Monthly Commentaries

“In the short run, the market is a voting machine,
but in the long run it is a weighing machine.”
Benjamin Graham

Although November marks the Day of Remembrance, for most credit managers it was a month they’d rather forget. To borrow an analogy from investment guru Ben Graham, Mr. Credit Market’s mood went from sour in October to rather ugly in November. Spreads on domestic BBB corporates (i.e. Rogers, Loblaws, Enbridge) were 25-35 bps higher over the month, preferred shares dropped 6%, and even the great Canadian banks saw their spreads move out over 10 bps.

Mr. Credit’s mood swings caused jitters, made some headlines and led to the Fund enduring its worst period of performance since inception. With that in mind, we decided to begin this month’s commentary with a broader look at the credit markets and our strategic approach to managing the portfolio going forward.

When most people hear about weakness in credit, their mind flashes back to 2008. The sheer magnitude and impact of the Global Financial Crisis left an indelible mark in our memories. And with no shortage of self-proclaimed pundits selling the ‘debt bubble end of the world’ story, fears of a repeat performance have been creeping into people’s minds.

While there are grains of truth to the ‘sky is falling’ claims, it is important to understand the assumptions and uncertainties of these predictions. The odds of a 2008 repeat are low, and a recession is not a foregone conclusion. Having said that, the expectation is for growth to decelerate, and a move from 4% GDP in the US to 2% will feel recessionary rough. Such a slowdown would lead to rating downgrades of investment grade issuers and defaults by riskier (i.e. high yield) borrowers. It would also test the structure and liquidity of credit markets. We think the greatest areas of concern lie in leveraged loans and the debt of lower quality high yield borrowers, who need the economic tide to continue to rise. To poorly paraphrase Warren Buffet, ‘you never know who is borrowing naked, until the economy weakens.’

On top of a slowdown, we have a backdrop of rising rates, the withdrawal of monetary stimulus, and an expansion that is long in the tooth. As these developments unfold, markets will continue to re-price assets and recalibrate return expectations. While the eventual magnitude and impact are unclear, what we can be certain of is an increase in volatility across asset classes.

For the past few years, volatility has been tempered with Mr. Market’s mood swings moderated by central bank ‘anti-depressants.’ But with the meds being taken away, he is left to navigate the changing world on his own. Throwing in wildcards such as Donald the ‘Tariff Man’ Trump, the China Syndrome, a Shakespearean Brexit tragedy, and the Italian opera, doesn’t help the withdrawal symptoms.

While his mood swings can be nerve-wracking and test our patience, turbulent times create interesting opportunities. We look to capitalize on the strengths of our strategy and offer an interesting investment option amidst the uncertainty. As for overall positioning, we will remain focused on shorter-dated, high-quality securities where we feel the risk of default is de minimus. At present, the average maturity of our corporate positions is 1.7 years, the interest rate duration is 0.39, and the levered yield on the portfolio is around 6% (after funding costs).

By holding shorter-dated, liquid, investment grade names, we retain the flexibility to respond to both positive and negative shocks. Another advantage is that mark-to-market losses, while painful in the short term, are much easier to stomach when the recovery to par is within sight.

As always, we will remain dynamic in managing and hedging the portfolio’s exposure. In the longer term, we will be looking for the babies that get thrown out with the bathwater in the form of opportunities to buy good assets at fire sale prices. Thus, boosting prospective yields by taking incremental amounts of risk while maintaining a substantial margin of safety.

We do expect the ride to be bumpy but given the limited time to maturity and quality of securities in our portfolio, the key for us is to dig in and allow the bonds to do their job; to repay coupon and principal. As always with investing, the greatest advantage is often to play the long game, particularly when the rest of the world is reacting to volatility and caught-up in short-term thinking. As Warren Buffet says, “games are won by players who focus on the field, not by those whose eyes are glued to the scorecard.”

Credit

It appears that fixed income managers still need to raise cash, resulting in net selling pressure. Given the dramatic reduction in new issues in what is normally a very active period, the need to sell might be waning, but we have yet to see concrete signs of this is occurring.

Normally, December sees a significant reduction in trading volumes during the second half of the month and is usually blessed with spreads grinding tighter as new issue supply dwindles and dealer inventories shrink. Perhaps this will be the case this year. However, since the latter half of December is a poor time to trade, flows (even small ones) can have a disproportionate impact on prices. We will be watching carefully. After all, like the Bank of Canada, we are data dependent.

From a portfolio positioning standpoint, we will maintain a cautious stance until a catalyst emerges for a reversal. Certainly, substantive progress on China/US relations would be a good start. It is always difficult to time the markets, and given the tone, the widening in credit spreads could persist. But valuations are starting to look more attractive and indiscriminate selling results in mispricings and investment opportunities. Accordingly, we will continue to concentrate on shorter-dated paper and remain patient for opportunities to establish positions from both the long and short side.

Rates

Both the Bank of Canada and Federal Reserve have been raising interest rates for several months. As a result, rates are nearing the neutral interest rate range. Unfortunately, nobody, including central banks, knows precisely what that rate is. Instead, as is the case with hand grenades and horseshoes, ‘close enough’ is the order of the day. But even ‘close enough’ is difficult given the volatility in other asset classes and the vast unknowns introduced by geopolitical events.

Sovereign bond traders are struggling to figure out when and where the central banks pause. As an example, only six weeks ago, they expected three hikes by the Bank of Canada in 2019. Now they expect only one. If the US and China suddenly reach a trade agreement and end all tariffs, the betting odds can quickly shift back to three.

As discussed throughout the commentary, volatility is the new normal!

Regards,

The Algonquin Team

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“If you think your teacher is tough, wait until you get a boss. He doesn’t have tenure.”
Bill Gates

On the list of things not to lose, our jobs typically rank pretty high. That’s why, as our mothers encouraged us to, we come to work ready to do our best. But sometimes doing the ‘best’ job can put that very job at risk.

