outside of Canada. If the banks choose to raise a significant amount abroad, it should be constructive for domestic credit spreads. The slide in equities and commodities will keep a lid on interest rates so fixed income funds ought to continue to see inflows, which could also be supportive for corporate bonds. That said, there doesn’t seem to be a catalyst for a significant narrowing of credit spreads in the near term.
As always, the future is unpredictable and successfully making decisions amidst uncertainty requires hard work, skill and bit of luck. We therefore wish all of you the best of luck for the New Year.
The Fund
Last January, we were preparing to give birth to our first fund. As with all new parents, the first year was full of new challenges, sleepless nights, plenty of learning and the occasional tears. That said, the transition from bachelor bank traders to parents of a fund was much smoother than anticipated. With many of the sell-side distractions removed, there was more time to watch trade flows unfold from a favourable vantage point. This enabled us to better identify and take advantage of superior risk/reward opportunities, leading to a return of 15.86% for the year. Furthermore, our relationships with the street and our knowledge of how the bond market operates proved particularly useful when navigating the treacherous waters of August and December.
All in all we are happy with our baby’s development and growth over the first year. As a team, we have put in a lot of hard work and had a lot of fun working together. We look forward to a lot more of the same, both the ups and the downs, but are obviously hoping for many more ups.
Market Notes
Like many other investors we noted that asset markets are now highly correlated. Global equity indices seem to move in lock-step (except for the damned TSX which only seemed to go down). Meanwhile bonds, which are supposed to offer diversification, also generally moved in the same direction as equities. We were pleased to see that on days that equities moved 1% to 2%, credit spreads would move in much smaller increments if they moved at all. This type of behaviour certainly supports our view that the fund offers investors excellent portfolio diversification advantages.
The other thing we noted was how frequently portfolio managers complained about the drop in bond market liquidity. Although there was much hand-wringing and moaning, there was precious little in terms of ideas on how to deal with it. Most of the comments seemed to be a form of nostalgia along the lines of, ‘in my day prices were reasonable and children respected their elders.’ Our view is that liquidity has changed and will continue to change. Asset managers must therefore alter their execution strategies. Those that find a new way to operate will be rewarded during difficult conditions, while those who cling to the past will likely generate sub-standard returns.
Looking Ahead
As wise investors have discovered, it is important to know what you don’t know. With that in mind, we are going to disappoint those looking for forecasts for the year ahead. What we do know, is that when the pendulum swings from despair to euphoria and back as fast as it is, that a myriad of opportunities are often unearthed. Accordingly, we go into 2016 optimistic, cautious and above all, ready.
Regards,
The Algonquin Team
There is no Free (Liquid) Lunch | November 2015
The topic du jour in the corporate bond world is liquidity, or more specifically the lack there of. Despite significant growth in the size of the market, it has become increasingly more difficult to buy and sell corporate bonds without moving prices.
Many are quick to point the finger at the Volcker Rule and Dodd-Frank and the restrictions they place on banks. Implicit in these theories is the assumption that prior to the new regulations, bond dealers were always willing to deploy capital to facilitate investors who want to buy or sell securities.
Seasoned investors who experienced the Asian financial crisis (1997), the Russian debt crisis (1998), the dot-com bubble (2000), the Great Recession (2008), and the European debt crisis (2011) might contest that point. In these times of stress, dealers were actively trying to reduce their inventories, making it easy to buy corporate debt but nearly impossible to sell without taking significant price concessions.
To understand why, it helps to take the perspective of the bank dealer. As with any business, the primary objective is to generate profits, with the difference being the dealer’s profits are subject to ‘mark-to-market’ accounting practices. Thus, during benign markets, when corporate spreads don’t move much, the bond desks are quite happy to provide liquidity in an effort to profit from the bid/offer spread. Furthermore, they are willing to hold inventory and earn the interest. In periods of stress, ‘mark-to-market’ losses make it difficult for traders to withstand large price drops, even though the odds of a default and incurring a permanent loss remains remote.
Taking into consideration the aforementioned crises, we feel that the liquidity provided by the banks has always been a mirage that is prone to evaporate under certain conditions. This is just the nature of liquidity, as the behavior of banks is both rational and acceptable for any profit seeking entity.
So what has been the impact of new regulation?
