Monthly Commentaries

“For every action, there is an equal and opposite reaction.”
Isaac Newton

The big, and perhaps most perplexing, question in fixed income land is: When will interest rates rise?

Unfortunately, we broke our crystal ball a few months back and will have to rely on economic theory and a bit of physics to unwrap the problem.

Theoretically speaking, rates should rise when the risk of lending money rises. When dealing with governments, the risk of default is typically assumed to be negligible (not a good assumption across the board – think Greece or Argentina). Accordingly, the focus tends to be on inflation. As such, prior to the economic meltdown of 2008, government yields generally traded one to two percent higher than expected inflation.

But over the past eight years this relationship has broken down. Today, government securities return less (sometimes far less) than inflation. One could argue that investors are so risk averse that they would rather lose purchasing power slowly than face potential capital losses in riskier assets. Others claim that we are in the grips of deflation and that bonds actually offer good value. Try telling that to anyone buying a home in Vancouver or Toronto, or to those who pay attention to their household bills.

So to answer the big question we must first ask, what’s keeping interest rates so low?

The simple answer is Central Banks. Through their quantitative easing programs (QE) they have been aggressively buying government securities in an effort to reduce long-term yields and spur the economy. As an example, the Bank of Japan (BoJ) owns a third of the government’s outstanding debt and continues to buy more. They, along with the Europeans, have driven rates into negative territory.

The impact of these purchasing programs is felt across the globe. In comparison to negative rates, Canadian and US bonds look very appealing. These relatively ‘juicy’ returns attract foreign buyers and apply downward pressure on domestic yields.

So what then will cause rates to rise?

Here we turn to physics for some help. All things being equal, if we remove a downward force on a stationary object, it will rise. If we were to remove gravity, we would float up and away. Since yields are being depressed by central bank buying, it stands to reason that when the buying ceases, rates should move higher.

In 2013 when the Fed revealed that they were going to scale back their purchase program, government yields shot up by half a percent in the aptly named ‘taper tantrum’. Should the European Central Bank (ECB) and BoJ end or curtail their operations, it wouldn’t be surprising to see similar and possibly even greater moves.

So while much is being made of the looming US interest rate hikes, we see this having little impact on the domestic bond market. Instead, if Canadians want to get an idea of when rates could be going higher, they should be looking east rather than south, searching for any signs that the ECB or BoJ are going to stop the QE gravy train.

The Fund

While credit spreads were generally unchanged over the month, the fund managed to capitalize on sector outperformance and generate yield from maintaining positions through the noise.

In anticipation that new issues from the energy sector would be well received, we purchased existing pipeline bonds in the secondary market. Inter Pipeline did a 7-year deal which was a riot. This led to a rally across the sector, creating a nice gain for the fund.

While the dust was settling in pipelines, our attention turned to insurance which had been a laggard for several months. Sun Life and Industrial Alliance did deals which performed well. Observing this behaviour, we opted to increase exposure to the sector and benefited as spreads tightened.

Active positioning and carry resulted in a gain of 1.01% for the fund in September.

Since Inception: 35.66%

Credit

With support from a lower than forecasted amount of supply, credit spreads performed well over the summer. But as with the autumn weather, the climate is looking a little less sunny and bright.

In addition to lingering concerns about the Fed and Trump gaining in the polls, another worry has emerged. Deutsche Bank is facing a significant fine from the US Department of Justice, putting the firm in a precarious position. A bank crisis of this magnitude would wreak havoc in global markets. For more on this please refer to our piece entitled Gesundheit.

Also, on the domestic front, bank dealers may be reluctant to significantly increase inventories ahead of the October 31st bank year end. As such, we think a medium risk posture with a fair degree of caution is justified at the moment.

Rates

Government yields moved in a fairly wide range throughout September, but finished little changed. Bond prices fell after the ECB failed to increase their quantitative easing program, but reversed course after the BoJ tweaked their program and the Fed opted not to hike rates. As discussed earlier, government bonds will continue to defy gravity for some time to come.

Surprisingly weak Canadian inflation data will keep the Bank of Canada on the sidelines, although the risk remains tilted towards further easing. With the US election weeks away, the Fed will say little and most certainly do nothing until a new president is selected.