Politicians forgo pursuing a policy they deeply believe in because of re-election fears. Corporate executives bite their tongue as not to express an unpopular opinion in the boardroom. Doctors overprescribe and overtreat to appease patients and avoid backlash.

The bottom line is that we all have a boss, directly (org chart) or indirectly (voters, clients), and therefore, all run the risk of being fired. And in the world of investment management, where results are so easily quantifiable and trackable, portfolio managers certainly feel the heat. This pressure can exert undue influence on investment decisions and is a risk that is often neglected by investors.

Of the 200 institutional investors interviewed by the Centre for Applied Research, the majority cited career risk as the largest determinant in their decision-making process. With around half of them feeling their jobs would be in jeopardy after 18-24 months of underperformance. Thus in asset management, career risk comes from underperforming your benchmark or peers in the short-term.

And herein lies the portfolio manager’s dilemma. To generate excess returns, you have to be different. But the more you deviate from your peers, the more likely you’ll have periods of underperformance. Thus running the risk of having a potentially superior portfolio but no investors.

In his quantification of career risk, Joachim Klement (2014) concluded that with quarterly evaluation periods, even highly skilled managers risk being unduly terminated. And the best way for them to protect their jobs is to minimize deviation from benchmarks. Thus industry professionals are incentivized away from outperformance and towards herding, closet indexing, and short-termism.

But surely, this isn’t what clients want. Or is it? Modern corporate culture purports to encourage failure in the pursuit of greatness. But how often does the leader of an ambitious yet ultimately unsuccessful project get promoted? Similarly, the objective for investors and boards might be long-term outperformance, but their behaviour is usually more short-sighted. And while retail investors typically get a bad rep for chasing returns, institutional allocators don’t appear to be much better.

Goyal and Wahal (2008) examined 9,000 hiring and firing decisions made by pension funds. They concluded that these decisions were based on who out or underperformed during the previous three years. Only for the pension funds to see the fired managers generate greater returns than the hired ones over the next three years.

Similarly, Goetzman and Oster (2012) discovered that university endowments, much like the students of their institutions, are subject to peer pressure. They noticed allocations being adjusted to more closely reflect peer groups, particularly by those that had been underperforming.

So, from the top down, investors, allocators and money managers fear leaving the herd and failing unconventionally. Portfolio managers are scared that markets can stay irrational longer than they can keep their clients. And investors worry about missing out by exiting a good fund too quickly or sticking with a bad one for too long. These fears create a spiral of irrational expectations from the bosses being met with irrational behaviour from the employees.

But as with most relationships, the one of boss and employee can be mended with communication, understanding, and trust.

Transparent communication ensures everyone is on the same page and offers the client a more holistic understanding of the strategy and its risks. With this deeper understanding, the investor can move away from evaluating the fund solely based on short-term performance.

And with this greater communication and understanding comes trust. The clients can trust that the manager has their best interest at heart. And the manager can trust that the client won’t run for the hills at the first signs of underperformance. And they both can trust that their interests are aligned in the common pursuit of ‘long-term greed.’

The Fund

In technical terms, September was a mixed bag for credit markets. Canadian spreads were essentially flat with modest moves on either side of unchanged depending on issuers, ratings, and maturities. Meanwhile, US credit had a particularly strong month with spreads broadly tighter by 8 bps.

NAFTA concerns weighed on the domestic market, and new issue supply picked up relative to August as approximately $10 bn hit the primary market. New supply was weighted towards financials with the most notable (and highly anticipated) transaction being the first domestic bank “bail-in” bond. This new structure will replace legacy senior unsecured funding and applies to domestic systemically important banks (D-SIBs). RBC was the first out of the gate to issue bail-in debt bringing $2 bn to market at a spread of about 16 bps over legacy deposit notes (around the midpoint of expectations). RBC followed this up with USD 1.8 bn issued south of the border.

Other notable transactions were foreign issuers, Sysco (wholesale food distribution) and Aroundtown (German REIT), tapping the Canadian market. CIBC also launched Canada’s first Women in Leadership bond, with the proceeds of the transaction going to support companies committed to promoting gender-diversity at the executive and board level.

While the performance in domestic credit gave little to be excited about, the mixed moves did provide some trading opportunities. In particular, the fund benefited from exposure to legacy deposit notes en route to a 0.47% month. Given that Canadian bond and equity funds were down around 1% in September, we hope our bosses are happy.

Credit

As we head into the last quarter of the calendar year, the outlook for domestic credit is more positive than has been for several months. New issue supply should be manageable, and there is a significant amount of cash coming from bond maturities and coupon payments (particularly in December) to help provide extra demand. Furthermore, the resolution of NAFTA (now USMCA) will help calm some of the nerves that had been nagging the market.

Furthermore, the general environment supports risk taking.The US-China trade war is in full swing with few shots left to be fired until early next year, leaving the Brexit negotiation (or fumbling) and Italian budget process as the potential spoilers. The latter two issues are probably not significant near-term factors. Given the dissipating headwinds and slight tailwinds for corporate credit, we have taken the opportunity to selectively add exposure.

Rates

Rates continued their steady ascent as deflation continues to ebb. In recent years, the final quarter has not tended to be friendly to bondholders. It appears that trend may continue this year. The USMCA deal should seal another 25 bps rate hike by the Bank of Canada on October 24th, and increase the odds of further move in January 2019. The Federal Reserve is poised to hike in December as it continues the steady march towards neutrality.