The increased cost of capital and compliance has curtailed some trading strategies and has reduced the bond dealer’s pain threshold. One response to these challenges has been to improve the quality and stability of the earnings by shifting from a pure liability driven trading model to one that incorporates more order based or agency trading. Furthermore, even in moderately stressed markets, those dealers carrying large inventories become highly motivated to sell quickly and mitigate losses. This rush to the exit can easily lead to further downward pressure on security prices and draw in other sellers as well.
Is it all doom and gloom? The optimists within us say there is always an opportunity in a problem.
The first step is acceptance. Liquidity has changed, and we must adapt to the new environment. A good start would be for investors to demand higher credit spreads for new issues (from all issuers) in order to compensate for the increased cost of trading. Given the recent widening of credit spreads, we believe this move is already afoot.
Also, as part of our process of acceptance, we need to understand that trading larger amounts of bonds will necessitate some flexibility and creativity. We cannot simply rely on dealers to be the sole providers of liquidity. Instead, investors themselves need to be a part of the solution.
Those with capital to allocate can work with the banks to step in whenever there is a motivated and time sensitive seller. In such cases the buyer is in a position to demand a healthy price concession. In the past, the yield on illiquid securities would compensate the dealers enough for them to use their balance sheet to hold them. In the current environment, they are more open to partnering with clients in unstable markets, creating interesting opportunities for investors to capitalize on.
The last part of acceptance is placing an increased emphasis on understanding the underlying liquidity of securities. Factors to consider include the number of investors who can own the security, whether a concentrated holding is controlled by one investor, the frequency with which the issuer accesses the market and the number of market makers active in the security. Using these and other variables, it is useful to group securities into buckets depending on the time required to liquidate in various market environments. In doing so, we can better match our liquidity needs.
So while the environment is new and the problems different, the old lessons still apply. Liquidity after all is like a taxi, never there when you truly need it. Regulatory changes have effectively reduced the number of taxis available, thus we must be more creative and thorough in our thinking. We must be careful to match our liquidity needs with the types of securities we invest in. And for those with patient capital or the ability to allocate to illiquid instruments, there can be interesting opportunities to explore and profit from.
Who’s Afraid of the Big, Bad Fed? | November 2015
“The luck of the third adventure is proverbial.”
Elizabeth Barrett Browning
After seven years at zero and nine years since the last hike, ‘Lady Janet of Brooklyn’ is poised to move interest rates higher tomorrow. Recent history suggests that the various asset classes ought to tremble with fear.
In 2013 when ‘Helicopter Ben’ Bernanke announced he would end his quantitative easing programs, the result was the ‘Taper Tantrum.’ Investors dumped their bonds, and equities slumped 7%. After a couple of months, people realized that the Federal Reserve was still a long time away from raising rates and promptly took bonds and stocks to higher prices.
Just this summer, Governor Yellen made it painfully clear that she felt the Fed would raise interest rates in 2015. That helped drag the TSX and S&P down by 10%. This time it took only a month or so for US stocks to recover handsomely, while the feculent TSX only managed to claw back a few percentage points.
In November it seemed as if everyone adopted the British WWII slogan, ‘Keep Calm and Carry On.’ Despite the odds of a hike at 80%, the shocking attack in Paris and rising tension between Russia and Turkey, the TSX, S&P and bond yields barely budged.
Perhaps investors have concluded that this is not their father’s tightening cycle with a series of successive rate hikes to come, and are confident that the Fed will be patient in their approach. Or perhaps, it’s just that the third time is a charm.
The Fund
With only $2.9B of new issue supply, and government bonds trading in a narrow range, we looked for active trading opportunities to generate returns beyond the carry component of the Fund. We took advantage of momentum as portfolio managers capitalized on the quiet market to add to their portfolios, and enjoyed solid returns from the telecom and REIT sectors, which had fallen heavily out-of-favour in the summer. Furthermore, our VW and ABS positions performed well enough for us to take our profits.
December is typically a good month for credit as the first two weeks are often busy with issuers trying to get deals out the door before things quiet down around year end. The result is that credit spreads normally narrow quite nicely. We remain cognizant that events could unfold differently this time, as people ponder the weakness in commodities, the removal of stimulus and a slowdown in China.
Credit
After several months of steady widening, Canadian investment grade credit spreads responded to the dearth of supply and generally performed in November. The BBB sector, which had been a laggard for most of the year, showed signs of life with REITs and telecoms leading the charge. Meanwhile, the bank NVCC sector continued to underperform as investors braced for potential supply after bank earnings season. By our calculations, the borrowing environment in the US market is attractive for Canadian banks, which means little in the way of bank deposit note supply in December.