Regards,
The Algonquin Team

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“A blindfolded monkey throwing darts at a newspaper’s financial pages
could select a portfolio that would do just as well as one selected by experts.”
Burton Malkiel – A Random Walk Down Wall Street

Whether they like it or not, every investment professional knows of the great dart-throwing chimp. The one that beats the experts at everything from picking stocks to forecasting geopolitical events. He is our punch line reminder that the future is unpredictable.

The difficulty with this predicament is that we are constantly required to make judgements about the future. Is this the right time to buy a house? Will we survive a five-hour plane ride with the kids? If I take the QEW will I get to my meeting on time?

While accurately predicting Toronto traffic is a fantasy, it would be nice to outperform a monkey with a dartboard.

So how can we make better forecasts?

This is the question that Dr. Philip Tetlock and the folks at the Good Judgement Project set out to answer. Through extensive tournaments, they were able to identify a group of ‘Superforecasters’ (also the name of Tetlock’s latest book). These individuals consistently outperformed intelligence experts, betting markets, the wisdom of the crowd, and yes, the chimp.

The good news is that they don’t have any special powers and we too can be Superforecasters. The bad news is the secret sauce is a rigorous approach and cognitive effort.

Their hard work begins by decomposing the problem into the ‘known’ and the ‘unknown’, fleshing out the blind spots, biases and assumptions. They then attack from the outside in, formulating an estimate with generic data and then making adjustments based on the particulars of the situation (not the other way around). This probability estimate is then updated with new developments, being careful not to either under or overreact to the information.

It is also worthy to note that their performance improved when they worked in teams where they were comfortable openly challenging each other’s assumptions and conclusions.

Overall the common thread to their accuracy was resisting the urge to jump to conclusions and balancing different, and even clashing, perspectives. And as with so many things, the best way to improve this skill is with loads of diligent practice, where successes and failures are critically analyzed.

Last but not least, it doesn’t hurt to have a bit of luck on your side. After all, each of us has been on the wrong side of chance at some point, and when dealing in probabilities with uncertainties, we can do with all the help we can get.

The Fund

We entered August expecting it to be a boring month in corporate bond markets. Instead, issuers sold $6.7 billion of new bonds in the domestic market and credit rallied strongly (round 1 to the chimp). But this was one of those times we were happy to be proven wrong. The increased activity created a larger set of opportunities. This combined with the good performance in credit spreads and the interest earned from our positions generated a strong return for a typically quiet month.

Credit

Nine times out of ten, we would lighten up on risk heading into Labour Day as September is traditionally a supply heavy month. This time, we have opted to maintain our current positions believing that some of the supply was pulled forward into August, and also because demand appears to be robust. Primary deals are so oversubscribed that very few people are happy with the allocations they have been receiving. As such, we feel there is a good deal of support underpinning credit spreads.

That is our base case, but there are several factors that could change that. September is typically a difficult month for equities. Also events such as the US election debates and meetings for the Federal Reserve, European Central Bank, Bank of England and Bank of Japan are potential sparks that could unsettle the markets.

Rates

Governor Yellen and company have served notice that further rate hikes are coming soon. The Federal Reserve doesn’t like to act close to an election date, meaning that the potential meetings for hiking rates are September 21st and December 14th. Our view is that December is the likely date as with the US election decided, the Federal Reserve will also have some clarity on the potential for fiscal stimulus.

Several months ago we forecasted a stronger Canadian economy by the middle of the year in response to the weak currency. Unfortunately, the response has been much more tepid than expected (round 2 to the chimp). That said, with the Federal Reserve poised to hike later this year, the currency ought to weaken further allowing the Bank of Canada to remain on hold for the balance of 2016.

Given the magnitude of bond buying by the European Central Bank, Bank of Japan and Bank of England, we predict longer term rates will remain fairly well anchored at current levels even if the Federal Reserve manages to hike the overnight rate twice in the fall (take that you damned dirty ape!).

Regards,
The Algonquin Team

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“Only the wisest and stupidest of men never change.”
Confucius

Graham and Dodd (two rather wise men) once referred to fixed income investing as ‘the negative art’. This is because unlike equities, with bonds the maximum upside is ‘fixed’. And it is the investor’s job to focus on the risk of loss, the negative, and decide if they are being adequately compensated for it.