We think that Federal Reserve Chairman Jerome Powell is going to make the US Treasury market a little more interesting by doing away with the ‘dot plot’ in the coming months. The ‘dot plot’ is essentially a poll of where Federal Reserve Governors expect the overnight rate to be over the next two years. The Federal Reserve started this process as a form of forward guidance to prevent bond traders from freaking out that quantitative easing had ended and that monetary accommodation was being withdrawn. Bank of Canada Governor Stephen Poloz did away with forward guidance early in his tenure because he said that it dampened ‘signals’ from the bond market. In other words, the Bank of Canada is very interested in understanding investor expectations on how growth and inflation are evolving. Forward guidance by central banks diminished this signal.

With the US overnight rate approaching ‘neutral,’ we think the Federal Reserve will drop forward guidance as it too will need a clear picture as to what market participants are thinking.

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“I like putting all my eggs in one basket and then watching the basket very carefully.”
Stanley Druckenmiller

Last month, we looked at the trend in wealth management of constructing more diverse portfolios as a means of risk reduction. We even drudged up Peter Lynch’s term, ‘diworsification,’ in reflecting on the risks of diversification for diversification’s sake.

This month we travel to the opposite end of the spectrum into the land of the concentrators. Its inhabitants include legendary investors such as Buffet, Soros, and Icahn, who through their words, actions, and performance espouse the virtues of highly concentrated portfolios.

But does the approach of holding fewer high-conviction positions belong only in the realms of the gods? Or are there paths to concentration that us mere mortals can follow?

Most people that venture down the concentrated route do so in search of higher returns. If you want to beat the market, you have to be different from it. The rationale for this particular method is that it’s better to invest in your top ten ideas than devoting any capital to number 57. Given the surplus of people scouring for value, there can’t be a lot of undervalued assets to be had. As such, capital should be devoted to a limited number of good opportunities. And with your eggs spread over fewer baskets, it’s easier to be a vigilant mother hen and watch over them closely.

The concentrators also argue that their approach serves to reduce risk. Taking a large position requires a certain level of confidence in the economic characteristics and prospects of the business. The assumption is that this necessitates and invokes a deeper level of due diligence and understanding of the investment. As such, the investor should also find it easier to remain steadfast through turbulent markets.

But therein lie the conditions. To be successful with this methodology, you not only need to be good at both security and business analysis but also have the right temperament and the time to devote to the investment process. The iconic money managers have spent decades honing the art of finding value and developing the fortitude to be ‘greedy when others are fearful’ (not to mention having a host of other advantages at their disposal).

Which returns us to our original question, is this the stuff of legends or does the thesis apply more broadly? Even if you have the right skills and temperament, do you have the time and energy? After all, even professional active managers struggle to select securities that outperform the market.

The authors of a working paper (Yeung et al.) provide us with a ray of optimism and perhaps a balanced approach to concentrated investing (unintended oxymoron). Based on the relative weights of positions in mutual funds, they created concentrated sub-portfolios of 5,10,15…30 stocks (representing the managers highest conviction picks). They found that the more concentrated the portfolio, the higher the volatility but also, the higher the returns and Sharpe ratios.

So perhaps the lesson for professionals is that they’re better off sticking to fewer positions and not diluting their performance. And as investors, we can consider allocating our portfolio across high conviction funds; therefore, receiving the benefits of concentration while diversifying across asset classes, strategies, and styles.

For the do-it-yourself investors who want more control on their big bets, there are another couple of diversification-concentration combos to consider. The first is to follow the conclusion of the Young et al. working paper and construct a portfolio of the high conviction positions of certain actively managed funds; using them as a subset of opportunities to consider.

The second method is for those who enjoy the sport of picking securities. A diversified portfolio augmented with a few large holdings. Taking on large positions if and only if (iff for the logic nerds) there is a deep understanding of the investment’s value and risks, and an expectation to achieve above market returns.

Although the legends would say there are no short-cuts in successful investing, it appears that the average person can enjoy some of the benefits of concentrated bets without making it their life’s work. The first question, of course, is whether it is your objective to outperform the market. Many investors are satisfied with market returns or lower performance for lower risk. But for those seeking higher growth, these hacks offer interesting options.

The Fund

After a relatively active July, August saw a return to more normal summer patterns with light issuance and thin trading volumes. Despite the low amount of new supply, the usual seasonal tightening was absent with domestic credit spreads unchanged over the month. South of the border, they followed up a powerful rally in July with weakness in August, with spreads wider by 5bps.

Weighing heavy on credit markets is the expectation of the looming fall issuance along with concerns about emerging markets (Turkey and Argentina in particular). The underperformer over the month was autos, with the main event being Moody’s downgrading Ford to Baa3 (one notch above high-yield) with a negative outlook. Ford 5y bonds widened 23bps on the news.

Of the $6.6bn in Canadian supply, the highlight deals were AT&T and BMO who managed to bring billion dollar plus deals into a quiet market. Both were generally priced well and were therefore well received. Several smaller deals (Crombie, Honda Canada, Daimler Canada) were also readily cleaned up.

With little in the way of trading opportunities, the bulk of the month’s 52bps return consisted of carry.

Credit

Fall is generally a busy period as the market comes to life after the summer doldrums. On the supply side, September will see a resumption of domestic new issuance. As for demand, bond maturities and coupon payments will inject around $31 bn of cash into the market this month. Furthermore, with US investors currently receptive to Canadian issuers (if not our autos and parts) domestic issuance might underwhelm.

It will be interesting to see whether supply expectations over or underwhelm, but the elephant in the fixed-income room is ‘bail-in’ debt. As of September 23rd, new senior debt issued by banks (formerly deposit notes) will be subject to conversion to equity under certain conditions. Countries around the world have been adopting similar structures to spare taxpayers from the burden of bailing out banks should another financial crisis develop. In Canada, the change will be limited to domestic systematically important banks (DSIB), i.e. CIBC, RBC etc.