On a regular basis, a variety of folks ask us about high yield bonds. Other than one position, which matures in nine weeks, we have avoided this market due to concerns over poor liquidity. Our conclusion is that the catastrophic destruction of wealth in commodity related debt poses contagion risk to other high yield sectors. As a result, we will continue to avoid this asset class for a while.
Rates
The Federal Reserve is largely expected to raise rates 25bps tomorrow. We believe the accompanying statement will be chock-full of ‘wait and see’ language as Ms. Yellen elaborates on what exactly she means by a ‘moderate pace’. Under this hawkish/dovish scenario, it shouldn’t be surprising to see bond yields dip post meeting. After a couple of days of bouncing around, the bond market ought to settle into a narrow range for the holidays.
The domestic economy continues to grapple with lower commodity prices. Despite a steady decline in the ‘loonie’, the export sector hasn’t given the economy a serious boost yet. Governor Poloz is undoubtedly weighing the need to add further stimulus, however he will likely be patient until the federal government unveils further details on their spending plans. Although the Federal Reserve will likely continue to hike in 2016, we believe the Canadian yield curve will remain anchored near current levels.
Regards,
The Algonquin Team
The Bulls Strike Back | October 2015
“Adventure. Excitement. A Jedi craves not these things.”Yoda
Not so long ago, in a galaxy not far, far away, equity markets shed more than 10% of their value. It was a period of great terror and despair. Investors lived in fear of a slowing global economy and the Empire unleashing their much dreaded weapon, the Fed rate hike.
But in the early days of autumn with the Fed unexpectedly turning dovish, and China and Europe reaffirming their commitments to further monetary stimulus, optimistic investors managed to regroup, force the ‘bears’ to retreat and take equities back to the levels from where they had fallen.
Easy it would be to get excited by this victory and the dramatic drop in market volatility, but as students of master Yoda, we exercise patience and prudence. After all, many of the factors prevalent in August remain the same. The Federal Reserve is once again poised to raise rates, China continues to grapple with the transition from being an export-lead to a market-based economy, and commodity prices are in a funk, which continues to exert a drag on domestic growth.
At the end of September we felt the market had priced in a significant amount of bad news. At current levels we feel greater prudence is in order, as we wouldn’t be surprised to see further volatility as sentiment waxes and wanes.
The Fund
The Fund had another strong month, although the path to success was not a particularly straight one. Early in the month we were caught off guard when BMO spooked the market with a C$600mm placement of 5-year rate reset preferred shares with a 5.85% coupon. The deal was extremely cheap, which sparked a dramatic widening of bank NVCC bonds. We were long TD NVCC bonds and decided to liquidate the position as the volatility of the securities became too great for our comfort. This position resulted in a loss of 35 bps for the fund.
Fortunately, our investment in VW C$ bonds more than offset this loss. A couple of days after the initial scandal was reported, we felt that VW bond prices had fallen too far. We purchased one and two year bonds which performed strongly in October. Gains on this position coupled with an improved tone in credit and a myriad of opportunities to trade actively contributed to a net return of +1.71%.
Credit
Although credit spreads continued to widen at the start of the month, once it became apparent that the new issue supply would be limited, market tone improved considerably. Liquidity generally improved as dealers felt more confident making markets in a calmer environment. Autos and Telco’s performed very well, while TransAlta (a name we consistently avoid) widened dramatically. Bank NVCC spreads were extremely volatile, widening 30 bps before staging an impressive rally to finish the month unchanged.
We continue to see reasonable value in corporate debt at current levels, especially since the potential for new issue supply remains fairly low. Given our concern regarding bouts of volatility, we prefer shorter dated notes over longer maturities bonds.
Rates
The Bank of Canada left the benchmark interest rate unchanged at 0.5% and revised growth and inflation forecasts lower. The C$30bn fiscal deficit the new Liberal majority government intends to run over the next three years should provide a modest dose of fiscal stimulus that reduces the need for an additional rate cut from the Bank of Canada. As a result, we expect short rates to drift slightly higher in the coming weeks as bond investors adjusts to a neutral central bank.
With respect to the US, the FOMC removed language from their October policy statement which pointed to a stable global economy as a precondition for hiking rates. Ms. Yellen and company are certainly setting the stage to raise rates in December. We expect the Fed to hike 25 bps in December, barring another bout of hysteria in the markets. That said, we believe the Fed will move very slowly and deliberately in 2016.