As of this morning, the XBB Canada Bond ETF has a net yield of less than 1.5% a year. The effective duration of the underlying portfolio is 7.73 years. In English, this means that a 1% rise in rates could lead to an 8% loss. Rates might not be going higher anytime soon, but the risk/reward profile doesn’t seem to justify the investment.

While the wisest of investors may already have their ideal portfolio allocation for the current environment, the rest of us can make efforts not to be amongst the stupidest. The logical conclusion is therefore to consider change.

The natural question is if not bonds then what?

One option is to just allocate to stocks, REITs and preferred shares. The theory behind this approach is if you’re in it for the long run the volatility shouldn’t matter, and historically the equity premium has been worth it.

Some investors have elected to stick with fixed income but have shifted their focus to high yield, emerging market and private debt. Others have opted to increase their cash holdings. A high interest savings account pays you 0.75% and cash has inherent optionality. It can be deployed when opportunities present themselves.

We also live in a world full of choice. Just going to the grocery store can create decision anxiety. Similarly, there is a wide array of investment products outside of the traditional options. We recognize that our fund represents one of these alternatives but also acknowledge that there are many others to cater for all tastes.

So how does one select from the menu of options?

When deciding where to allocate, your choices should match your needs, objectives and ability to withstand loss. In the end, how you choose to adapt needs to work for you. The important thing is to adapt.

The Fund

Since Inception: 32.14%

After maintaining a light risk posture through June, our plan was to be a buyer of the post-Brexit dip. Although the dip was both shallower and shorter than anticipated, we were aggressive and managed to enter positions at attractive levels.

As the month wore on, we steadily increased our exposure, balancing the portfolio between both high quality and BBB credits. Of particular note was our position in subordinated Bank NVCC bonds, where we saw good value supported by strong technicals. The outperformance of these bonds along with the rest of our BBB exposure contributed significantly to the net return of 1.73% for the month.

Our plan for August is to slowly peel back risk in anticipation of robust issuance in the fall.

Credit

Credit spreads typically grind tighter over the summer as new issue supply is limited. After $11.5bn worth of issuance last month (largely bank paper), one is hardly justified using the term ‘limited’. Yet this supply was absorbed surprisingly quickly, and credit spreads did as they are supposed to in July and tightened across the spectrum. Lower rated/higher beta securities outperformed due to the preponderance of bank bonds.

Towards the end of the month, the rally stalled as a few portfolio managers decided to reduce exposure. They were either locking in gains or having flashbacks of last August when stocks decided to drop 10% in a matter of days. Barring an exogenous shock, spreads ought to remain stable for a few more weeks until people start to focus on the threat of new supply.

Rates

As Brexit fears receded, yields shifted slightly higher. With rumours of ‘helicopter’ money in Japan as well as further monetary stimulus by the ECB and BOE, bond markets ought to remain well supported. A few folks have suggested that the Fed could raise rates in September; an event we consider unlikely until December at the earliest. The Canadian economy continues to limp along, keeping the Bank of Canada patiently waiting (and perhaps praying) for the weaker currency and fiscal stimulus to boost hiring.

Regards,
The Algonquin Team

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“But apart from the sanitation, the medicine, education, wine, public order, irrigation, roads, the freshwater system and public health, what have the Romans ever done for us?”
Monty Python

After a century of watching countries declare their independence from them, the British decided it was their turn. With a vote to leave the European Union, Britain enters into unchartered territory, and that too without a prime minister, a functioning leader of the opposition or a football manager. And everyone knows how the markets love uncertainty.

As can be expected, sterling has taking a pounding (bad pun intended). Equities have become more volatile and bond yields are dropping in anticipation of further stimulus by the Bank of England and the European Central Bank. Gold bugs are overjoyed to see their precious metal rocket higher as people seek safety, and punsters are having a field day creating catchy exit terms in case another domino falls. Our personal favourite so far is “Austria la vista, baby.”

At this stage, with so much undetermined, it is still too early to tell how this story will unfold. While markets showed some optimism late in the month, we expect little follow through in the near future. Currently, the list of unanswered questions is growing much faster than the list of answers. As a result, imaginations and the media can run wild forecasting a variety of negative scenarios. This has the potential to roil markets from time to time.

As this saga continues to develop, we will focus on identifying potential pitfalls and opportunities that may arise. Given that market reaction to a negative surprise could be swift and severe, our larger concern for the moment is avoiding landmines.