The big debate is over how much the banks have to compensate bond-holders for the equity conversion risk. In the early summer, the rumour mill was angling for 10bps back of deposit notes (probably started by bank treasurers). Now there are whispers of 20bps wider (probably the prospective buyers). We believe there is a vested interested by the banking community for the first deal to succeed, so it will likely be priced attractively to draw in a wide array of buyers. Furthermore, we anticipate that banks will starve the market of supply to help ‘goose’ a new deal.

The elephant status of the new notes is due to banks being the largest issuers in the market, and as such, the spreads of many other borrowers are valued relative to deposit notes. It’s going to be very interesting to see where bail-in debt is priced in comparison to deposit notes and whether the pricing of other issuer curves will be affected.

At this point, the last Schedule A deposit note will be extinct on March 1st, 2028 (BMO), and we expect the existing paper to have some ‘collectors’ premium. We used any weakness during the summer to add to our positions but recognize that benefitting from legacy value is a long-term trade.

While the supply dynamics and the introduction of bail-in debt could dislocate the market and open up opportunities, we have to remain vigilant of the external backdrop with problems in Argentina and Turkey bubbling away, the prospects of a no-deal Brexit growing, and the expanding trade war being waged by the US.

The only certainty is that it will be a very interesting run into year end.

Rates

Despite the ‘Turkish currency delight,’ lack of a NAFTA deal, and high odds that the tariff battle with China would escalate, bond yields failed to break out of recent ranges. There was some excitement in Canada, as the yield differential between 5y and 30y bonds touched a scant 6bps (30y rates briefly dipped below 10y rates). A few pundits have made the rounds talking about the recession signalling power of an inverted yield curve. Central bankers, on the other hand, point out that quantitative easing might still be exerting undue influence on the curve, thereby making it more difficult to read ‘smoke signals.’ We are aligned with this view and would be much more concerned if 5y yields were to trade below 3-month T-Bills.

Looking ahead, the Federal Reserve is expected to hike 0.25% later this month, while the Bank of Canada is expected to follow suit in October. With the market having priced these in, we don’t see a reason for the recent trading range to break.

Regards,

The Algonquin Team

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“The idea of excessive diversification is madness.”
Charlie Munger

The route to creating and building wealth usually involves concentrated bets. Entrepreneurs notoriously put all their eggs (and often some borrowed ones) into a singular basket. Others pursue and accumulate riches through focusing their time, energy, and resources on a chosen career path. After all, it would be odd and perhaps disconcerting if your doctor also ran a successful law practice.

But when it comes to managing our accumulated wealth, more and more of us prefer the diversified approach. Over the past fifty years, the trend has been towards greater and greater diversity, as the average number of holdings in funds has steadily increased since the early 80’s.

The rationale behind spreading your eggs over several baskets is prudence (and to help sleep well at night). After all, any single investment or asset class could experience severe drawdowns. As Ray (A Man for All Seasons) Dalio once put it, over a lifetime ‘it’s almost certain that whatever you’re going to put your money in, there will come a day when you will lose fifty to seventy percent.’

But in our pursuit of risk reduction through diversification, have we become folly to ‘diworsification’?

The shift towards broader portfolios is attributed to Harry (‘diversification is the only free lunch’) Markowitz. His Noble Prize-winning Modern Portfolio Theory illustrated the risk mitigating benefits of constructing portfolios across various investments and provided a mathematical framework to do so. This elevated investing from individual security selection to holistic portfolio management, where the game becomes optimizing risks and returns.

Furthering the trend has been the proliferation of index funds. In and of themselves tools for diversification through broad market exposure. But beyond their direct intention, they have also had the knock-on effect of increasing the number of positions held by active managers. This is due to client and benchmarking pressures, which has increased the average number of holdings in active equity mutual funds to over 200 stocks. Given the benefits of diversification become negligible after 20-40 holdings, is this overkill?

The risks in over-diversification are compromising and confusing quality for quantity. In the compromise, an active manager’s skill and strategy become diluted to the point of producing broad market returns, leaving the investor paying for nothing. In the confusion, there can be a false sense of security in owning numerous positions even when they are highly correlated. Furthermore, as the number of securities in a portfolio grows, we risk not seeing the forest for the trees and spending too much time debating a 1% position than on the real drivers of success.

We are never fans of throwing babies out with the bathwater and are not arguing for the abandonment of diversification. After all, even giving all your money to Warren Buffet would have led to two 50% drawdowns in the past twenty years. But while a diversified approach might be appropriate given an investor’s objectives and risk tolerance, a more than superficial application of the concept is required.

Ultimately, the objective is maximizing return for a given level of risk, and while diversification is a means to this, it is not an end unto itself.

The Fund

It was the best of times, it was the worst of times. Ok, that’s a bit dramatic and not totally accurate, but July was a tale of two markets. After the worst start to a year in a decade, US credit saw the strongest monthly rally in two years. US investment-grade spreads tightened an impressive 15 bps driven by a slow down in issuance, renewed interest from Asian buyers, and very low dealer inventories.

Canadian credit marched to a different drummer as corporate bond spreads were mostly unchanged on the month. Although we also saw a reduction in new issues (approximately $7.5bn in July), dealer inventories remained high in the absence of meaningful investor demand following a very robust June supply ($12.7bn). This led to brief rallies being met with profit taking and ultimately produced an unremarkable month on this side of the border.

We didn’t alter the portfolio composition in a meaningful way, however, we did reduce some of the hedging positions which slightly improved the carry. Three-quarters of the month’s 0.46% return was from interest earned with active trading contributing the rest.

Credit

With the Canadian market still digesting the new supply from the first half of the year, the typical summer “grind” tighter did not materialize in July. But there are signs that it might just be delayed by a month: the issuance calendar should be light, dealer inventories are shrinking, and investor cash balances have increased.