Regards,
The Algonquin Team
Every Day is Game Seven | September 2015
“You can observe a lot by just watching”Yogi Berra
What you observe depends on what you are watching. Those watching the Blue Jays were treated to a thrilling ride en route to their first American League Championship Series appearance in 22 years. Those watching their investment account balances and the markets in September experienced a different sort of thrill ride. After a terrible August, the end of the quarter brought its own set of challenges. While the turbulent markets and the Volkswagen scandal led to indigestion on the part of investors, they provided sensational headlines and plenty of fodder to lather up a bearish sentiment. Rather than add to the fear mongering, we thought it best to step back from the noise and look at the markets from a distance. With that in mind, we would like to share some observations that might suggest that the sky isn’t falling just yet.
Although oil traded violently, at times moving 8% in a day, it ultimately didn’t go anywhere and closed where it opened at around $45 per barrel, which may indicate that it has finally found a support level. Secondly, even though the TSX was down 4% on the month, it finished almost 2% higher than the lows of late August. Lastly, despite weaker economic data and a reluctant Fed, Canadian bond yields were virtually unchanged.
While these observations provide some perspective and perhaps comfort, they by no means suggest the worst is behind us. Rather, our read of the tea leaves is that the markets have justifiably priced in a substantial amount of negative information, and are likely to continue to move sideways until a clearer picture of the health of the global economy is formed. We’d like to see daily stock market moves of less than 0.5% before we can be comfortable that the worst of 2015 is behind us. In the meantime, perhaps the best course of action for long-term investors is not to watch the market. As history has shown, overreacting to noise and deviating from one’s plan rarely serves one’s investment objectives. And with the Blue Jays providing the thrills, it is easy to stay distracted.
The Fund
Even though spreads generally widened, there were decent opportunities to actively trade credit in September. We played an aggressive game, but instead of swinging for the fences, we choked up on the bat and looked to hit singles and doubles. In particular, Volkswagen’s debacle provided us with a unique occasion to trade their credit from both the short and long side. We also pounced on the solid tone in long dated utility and pipeline bonds, actively trading a couple of positions that contributed handsomely to September’s performance. These timely hits coupled with an effective defence lead to a +1.68% return for the month.
The old adage ‘you can’t win ball games without good defence’ is our mantra for October. The tone in credit markets remains weak, so caution is the order of the day.
Credit
After the dismal performance of credit spreads in August, we looked forward to a strong recovery in September. It turns out credit batted ‘five hundred’. Spreads did narrow early in the month in spite of a wall of supply, but reversed course as time wore on, closing modestly wider over the period. Contributing to the reversal were unanticipated events surrounding Molson’s and Volkswagen. To be fair to Molson’s, their bonds got sideswiped over the potential merger between AB InBev and SAB Miller, while Volkswagen got caught trying to steal a base.
While the month did see an increase in bond supply, new issues were priced with extreme concessions, which adversely affected secondary market spreads. As an example, we sold 8 year Bell Canada bonds at a credit spread of +188. Two days later, Bell announced a new 7 year bond at a spread of +195. By the end of the deal, the 8 year bonds we sold were trading around +205.
With a great deal of the year’s new issue supply out of the way, we expect that spreads will stabilize near current levels. Having said that, we do remain wary of the fragile tone in credit markets.
Rates
The fact that the Federal Reserve chose to keep rates unchanged was not a total surprise, however, the ‘dot plot’ revealed that one voting member felt that an ease into negative territory was warranted. This bombshell helped spark another kerfuffle in equity markets, resulting in Janet Yellen clarifying her stance on the matter. While she still foresees a rate hike in 2015, the market currently disagrees with that view and is pricing the odds of it happening at less than fifty percent. As far as the Bank of Canada is concerned, we don’t believe 3rd quarter GDP results will sway them one way or the other. It makes far more sense for the BOC to wait and see which party forms the next government and understand the impact of the fiscal policies they will pursue before making their next move. Our view is that the Bank of Canada will remain on hold, and that short end rates will drift slightly higher over the next six months.
Go Jays Go!
The Algonquin Team
One, Two, Three… | August 2015
“Everyone has a plan until they’ve been hit.”Joe Louis
Those that have seen Ronda Rousey fight (she won three UFC title defences in a combined total of 64 seconds) or have witnessed the ferocity in her eyes cannot fathom why anyone would be willing to step into the ring with her. We suspect many investors felt the same way about putting capital to work in August. The sheer magnitude of the moves and subsequent knee jerk reactions in stocks and bonds made it virtually impossible to navigate a sensible course without suffering a bit of bruising.