The Fund

The run up to voting provided lots of lively debate and discussion, but not a good basis for investing. Given the ‘too close to call’ nature of the referendum, we felt risking capital based on a view of the result constituted gambling not investing. Accordingly, our focus was on potential reactions to either outcome. We concluded that a decision to leave could result in significant turmoil, while a vote to remain would cause a small relief rally.

Due to this asymmetric payoff profile, we opted to significantly reduce exposure and sit on the sidelines for most of June. On referendum day, a rate position was added to hedge the remaining credit risk. Had the outcome been to remain, the fund would have missed out on a bit of performance. But with an eye to protecting capital, we decided it was better to miss an opportunity than take on imprudent risk.

As results from polling stations started pouring in, we were extremely pleased with our decision to be conservative. In the aftermath, we cautiously added to the portfolio at attractive entry points.

Credit

Although credit spreads were generally flat on the month, they moved through a tremendous range based on daily poll results. During a bout of misguided enthusiasm just prior to voting, spreads tightened significantly. Immediately after the outcome was known, they widened 10 to 25bps with subordinated financial issues leading the way. Portfolio managers opted not to do any significant selling. This was probably to avoid adversely impacting their performance versus the index by incurring significant trading costs so close to quarter end. Other factors that likely held back the urge to liquidate include an expected summer slowdown in new issuance and limited liquidity. We are cautiously optimistic that July will see a modest tightening in credit, although fragile market psychology means volatility can quickly return.

Rates

The big question with rates is ‘how low can they go?’ The relentless drop in Canadian and US yields seems set to continue. On the domestic side the jury remains out on the prospects of improvements in our economy. ?While higher oil prices are a welcome relief, it will still take some time before energy investments pick up. Concerns are growing in the export sector as there are doubts around the strength of our favourite trading partner south of the border. With these factors and the increased uncertainty caused by Brexit, both central banks will be on hold as they assess the consequences.

Adding further downward pressure on North American rates is the fact that almost 10 trillion of government debt is now trading at negative yields. Relative to European and Japanese bonds both Canadian and US securities will look very attractive to foreign investors. Canada will have a particular lustre as the UK’s drop from the AAA ranks may force a few managers to increase their allocation to Canadian debt. The patience of bond bears (if there are any left) will continue to be tested.

Regards,
The Algonquin Team

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“The house doesn’t beat the player. It just gives him the opportunity to beat himself.”
Nick the Greek

For this month’s commentary we are following our colleague Brian on a field trip to the casino. Being the responsible gambler that he is, Brian has predetermined that he is willing to play with $500 (high rollers, please hold the snickers). After a series of well-played hands and bit of luck, his stack sits at $1,000. He takes a moment to slip the original $500 stake into his pocket and continues to play only with his winnings.

At this point our friend is relaxed, loose and fancy free. He orders a round of drinks for the table and starts making more aggressive bets and takes on bigger risks. After all, he’s now playing with the house’s dough. While Brian may have suddenly made some new friends, he is breaking one of the fundamental principles of money – it is fungible. The house’s money is still money, and the $500 on the table has the same purchasing power as the $500 in his pocket.

A similar phenomena occurs in the investment landscape. Suppose Brian bought a stock at $50 and it’s now trading at $100. It might not bother him if it dipped down to $80, as he would still be in the black. But if he bought that stock today at $100 and it dropped down to $80, he would not be too pleased. The same applies to portfolio managers, who can become more aggressive and take larger risks following a period of strong performance. This is because optically and psychologically it is much more palatable suffering a 1% loss on a year when you are up 10% than in a year when you are up 2%. But once again, the net effect is a loss of 1% and the impact on long run returns will be the same.

To avoid this trap, one must disregard the past and maintain discipline irrespective of the starting point. As investment managers we must apply the same rigour in our process regardless of our performance to date. At the casino, Brian needs to play based on having $1,000 not on having started with $500. When evaluating an investment we own, we must consider the current price and conditions, not where we got in. After all, profits are profits and losses are losses regardless of whether one is already up or down.

The Fund

The market dealt us some great cards in March and April, but as May rolled around it felt as if the deck was stacked against us. Credit spreads started leaking wider so we decided to pocket our chips and head to the side lines. Our strategy during this period was to shift the portfolio into shorter dated securities and earn some defensive yield while watching things develop. With the weak tone and a few deals not performing, our defensive approach kept us out of trouble. By avoiding losses and focusing on conservative carry and active trading, we were able to generate a decent return in a difficult credit environment.