Given these factors, it is possible that the domestic market plays a little catch-up to the US market. The challenge is balancing the appropriate risk posture into a seemingly more constructive near-term credit environment while recognizing that fall typically presents plenty of opportunities to add to credit through new issues. We have increased our exposure slightly as we believe that a ‘catch-up’ move is a reasonable probability, but are keeping a close eye on a host of percolating issues: tariffs, NAFTA, Brexit, Italy, Turkey, and interest rates to name a few.

Rates

As expected, the Bank of Canada (BoC) raised rates to 1.5% in response to surprisingly resilient economic growth. Headline inflation is well above 2%, and so far there is little sign that the headwinds of elevated house prices and NAFTA uncertainty are having a material negative impact on the economy. After having been in the camp of ‘one and done’ this year, we have shifted to thinking that the BoC raises again in 2018. A positive outcome on NAFTA probably seals another hike in the fall, and even if a deal has yet to be reached, the chances of a move remain high.

The shape of the yield curve continues to perplex everyone. The fact that you need little more than your fingers and toes to count the number of basis points between 2-year and 10-year rates has people worried that an inversion (long yields lower than short yields) and hence a recession is just around the corner. While this may be the case, the European Central Bank and Bank of Japan quantitative easing programs continue to exert significant influence on bond markets. When the Bank of Japan allowed 10-year yields to drift from 0 towards 10 bps, yields around the world also rose. It is quite possible that as these central banks throttle back on their buying that the curve takes on a more normal shape.

Regards,

The Algonquin Team

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“In football everything is complicated by the presence of the opposite team.”
Jean-Paul Sartre

As the calendar flips from June to July, it marks the midpoint of the year and the first weeks of summer (yeah). And while the temperatures in Toronto have warranted heat warnings, it’s a different type of fever that has been running through our office, that of the World Cup.

With the first of the semifinals set to kick off later today, we offer our version of a halftime report (minus the funky graphics and British accents). After the commercial break, we’ll look at the markets and fund performance over the past six months and our approach heading into the second half.

While the 21st FIFA World Cup has delivered many memorable moments, for credit traders, 2018 has so far been a year we’d rather forget. After a strong start out of the gates in January, Canadian investment grade spreads have widened 22bps taking them higher by 13bps on the year. South of the border, they are experiencing the worst first half to a year in over a decade (including 2008), with spreads now sitting at levels last seen 18 months ago.

Meanwhile, equities have traded in a 10% range, and at the end of June were modestly higher on the year. While much of the attention lately has been on interest rates, the Canadian 10y has traded in a normal 0.5% range and is close to unchanged from December. And after drifting higher from a starting point of 2.4%, the US 10y seems to have settled between 2.8% and 3%.

The disconnect and weakness in corporate debt appear foreboding, with a few folks fretting that a recession might be lurking around the corner. However, it is worthy to note that the moves in credit have not been violent but have been more of a steady leak wider. And while macro uncertainties have contributed to higher spreads, the main drivers appear to be technical, supply and demand factors.

With bankers and corporations keen to issue new bonds ahead of further rate increases and the ECB unwinding QE, the market has seen a heavy amount of supply. Domestic issuance is up year-over-year, and the pace in the US is close to 2017’s record-setting totals. Given the widespread perception that yields are heading higher, the demand for fixed income product has generally been lukewarm. As a result, new deals have been coming cheap and repricing secondary debt lower.

US tax reform has also sideswiped bond investors. Many companies invested their offshore holdings in short-dated corporate paper, which was sold to repatriate the cash. Furthermore, the usually reliable demand from Asian investors has slumped since the derivative market is not conducive to purchasing dollar-denominated debt on a currency hedged basis. This accumulation of factors has resulted in sloppy price action.

As for the fund’s performance, the 1.17% YTD doesn’t look so good on the halftime scoresheet, especially when measured against the annual 6% to 9% target. Prevailing market conditions meant the focus was more on keeping the ball out of our net than on scoring goals. The moves in credit led to losses, but defensive positioning and portfolio hedging mitigated the negative impact and preserved some of the carry and gains from active trading. The silver lining of wider spreads is greater compensation for credit exposure resulting in a higher yield on the portfolio going forward.

The natural question is whether we will try to engineer a ‘come from behind’ victory in the second half.

Unlike the beautiful game, where teams that fall behind take additional risks to stage a comeback, the score in portfolio management is cumulative. So, to determine if a change in tactics is warranted, we need to assess whether the investment environment will be different. Other than the potential for a lower amount of supply, the rhetoric around trade and the removal of monetary stimulus by central banks indicate a continuation of the choppy trading environment.

Accordingly, we will continue to play tight defence while looking for opportunities to counterattack and shift to offence again. Although scoring goals is more fun than defending your net, our experience has taught us the value of living to fight another day.

The Fund

Last month saw a continuation in the supply theme, with $ 14.5bn of Canadian issuance setting a June record. As usual, domestic and foreign banks were featured sellers. Also coming to market were TransCanada Pipelines and Hydro One, who both managed to issue sizeable 30-year deals. Keyera Corporation did an inaugural 10-year public deal, while Canadian Tire returned to the market after a ten year plus hiatus.

Despite the record-breaking volume, prices held up quite well until the last week of the month. Much like some teams that flubbed the ball during stoppage time, the market couldn’t hold as the ‘tariff chirping’ gave way to concrete actions. The result was a two to three basis point widening on the month, which cut into some of the return generated by carry and active trading, leaving the fund with a 0.26% gain.

Credit

Given one of the headwinds for credit has been the imbalance between supply and demand, a shift in this dynamic could offer spreads some stability and perhaps performance. And there are signs that the scales could be tilting back towards normal.