The heart of the matter lies squarely with perceptions surrounding the health of the Chinese economy. For as long as we can recall, few people have trusted China’s official economic statistics and have looked to other indicators such as commodity prices, electricity consumption and satellite imagery to get an objective sense of the nation’s economic health. When China devalued the Yuan, they caught the market by surprise and sparked fears that policymakers were beginning to panic about the true state of the economy, triggering a violent international sell off across financial assets.
The Fund
We anticipated that August would provide little in terms of active trading opportunities, so we decided to employ a bond trader’s version of the ‘rope-a-dope’ strategy that propelled Muhammad Ali to victory over George Foreman. We increased our holding of short-dated bonds with the belief that interest earned would exceed losses from credit widening. For the first two weeks, we slugged it out toe-to-toe with the market with the yield from the bonds offsetting the losses from the gradual widening in credit spreads. The turning point came when China devalued the Yuan. In the days that followed, we endured a relentless volley of head-shots as equities melted and the appetite for investment grade credit seemed to evaporate. The street had no interest in buying securities, and market makers dramatically lowered their bids in order to discourage further selling. Even the typically stable front end of the credit curve was hammered, leading to a modest loss for the fund this month (-0.25%). While we are greatly annoyed with ourselves for missing an opportunity to reduce our risk further, in a month where the TSX was down 4.2% and the Canada Universe Bond Index lost 1%, we won’t beat ourselves up too badly.
Looking ahead, we do think credit spreads at their current levels offer tremendous value for patient investors. Market dislocations often create a myriad of opportunities that can be exploited once volatility dissipates. We look forward to a very interesting September.
Credit
We had to look back to the fall of 2008 to find a period where credit spreads widened as violently as they did in August. The ‘triple B’ space has been in trouble since early summer as the unprecedented growth in supply pointed to the need to re-evaluate pricing, but the dramatic widening in higher rated credit spreads was rather surprising. We suspect that nervous fund managers preferred to increase their cash allocations and ended up selling whatever they could, not necessarily what they should. With bond dealers already full up to their eyeballs in ‘triple B’s’ and an effective buyers’ strike in place, accounts started selling bank paper and short-dated corporates. Volatile equity markets pressured dealers to reduce prices even further in order to avoid increasing their already bloated balance sheets.
While credit spreads are at extremely attractive levels, we remain wary as anxious issuers are lining up to borrow at the first available opportunity. In this environment, any new supply will require hefty concessions in order to whet the appetites of investors courageous enough to put money to work. That said, we intend to be very selective ourselves with respect to how and when we re-enter the ring.
Rates
We may be on the cusp of an extremely important change in global bond markets. Since 2003, China has engaged in an unprecedented accumulation of reserves, buying almost 4 trillion of foreign assets mostly in the form of bonds. This buying has essentially been a form of quantitative easing and has also been blamed as the cause of the ‘Greenspan Conundrum,’ as well as significantly contributing to the decline in real yields. Now that China has turned its attention to managing and defending its currency, it has started selling foreign assets. There are estimates suggesting that China sold 100 billion of US treasuries in August. Should China need to continue to defend its currency, we could see a prolonged trend where real yields continue to rise irrespective of actions by the Bank of Canada or the Federal Reserve.
On the topic of central banks, we think the Bank of Canada will be patient with rates. They will assess a few months of data to determine whether a weaker currency will offset weaker commodity prices. Furthermore, the various political parties have different fiscal plans which the Bank of Canada can only take into account after the federal election. Meanwhile, making a call on when the Federal Reserve will raise rates has become more difficult due to the volatility in stocks. We remain in the camp that ‘lift-off’ is a 2015 story, but acknowledge the Federal Reserve is not married to a particular start date, and will have little difficulty deferring a decision until the market settles down. At this point we see a 50% chance of the Federal Reserve hiking rates in September.