June should be busy in terms of issuance, the FOMC meeting and ‘Brexit.’ We should be dealt a few promising hands, but we’ll be quick to fold if we sense that the odds are unfavourable.

Credit

After a two month rally that saw credit spreads reach levels last seen in November, the market started to tire. By mid-May credit spreads were back to flat-on-the-year.

Dealers tried to bring a few deals to market, but oddly enough, a couple of companies felt they could raise money without a new issue concession. We opted to pass on those deals, which was a good thing as they ended up under water within a day or two. Corporate bonds might have continued to lose their lustre had it not been for the GE tender which put a great deal of cash into investor hands (approximately $3.5B). Flush with a new bank roll, portfolio managers were back at the table placing their bets.

At the beginning of the month we exited our position in Canadian bank paper as spreads were near their tightest levels over the past year and with the expectation of significant supply post earnings. With the banks opting to source funding abroad and through short dated floating rate notes domestically, we re-entered our position in deposit notes and NVCC bonds toward the end of the month. However, being wary of ‘Brexit’ related volatility our position remains quite manageable.

Rates

Janet Yellen and company became decidedly more hawkish as they made noises about a possible rate hike in June. It appears that equities have finally come to terms with the idea of higher rates, as stocks barely flinched. Governor Yellen has demonstrated a great sensitivity to market tone so the odds of a hike are very difficult to say, especially as stocks may become unglued should ‘Brexit’ fears resurface.

Canada continues to struggle with a problematic blend of an overheated housing market in Vancouver/Toronto and serious economic slowdowns in oil producing provinces. The Bank of Canada is in a tough spot as monetary policy is a blunt instrument that can’t be specifically targeted to a particular region. As such, Mr. Poloz and company ought to remain on hold in hopes that the weaker currency and modest recovery in oil prices leads to better economic prospects.

Regards,
The Algonquin Team

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“The waiting is the hardest part”
Tom Petty

Waiting is one of the most frustrating yet inevitable parts of life. We are all waiting for something. And when that something comes, we’ll move on to waiting for something else. It’s as certain as death and taxes, and we even wait for those.

Not all waits are created equal. They come in all shapes, sizes and lengths. Some can be filled with the excitement of anticipation, while others can be downright painful.

Unfortunately, it seems investors are currently enduring the latter type. It’s similar to the predicament that befell Vladimir and Estragon in Waiting for Godot. Like the two protagonists, everyone seems to be anxiously waiting for something to happen, with no clarity as to when or even if the wait will end. Moreover, it isn’t clear that anyone even knows what they are waiting for.

Are we waiting for equites to reverse once more or carry on to new highs? Are markets waiting for the Fed to hike rates or keep them on hold? Is the anticipation for inflation to rise or fall? Will the Raptors ever find their playoff nerve or are they doomed to fall at the hands of D Wade and the Miami Heat?

The good news is that when you are waiting for anything to happen, something eventually will. Hopefully at that point we will have more clarity as to which direction the markets are heading. In the meantime, we must remain patient, where our patience is measured by how well we behave while we wait.

The Fund

After the spectacular rally in March, we expected a hangover of sorts in April as people anxiously anticipated the other shoe to drop. Given the nervous environment and a lack of compelling opportunities, we started off the month by reducing risk and focussing on our active trading strategies. Upon detecting that restless investors were beginning to pick away at dwindling bond inventories and with the relentless comeback in oil and equities, we decided to increase our exposure once more. Unlike March, when investment grade credit rallied sharply, the move in April was more of a grind, almost as if the advance occurred begrudgingly. Recognizing this, we opted to keep the portfolio composition tilted towards higher quality and shorter maturity securities so that we could scramble to safety if required.

Credit

The story in April was a simple case of demand continuing to outstrip supply. Despite expectations for a significant amount of new issuance this year, total volumes remain well below forecast, forcing impatient investors to clamour for new deals. A by-product of this drought was a steady tightening of credit spreads as portfolio managers were forced to pick over limited dealer inventories. The scarcity situation was further exacerbated when GE Capital Canada surprised the market with a tender to buy back up to $5.2B of outstanding debt.