The repatriation related selling of US paper appears to have run its course, with elevated spread levels having attracted buyers to the front end. On the new supply front, the summer months should offer the markets some respite, with issuance typically light until labour day. Also, with the issuance of bail-in debt by domestic banks widely expected in the fall, there is speculation that the supply of deposit notes will be carefully managed to increase the receptiveness of investors for the new paper. An overall reduction in the amount of supply could lead to portfolio managers chipping away at dealer inventories and helping spreads to narrow.

The other key determinant will be how the macro picture unfolds, with the dominant themes being trade and the withdrawal of monetary stimulus. Given that the unpredictable nature of these factors could offset the positive technical developments in the corporate market, our game plan remains defensively opportunistic.

Rates

Bond traders had their hands full in June as the odds of the Bank of Canada hiking on July 11th waxed and waned. A few pockets of weak data sent the shorts scurrying for cover ahead of speeches by Governor Poloz and the release of the Business Outlook Survey. Given the barrage from the US administration about how ‘Canucks’ have been taking advantage of American workers, people feared that business investment and exports were heading over a cliff. Surprisingly the Survey revealed little weakness, as firms struggle to keep up with demand. As a result, the odds are around 85% that the Bank hikes rates 25bps on July 11th.

Governor Jerome Powell held his first FOMC meeting as chairman. The press release, as well as comments made in the press conference, suggest that the Federal Reserve is on track to raise rates two more times by Christmas. The European Central Bank also revealed how they intend to scale back their quantitative easing plans in the fall. Despite these rather ‘rate unfriendly’ developments, yields remain well off the highs for the year.

Regards,

The Algonquin Team

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“Politics is not the art of the possible.
It consists in choosing between the disastrous and the unpalatable.”
John Kenneth Galbraith

For centuries, Italian chefs and vintners have been serving up a wide array of culinary delights. However last week, it was their politicians adding some spice and flavour to the markets, leaving many investors with a case of indigestion.

Amidst the political uncertainty and fears of a Euro exit surfacing, Italian 2-year yields went from being negative in the middle of May to as high as 2.75% last Tuesday. The velocity of the move sparked flashbacks to the summer of 2011 and the Greek debt crisis, leading to negative ripples across global markets.

Untangling the developments out of Rome is like unwinding a bowl of spaghetti, and is a task that we do not claim to have successfully undertaken (it’s all Italian to us). But we thought a summary of the events and the backdrop would at least offer some vague insights into the situation.

On March 4th the Italians went to the polls, with an electorate not only despondent about failing to qualify for the world cup but also frustrated with their economic prospects. Contrary to global and European trends, Italy has seen weak economic growth, high unemployment, and declining house prices. On top of this, there have also been concerns over social cohesion and a rising tide of anti-migrant sentiment.

The result of the election was a hung parliament with the big winners being two populist parties. The anti-establishment Five Star Movement won the greatest proportion of the vote, 32%, with the far-right League tripling their share to just under 18%. Despite both parties appearing to support an ‘Italeave’ from Europe, Italian bond yields declined, and equities rose in the months that followed. That was until May.

On May 21st, after over two months of limbo and negotiations, the two parties proposed the relatively unknown law professor Giuseppe Conte as the Prime Minister of their coalition. But after President Sergio Mattarella vetoed their nomination of Paolo Savona for finance minister, a known Eurosceptic, Conte and the coalition abandoned their mandate to form a government. Consequently, this ignited fears of a July election that would act as a proxy referendum for exiting the EU and in which the populist parties were expected to strengthen their foothold.

These developments led to a quick repricing of Italian bonds, a country that ranks third globally in most outstanding debt after only the US and Japan. In the case of the Greek crisis, interest rates rose over 20% in 2011, so relatively speaking this was a modest move. Perhaps it was just an overdue repricing of risk or a cautionary signal to the Italians of the path they were heading down. If it was a warning shot across the bow, it appears to have worked.

Only a few days after the President installed Carlo Cottarelli, former director of the IMF, as the caretaker Prime Minister, the coalition formed a government with Conte as PM. The Five Star Movement and League also walked back rhetoric of leaving the single currency and shifted towards negotiating changes to EU rules and regulations. These moves calmed investors and took two-year rates to just above 1.5% (as we write).

With Germany and Brussels likely to play hardball, the stage is set for a long game of political back and forth. The diplomatic dance will continue to add spice to the markets, as people react to the latest developments. And as is so often the case in such affairs, the outlook is murky with the chance of some unexpected twists, or in other words, ‘cloudy with a chance of meatballs.’

The Fund

For the first four weeks of the month, domestic credit experienced modest weakness, with the Fund tracking towards a small positive on the back of active trading and interest earned. But in the final few days of May, Canadian corporate spreads widened 5-10bps due to the political uncertainty in Italy and concerns over Trump’s steel tariffs.

Further exacerbating the move wider was $5.25 billion of issuance last week, taking the May total of new supply to over $11 billion. The concessions on the new deals were generous, but given the weak environment, rather than rallying, these bonds simply repriced existing debt wider. While higher spreads were seen across the board, bank subordinated bonds, auto finance, and “hybrid” securities underperformed.

The rapid widening turned what would have been a small gain for the month into a small loss of 25bps.

Credit

With the moves last week, the difference between corporate and government debt has increased by over 20bps since February. US credit is wider by roughly 22bps year-to-date, making it the worst start to a year since 2008. Whereas geopolitical events have contributed to the weakness, a slightly larger-than-expected supply of new issues hasn’t helped.

The pace of issuance generally declines in the summer, so there is a tendency to see credit perform (absent twitter or other geopolitical bombs). And while the decline has been orderly, a few pockets of value have opened up, creating some interesting investment opportunities.

Although the current environment remains a little volatile, the reward for taking credit risk has improved. Accordingly, we continue to proceed with caution while looking to take advantage of the dislocations that such markets generate.