Out of the Frying Pan, Into the Fire | July 2015
“A good retreat is better than a bad stand.”Irish Proverb
To use a very technical term, the markets in July can be best described as ‘poopy’. As the Greek saga disappeared from the radar screen, the market shifted its focus to the ever puzzling Chinese stock market. For the most part, many markets managed to shrug off the volatility in China, concluding that an index which surged almost 100% in six months was probably due for a significant correction. Some pundits were keen to link the plunge in Chinese equities to the collapse in commodity prices, however, we note that commodities were struggling when the Shanghai index was rocketing higher. Our view is that the precipitous fall in the commodity complex has more to do with global supply and demand imbalances rather than with Chinese stocks. Whatever the causes may be, the effects were certainly felt at home, wreaking havoc on the TSX and Canadian dollar. In our space, domestic credit was uncharacteristically spooked. Typically, Canadian credit markets are resilient and it takes some sizeable external shocks to impact them. This time things are really different, as Canada managed to underperform most G7 markets due to concerns that recent economic weakness will persist. We worry that the underperformance will continue for quite some time.
The Fund
After taking a very defensive posture through June, we began July by investing in opportunities we had been monitoring and ramped up our market exposure anticipating the return of vibrant markets. Our enthusiasm quickly waned and midway through the month we beat a hasty retreat as tone and liquidity in the credit markets were dreadful. Although credit spreads widened 5 to 10 bps on the month, our active trading allowed us to generate good returns. While we believe that credit spreads are on the ‘cheapish’ side, we remain wary of committing too much capital in August as tone remains poor.
Credit
The post Greece enthusiasm brought out the issuers, and for a short while it appeared that the party had started once again. New issue concessions were generous which meant they performed reasonably well. We noted that only ‘A’ rated credits or better were able to come to market as the ‘BBB’ space still suffered from poor liquidity forcing these issuers to defer deals or issue in the US market. Throughout the month liquidity steadily worsened as dealer inventories continued to grow. We remain hopeful that August will bring a long pause to issuance which might settle the market as we wrap up the summer and head into fall. While we are maintaining a concentration in more liquid high quality names, we look to selectively add certain ‘BBB’ names in short-dated maturities. The challenge for August will be generate strong active trading returns, as bid-offer spreads continue to widen.
Rates
Canadian yields continued to drop all month as the Bank of Canada cut rates 25 bps in acknowledgement that the oil shock is going to have a longer impact. Currently, the market has priced in another 25 bps cut by year end. We also observed that the debate about quantitative easing has already begun. We feel that the Bank of Canada is still a long way from unleashing this weapon, and would only do so after another 25 bps cut and the use of ‘forward guidance’ is exhausted. At current yield levels, the market is vulnerable to any positive economic news. We suspect that better news is coming as it takes time for the non-commodity export sector to benefit from the weaker loonie which has depreciated approximately 13% since December 31st, the benefit of which will not be felt until early 2016.
The Federal Reserve set a fairly low bar for economic performance over the next six weeks in order to hike rates. It is clear to us that Governor Yellen is keen to raise rates this year (we still think September) so that she can avoid the risk of having to move aggressively in the future. The key will be wage growth. Since the Employment Cost Index was disappointing, the Federal Reserve needs to see good hourly earnings numbers on each of the next two payroll releases. We expect both the bond and equity markets to take the first few hikes in stride, meaning the risk of another ‘tantrum’ is likely a 2016 event.
Weather the Storm | June 2015
“The storm starts, when the drops start dropping. When the drops stop dropping then the storm starts stopping.”Dr. Suess
The Fund
June proved that when it rains, it pours. Investors not only endured heavy rainfall, but also some rather ugly investment returns. The former we will leave to the meteorologists to explain, the latter we attribute to the crisis in Greece and the insanity that is the Chinese stock market. For the month, the S&P/TSX was down 3.07% while the FTSE Canada Universe Bond Index lost 0.56% (so much for bonds providing diversification!). Over the same period, we generated a positive 0.25% return for our investors.
Heading into the month we were skeptical about the negotiations in Greece and apprehensive about the market’s ability to absorb the endless wave of bond supply. Accordingly we upgraded the quality of our holdings and reduced our outright core duration and credit risk as we moved into capital preservation mode.
With the endgame for Greece in sight, and credit cheapening back to levels seen in late fall, we are looking for buying opportunities. That said, we would like to see an improvement in liquidity before becoming particularly aggressive.
Credit
June was a challenging month for BBB sector credit spreads which widened 5 to 15 bps. Not only has there been a deluge of supply, but the downgrade of various Enbridge entities to BBB+ by S&P has resulted in institutional accounts selling BBB bonds to stay within their investment mandates. As a result, dealers who are increasingly reluctant to add to already bloated inventories, have cheapened their offerings and widened bid/offer spreads.