As battle-scarred bond market veterans know, prices rise until they don’t. We expect to see an increase in new issues at some point in May, which investors will stampede to buy. While our intention is to be a part of the early rush, the key is to be ready to step aside should the trickle of new deals become a torrent that forces credit spreads wider once more.

Rates

Waiting for the Federal Reserve has been painful for the bond bears, as Ms. Yellen and company are moving slower than molasses in winter. Traders who have been hanging around for years salivating over the prospects of making easy money by being short bonds are going insane over the agonizingly slow pace of hikes. Governor Poloz has adopted a similar approach with his wait-and-see attitude towards changing Canadian rates. Although the Bank of Canada will likely keep overnight rates stable for some time, yields are set for a modest rise simply to accommodate the $40 billion of additional government securities that will hit the street this year. Everyone will have to wait and see how high yields will drift to accommodate the bumper crop of government bonds.

Regards,
The Algonquin Team

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“It would be so nice if something made sense for a change.”
Lewis Carroll – Alice’s Adventures in Wonderland

‘Twas a warm summer’s day in August when equities ventured down a mysterious rabbit hole and into a nonsensical world of uncertainty. Like Alice’s Adventures in Wonderland, the journey has been confusing, chaotic and at times rather harsh. But unlike dear Alice, these markets don’t need magic cookies, mushrooms or strong catalysts to shrink and grow at random. The shifts in investor sentiment take care of that.

In the past eight months, the S&P has experienced four swings of over 10%, including starting the New Year with a dramatic fall only to climb back and finish the quarter pretty much unchanged. With no significant changes in the underlying global risks or economic fundamentals, making sense of these moves is like trying to understand the gibberish at the Mad Hatter’s tea party. As Alice put it, ‘you might do something better with the time than wasting it in asking riddles that have no answers.’

The only conclusion we can draw is that uncertainty around the central banks and the health of the global economy has driven investors between the extremes of panic and euphoria. It seems that at every turn we can see the eerie grin of the Cheshire cat reminding us that ‘common sense doesn’t really work here.’

While it is easy to get lost in the madness and chaos, one must remember that cooler heads typically prevail. With the exception of arguments with small children, reason can oppose nonsense, and in the long run reason will win.

The Fund

Given the strategies we run and the risk parameters within which we operate, March certainly qualifies as an exceptional month. To explain how the returns were generated, we are enlisting the help of a pretty picture.

The graph below shows a composite of ‘BBB’ rated Canadian credit spreads and our credit exposure (CS01) since the Fund’s inception. Over the period, spreads have steadily drifter higher and increased sharply in the first six weeks of 2016. As per our mandate, we have actively managed our exposure depending on the market conditions and opportunities.

In the middle of February, we decided the opportunities in credit were overwhelmingly compelling. The yields on corporate bonds offered tremendous value and provided a healthy cushion to withstand further spread widening. Accordingly, we targeted higher beta sectors such as energy, subordinated bank debt and REITs. As spreads started narrowing, we steadily increased our overall exposure.

The rally in credit combined with our positioning and active trading were responsible for the majority of the Fund’s gains, while carry contributed the rest. At the end of the month, the portfolio was distributed across a larger number of smaller investment grade positions to facilitate rapid liquidation should conditions change and a reduced exposure be warranted.

Credit

Canadian credit spreads have narrowed steadily since late February thanks to the rebound in equity markets and lighter than expected new issue supply. As has been the case in the surreal markets of late, investor sentiment shifted quickly in favour of non-government bonds. Dealers, who had been defensive for months, simply weren’t warehousing enough inventory to satiate this suddenly materializing demand for corporate debt. The result forced credit spreads to recoup most of the losses on the year. We are cognisant that despite the recovery, investment grade bonds still offer good value.

Looking ahead, the corporate bond market still has a positive bias to it. New issue supply ought to continue trending well below forecast in April, supporting valuations. Having said that, we have taken some chips off the table and upgraded the credit quality of our portfolio. This provides us with the flexibility to take advantage of the opportunities that will inevitably surface.