Rates

In response to ‘the Italian Job,’ Canadian yields dropped 20 to 30bps lower. As some of the uncertainty ebbed, a portion of the move did reverse.

The Bank of Canada meeting, which was held in the midst of the mayhem, turned out to be a bit more interesting than expected. The press release was a touch more forceful about the need to raise interest rates in the coming months. As a result, the odds of a 25bps hike in July now sit around 75%.

South of the border, the good times continue to roll, keeping the Federal Reserve on track to raise rates again in June. At some point, it’s possible for worries about a more aggressive hiking path to roil the markets.

Across the Atlantic, speculation about when and how the European Central Bank will taper from their quantitative easing program is starting to build. As a result, the upward pressure on yields remains.

Regards,

The Algonquin Team

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“People change and forget to tell each other.”
Lillian Hellman

Ask any couple that has been together for a while, and they will tell you that relationships change. They go through phases, have their ups and downs, and experience shifts in dynamics. Through her neuroimaging research, Dr. Helen Fisher has even shown how our brain’s chemistry evolves through the various stages of love, from the intensity of initial attraction to the deeper bonds of attachment.

As far as relationships go, the star couple of most investment portfolios, the ‘Brangelina’ if you will, are bonds and equities or ‘Bequities.’ While they lack the glitz and glamour of Brad and Angelina, their relationship is a key driver of portfolio returns and should be central to asset allocation decisions. The trouble is, as with so many famous couples, theirs is a turbulent and often unpredictable affair, at times pulling in opposite directions and at others moving in tandem.

Last month, both partners made headlines as a rise in yields not only took fixed income lower but precipitated a sharp sell-off in equities. This was not only painful for investors but raised questions on the interplay between the two asset classes.

Over the past two decades, the expectation has been that fixed income would provide at least a partial offset to losses from equities. The assumption being that meddling on the part of central banks would prop up securities, in what became known as the ‘Fed Put.’ This has certainly been the case since 2009, with lower interest rates and monetary stimulus creating a honeymoon period with strong performance across risk assets. But it now appears that investors need to realize that the central bankers are ‘just not that into you,’ and that the correlation between stocks and bonds could be changing.

In trying to understand the dynamics of romantic relationships, the psychologist Robert Sternberg developed a triangular theory of love with the three components being intimacy, passion, and commitment. When it comes to the relationship between stocks and bonds, economists see the key drivers being valuations, inflation, unemployment, growth, and the level of interest rates.

Taking valuations as a starting point, there are concerns around the expensiveness of stocks, and given the low to rising yield environment, it is difficult to see much value in fixed income. Although it is far too early to call for ‘inflationary times,’ with unemployment near historic lows, strong global growth, and the potential for trade wars putting upward pressure on prices, there is the possibility that inflation surpasses current forecasts. All of this combines to create a difficult environment for the traditional beta portfolio.

So after almost a decade of being the investors’ darlings, with both of them performing well, the outlook for ‘Bequities’ isn’t so rosy. The return expectation for fixed income is flat to small negative, with the risk being that rates rise faster and higher than anticipated, turning the small negative into a large one. If this does happen, there is potential that an already jittery stock market follows suit on the downward path. Perhaps then it is time for this couple to consider following ‘Brangelina’ and start dating other asset classes.

The Fund

The markets seemed intent on solidifying February’s reputation as a miserable month. Credit gave back January’s performance and then some, with spreads widening 5 to 25 bps on the month. The recent outperformers such as bank subordinated debt (NVCC) and REITs were particularly hard hit. Generically, spreads are 2 to 3 bps wider YTD in Canada, and roughly 7 bps wider YTD in the US.

The initial damage resulted from the dramatic drop in equities, although when stocks recovered and stabilized (sort of), credit continued to leak wider under the weight of new supply. Despite the poor tone, issuers (perhaps concerned about rising rates) sold $9.6B in the primary market (2nd highest February issuance in history), with the vast majority coming at the tail end of the month. This led to the market being overfed in a short period of time, particularly as US bond funds/ETFs experienced large redemptions, forcing managers to liquidate holdings. We don’t believe Canadian managers are experiencing significant redemptions. However, the situation south of the border kept some people on the sidelines. The dynamic in the marketplace meant there was no place to hide, as even normally ‘safe’ short maturity bonds were pressured wider as well.

After January’s solid rally in credit, we had trimmed longer maturity positions preferring to concentrate in the two-year and under space. Throughout February we used pockets of liquidity to reduce risk further and add to hedging positions. Although we did not give back all of January’s gains, the fund was down 45bps this month.

Credit

Given the turmoil in the markets, any forward-looking views should be taken with a grain of salt, and we remain prepared to adapt to changing situations. Accordingly, we continue to maintain a more defensive and flexible posture but are mindful that volatility can create some interesting opportunities. With that in mind, there are a few particular developments that we are watching closely.

One of which is how well the flood of M&A related new issuance from CVS and Choice REIT is digested. Also, high on our radar are the inflows and outflows from bond funds and ETFs, which will determine the buying or selling pressure exerted by traditional asset managers. Furthermore, with the rise in interest rates the all-in yields of the 5y space have become particularly attractive, therefore, we are monitoring further term extension from the long only crowd, as they move from shorter to longer-dated securities.

As always, one eye must be kept on the chaos within the White House as protectionist threats at month-end led to another risk-off move. With equities already in a fragile state, we are hopeful to get a more rational direction in trade policy from the U.S. administration but remain cautious of the headline risk that can come from 4 am tweets.

Despite the negativity pervading the markets, higher credit spreads do not seem to be attributed to fears that a recession is looming. Instead, it appears that investors are reassessing valuations and are struggling to digest a deluge of issuance. The silver lining is that widening episodes set the conditions for better prospective returns either because carry improves or spreads narrow.