New issues have offered greater price concessions but fresh supply has simply tended to re-price existing bonds cheaper. We believe this is a sign that the current weakness could persist for some time. The market certainly needs several weeks of reduced supply in order to digest the issuance to date. Although we have adopted a defensive posture, with the portfolio invested in short maturity bonds, we anticipate increasing risk as we see interesting opportunities unfold.
Rates
Even though the now famous FOMC ‘Dot Plot’ suggests the Fed is likely to hike rates for the first time in nine years this September, the turmoil surrounding Greece has the US market struggling to decide where rates should be. While we anticipate a September hike, we recognize that the Fed will not hesitate to delay liftoff if the financial markets haven’t settled down by then.
In Canada, the commodity sector continues to exert a remarkable drag on GDP, while lower gasoline prices and a weaker loonie have yet to stimulate other parts of the economy. Following the negative April GDP print, it certainly looks as though the Canadian economy may contract for the second quarter in a row. From our humble office near the lake, we can almost hear the bank economists on Bay Street whispering the ‘R’ word. Following the advice of John Maynard Keynes “When my information changes, I alter my conclusions. What do you do, sir?” we are dropping our view that the Bank of Canada will not cut rates again this year. The odds certainly favour another cut as early as mid-July.
Who Broke the Bond Market? | May 7, 2015
Financial headlines are usually the domain of stocks and currencies, but lately it has been the bond markets that are making the news.
On April 17th, German 10 year bond yields hit a record low of 5 bps. A mere 20 days later, they touched 75bps. I can’t recall bond yields of any sort ever multiplying so rapidly. Over the same period, Canadian and U.S. 10yr bond yields have climbed 40bps.
Before panicking over the recent moves, one should consider the starting point. For the past six months, yields have trended lower as the bond market became enamoured with the idea that deflation was a significant risk. The herd managed to convince itself that lower oil prices would lead to negative CPI numbers, which would start a vicious cycle where consumers would stop buying things in hopes of lower prices in the future. The ECB poured fuel on the fire when they launched their quantitative easing program, confirming the existence of deflationary pressures.
This is where the ‘greater patsy’ trade erupted, as traders started buying bonds in order to sell them at much higher levels to the next ‘patsy’, namely the ECB. With a clearly identified buyer, investors even played the game in longer dated securities which have the greatest sensitivity to inflation. The whole purpose of QE is to raise inflation, so what in the world were 10 year German yields doing at 5 bps?
In the past few days, we saw positive inflation figures out of Europe which got people thinking that perhaps the ECB would stop QE early. With fears that the ‘patsy’ might leave the game, smart money started looking around for the next ‘greater fool’. With no one stepping up to play that role, the rout was on. Canadian and U.S. yields, which were dragged lower by the game in Europe, naturally got side-swiped in the reversal.
I don’t think this means we have started a meaningful move towards normal rates. The ECB for the time being remains committed to a €60 billion a month asset purchasing program through September 2016, which implies that the game of hot potato will at some point commence again. My guess is that point is close.
The take away from the recent move is that investors need to think carefully about the interest rate sensitivity in their portfolios. The volatility of the last 20 days hasn’t been kind to traditional asset classes. Imagine what a sustained move to more normal interest rates would do to your portfolio.
Firing on all Cylinders | May 2015
“I fear the Greeks, even when they bring gifts.”Virgil
The Fund
Along with the warmer and longer days that mark the beginning of patio season, May brought with it a host of challenges for investors to grapple with. The prospect of a Fed hike coupled with the volatility in European bond markets and the exasperating negotiations between Greece and its creditors caused jitters on both sides of the Atlantic. In light of these conditions, we cautiously allocated our capital and diligently controlled our overall exposures. This conservative approach placed more emphasis on our core carry and relative value strategies which performed faithfully, while ample active trading opportunities in both credit and rates contributed excess returns.
As we head into June, we can only hope to find closure on Greece. Given the time constraints and how little either side is willing to bend, the risk of an accident appears to have risen materially. In some ways, I think the best outcome could be for Greece to default and then let things play out as they may, since any agreement at this stage will merely kick the can further down the road as it has been so many times before. A default might put Greece onto a sustainable economic path. The uncertainty should be put to rest once and for all and not delayed any further. While the financial markets could become unglued in the short term, I think they would settle down in fairly short order as Greece’s odyssey draws to a close.