Rates

The ECB managed to surprise everyone by firing what looks to be every bullet left in the chamber. They cut the deposit rate to -40 bps, re-instated low cost loans to banks to allow them to lend at higher rates and increased quantitative easing to €80bn/month. Most surprisingly of all, the ECB announced that they will be buying non-financial corporate bonds. The details for the moment are sketchy, but there is little doubt that the ECB’s efforts will lend support to global bond markets.

On this side of the pond, the Liberal budget delivered the promised fiscal stimulus that should keep the BoC on the sidelines for months to come. Meanwhile, Janet Yellen reiterated that the Fed would be very cautious in its approach to lifting rates. As such, ‘low for longer’ continues to be the theme in fixed income.

Regards,
The Algonquin Team

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“Waves are not measured in feet or inches, they are measured in increments of fear”
Buzzy Trent

Warren Buffet famously quipped that ‘only when the tide goes out do you discover who’s been swimming naked’. Given that the markets of late are more like a series of mammoth waves, we thought a surfing analogy was appropriate for February’s commentary.

As in the world of money management, when things are calm and the waves manageable, everyone is happy to stay in the water. It is in places like Mavericks, California, where waves have been known to reach 25 metres, that one’s hard work, skill and nerve are put to the test. The currents underlying the choppy markets of the past few quarters have been more like the latter, filled with more pounders than ripples.

Concerns about global economic fundamentals, declining confidence in central banks, the precipitous fall of oil and a myriad of geopolitical risks have all contributed to some gnarly conditions. Riding every wave leaves you at the mercy of the ocean and increases the odds of a wild wipe out. On the other hand, if you hide on the shore for too long, you risk not getting back into the water and missing out on some great opportunities.

Our preferred approach is to remain in the water but be selective, choosing which waves to sit out and which to catch. We constantly remind ourselves that when taking on big surf that we have to remain focussed, agile and ready to paddle ‘like hell’ to get out of the way if necessary.

The Fund

Since the latter half of December we have chosen to ride a few safer swells, but mainly watched from the line-up as things developed. Around the middle of February, with credit spreads generally wider by over 25 bps since year end, it seemed that the market was becoming too pessimistic and that conditions were right for more aggressive positioning. We took the opportunity to add a few short-dated oil bonds and increased the overall credit exposure of the portfolio. The rally in the second half of the month coupled with active trading opportunities generated a strong 1.49% return for the Fund.

At current levels, investment grade bonds compensate investors well on a risk adjusted basis, and with folks becoming receptive to new issues, we expect to be busy in March.

Credit

Despite the tightening of spreads in the latter two weeks, credit still ended the month wider. Trading in the secondary market continues to be erratic with liquidity waxing and waning based on equity volatility. New issue volumes picked up after an exceptionally quiet couple of months, although supply was well down compared to last February. TD issued Canada’s first ever 10 year NVCC bond (Tier 2 Capital), which was very well received and could pave the way for other banks to launch similar products. Otherwise, banks continue to raise money offshore, which has helped stabilize domestic spreads.

The oil sector finally received a little good news. First of all, Enbridge bond holders who have endured upwards of 60 bps of spread widening since early December saw spreads tighten 10 to 15 bps when the $2B equity raise was announced. The rating agencies completed their reviews of oil & gas companies resulting in downgrades including Encana and Cenovus joining the ranks of ‘junk’. With this event out of the way, energy debt started performing a little better. There should be mondo opportunities in the coming weeks to keep us on our toes.

Rates

Government bonds remained volatile as investors reacted to dramatic swings in equities. At one point, Canadian 10 year yields hit a record low yield of 0.917%. While that may be a decent save percentage for an NHL goalie, it is a dreadful return for locking up your money for a decade. Short yields rose slightly as traders scaled back bets on the Bank of Canada easing rates in the near future. We expect Governor Poloz to hold steady for some time as he assesses the impact of fiscal stimulus on the economy.

In the US, the odds of a March rate hike by the Federal Reserve declined to nearly zero as the economy struggles with the impact of a strong dollar and foreign economic weakness. That said, domestic demand should remain fairly strong, leaving the window open for the Fed to raise rates a couple of times this year.

The European fixed income market continues to bewilder, as German yields out to 8 years are now negative. Expectations are extremely high that the European Central Bank will either aggressively push rates more negative or expand the quantitative easing program. Given their track record of under-delivering in times of need, the risks are that they will disappoint, which could spark yet another bout of € yield volatility.

Regards,
The Algonquin Team

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