Rates

The big picture view remains the same. Global growth remains strong enough to prompt central banks to move away from monetary stimulus. The risk is that US yields move higher than most people expect. Fortunately, Canadian rates shouldn’t move as much. A potential creeping trade war with our largest trading partner, high personal debt levels, and an uncertain housing market will likely temper the Bank of Canada’s enthusiasm to pursue multiple rate hikes this year. The Federal Reserve will likely deliver three or four more hikes in 2018, while the Bank of Canada might just have one more left to do.

Regards,

The Algonquin Team

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“Gravity wants to bring me down.”
John Mayer

Since the Great Recession of 2008, interest rates, like early aviators, have had to contend with the power of gravity. But while the Wright Brothers were dealing with a natural physical force, the downward pressure exerted on bond yields has been an artificial phenomenon.

Through aggressively cutting overnight rates and the implementation of Quantitative Easing, central bankers have pushed interest rates to generational lows. But with global economies gaining rather than losing steam and few signs of faltering amidst the strength, the central banks are poised to reverse polarity.

If our memory of force diagrams from high school physics serves us correctly, by removing gravity and applying upward pressure, rates should rise. Even though investors and markets are expecting this, there is much uncertainty about the pace and magnitude of the rise, and the impact of removing stimulus.

Given that we broke our crystal ball and the countless paths interest rates could take, we prefer to focus on where we are and what we know to gain some insights into where we might be going.

From 2015 to 2017 the US, Europe, and Japan issued USD 3.77 trillion of debt. Over the same period, the Bank of Japan (BoJ) and European Central Bank (ECB) purchased USD 4.88 trillion of sovereign bonds. The sheer scale of the purchasing programs is believed to have lowered yields by more than 1%. While the BoJ will likely continue its buying, the ECB is expected to start scaling back later this year. The great unknown is what yields will investors require to shed other assets and fill the void left by the central banks.

Turning our attention to economic health, things are going very well south of the border. It is highly probable that the large dose of fiscal stimulus (tax reform and deregulation), delivered at a time of low unemployment (4.1%), will eventually translate into wage growth. In the near term, real GDP and inflation could reach 3% and 2% respectively. A 5% nominal GDP (compared to around 4% for the past decade) coupled with the government needing to fund a growing deficit by borrowing USD 200 billion more than last year, and it isn’t surprising that yields have been rising. Perhaps the biggest surprise is that the move hasn’t been larger.

The picture in Canada is a bit murkier due to concerns around the indebtedness of our fellow citizens and other potential headwinds for the economy. The Bank of Canada has responded to tremendous employment growth by raising rates 0.75% since July. On the surface, this may not seem like much, but some estimate that the increase in debt service costs will shave 0.7% off disposable income. With 60% of our domestic GPD coming from consumer spending, this could create a 0.4% drag on growth.

The hope is that exports and capital investment will pick up the slack. Although deals with Europe and Asia are positive for trade, the lack of clarity around NAFTA may hurt exports and capital spending. These factors won’t likely be powerful enough to alter the upward direction of Canadian rates but could limit the extent of the move or slow the pace of increase.

Further complicating the domestic interest rate outlook is the global nature of sovereign bond markets, with demand from international investors often determining the yields at which governments can finance debt. This means that interest rate moves in one part of the world can spill over to other jurisdictions. As long the government needs to access debt markets, their bonds will have to offer attractive yields relative to other countries, even if the preference is to keep rates low.

While we agree with Yogi Berra, that ‘it’s tough to make predictions, especially about the future,’ from what we know today, it does appear that interest rates are on an upward trajectory. But as early aviators discovered, the journey higher can take many different paths and often involves bouts of turbulence.

The Fund

On Friday, February 2nd, our Fund turned three years old, and like many new parents, we’re surprised at how the time has flown. As we have said before, it takes a village to raise a Fund, and we would like to mark this milestone by thanking all our ‘villagers’ for your tremendous support.

In January, credit markets zigged while bond and equity markets zagged. With interest rates moving higher the Canadian Universe Bond Index was down (0.8)%, the TSX dropped (1.36)%, but the momentum in credit continued as spreads tightened 8-9 bps. Corporate new issues started off slowly but picked up materially as the month progressed. These deals were very well received as the demand for corporate bonds remained extremely robust.

On top of the general performance in credit, the Fund benefitted from exposure to REITs and bank subordinated debt which outperformed other sectors. We did take some profits by trimming positions into the rally. We were also rewarded for having increased our floating rate note (FRN) holdings over the past several months, as rising rates saw demand for these securities pick up. We added to this exposure in January but are paying close attention to valuations on these offerings as the heightened demand for FRNs has tightened coupon spreads.

Through maintaining tight interest rate hedges and capitalizing on the performance in credit, the net result was a gain of 1.19% on the month.

Credit

All eyes are on the shaky equity markets, and this is certainly the near-term focus. Although credit markets have been more orderly, spreads are trading moderately wider. Sustained weakness in stocks should lead to further widening.

On a positive note, dealer inventories are currently on the lighter side (especially in the US), and the supply calendar looks very manageable. Also, volatile markets tend to reduce the propensity for dealers to bring new issues even though rising yields make them more attractive.

We continue to maintain a modest risk exposure, with positions concentrated in shorter-dated securities. We will be proceeding with great caution, looking for attractive opportunities, and remain prepared to increase our hedging activity if warranted.

Rates

The Bank of Canada raised the overnight rate 25bps and bond yields moved roughly 20bps higher in January. Neither the Bank of Canada nor the Federal Reserve meets in February. The bond bears should not care because both banks are on track to raise their respective overnight rates two or three more times this year.

Regards,

The Algonquin Team

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