Credit
May saw the return of the ‘borrower’, with corporate new issue supply reaching $8.1 billion. After an onslaught of Canadian bank debt, it was good to see a more diverse array of issuers, including a $1 Billion US Maple deal. For the most part deals continued to be well received, however secondary market performance was not as strong as earlier in the year. We expect to see the recent pace of issuance extend into June as several companies are in the process of wrapping up roadshows, which generally culminate in deals being announced. We believe that institutions with vast distribution engines (banks) continue to see strong inflows into their fixed income funds and remain aggressive technical buyers, while smaller accounts are becoming more selective. With these factors in mind, we remain wary of a widening in credit driven by supply fatigue.
Rates
After sitting on the sidelines for the bond market sell-off in April, we couldn’t help ourselves and joined the party. We established a modest short position in rates, and took profits once the market hit our target levels.
The 0.6% drop in Canadian Q1 GDP was much weaker than anyone expected, sparking the market into pricing a healthy chance of a further rate cut. With commodity prices in a funk, and provincial tax hikes offsetting federal tax cuts, it is difficult to see how job creation will take hold in the short to medium term. Although I feel like “waffling”, I will stick to my original call that the Bank of Canada will remain on hold for the balance of the year.
US data has been uninspiring to say the least. The Q2 data hasn’t bounced back to the extent people were expecting after a lousy Q1. From what I can tell, US consumers are saving the windfall of lower gasoline prices rather than spending it. Despite seemingly lacklustre numbers, I believe the US economy is on a good track which means that a Fed Funds rate of nearly zero is no longer warranted. I still expect the first hike to come in September with subsequent increases coming at a slow pace.
The Pause that Refreshes | April 2015
“Luck is a matter of preparation meeting opportunity”Lucius Annaeus Seneca
The Fund
Coca-Cola used the slogan “the pause that refreshes” to sell Coke 85 years ago. Today, it serves to remind me that when pursuing a goal, it makes sense to pause every now and again to assess one’s progress. As fate would have it, we launched the Algonquin Debt Strategies Fund on the very day that Canadian 10yr bond yields hit their record lows at 1.23%. Buyers of Canadian 10yr bonds on February 2nd would be facing a capital loss of more than 3% at April month end. On the other hand, investors in the Algonquin Debt Strategies Fund have enjoyed a return in excess of 6% over the same period.
So, have we just been lucky? The environment into which we launched the Algonquin Debt Strategies Fund was no doubt favourable to our cause as credit spreads had widened significantly in the fall, new issue activity had been light, and investor pent up demand was ravenous. As Lucius Seneca pointed out 2000 years ago, one needs to be ready when opportunity knocks. In our case, the setting allowed us to utilize not only the trading skills we have honed as market makers over the years, but also the relationships we have fostered with sales people, traders and syndicate folks on Bay Street. So the answer to the question is both a resounding “yes” and a resounding “no.” While we were lucky to have a target rich environment, we had the skills and
knowledge to exploit it.
Credit
Even Usain Bolt must take a rest between sprints, so I wasn’t terribly surprised when after a record breaking Q1, Canadian bond supply fell below historical averages in April. The good news for investors was that this allowed for an orderly transition of recent issuance into stronger hands, resulting in modest spread performance in bank deposit notes, energy related bonds and across most of the REIT space. We maintained a light credit risk profile early in the month due to renewed tensions surrounding Greece’s negotiations with their creditors, and increased our risk once it was clear that the proverbial can had been firmly kicked into May. With the flood of new issues digested, I believe the market is ready for supply once more, and we have positioned the portfolio so that we can actively participate in any attractive primary deals that may come
along.
Rates
The economic data throughout the month did little to change our view that the Bank of Canada will not cut rates any further this year, and that the Federal Reserve will hike rates in September. We went into the April Bank of Canada meeting with a tactical outright short position in two year bonds, which were effectively priced for a 25bps cut at the time. We unwound the trade shortly afterwards for a profit as the front-end yields rose when the Bank of Canada kept rates unchanged. Over in Europe, we were surprised at how quickly the mood changed as the capitulation in German Bunds prompted a global sell-off in fixed income. I’m kicking myself for missing an opportunity to establish a short position further out on the yield curve. At least we maintained a well hedged portfolio throughout the downturn, so the only damage done was to my ego. That being said, the recent volatility in interest rates has been striking and at times even dangerous. From a capital preservation standpoint I see no harm in waiting patiently on the sidelines for the dust to clear. We will concentrate on our core credit strategies instead.