Monthly Commentaries

“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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“I hate to lose more than I like to win.”
Larry Bird

If you were watching your stock portfolio closely last month, you were reminded of just how much losing hurts. Behavioural economists postulate that the pain from loss is twice the joy of gain. While the magnitude can vary between individuals and situations, it seems fair to conclude that losing sucks.

The danger of this pain is that our emotions can take over. So rather than join the ‘chicken little’ parade and rehash all the negative news, we thought it more useful to remind our readers of a couple of the psychological pitfalls associated with losses.

By our very nature humans are averse to losing. For our survival this makes sense. It is more prudent to be aware of threats than opportunities, to protect what one has than take risks to gain more. This feeling is accentuated by the recent sting of falling markets. This can lead us to passing up on opportunities with attractive risk/return profiles, as we overemphasize the prospects of further loss.

On the flip side, losses can make some of us more aggressive in taking risk. Consider the following two scenarios:

1. Receive $900 for sure OR take a 90% chance to get $1000 and 10% chance of getting nothing
2. Lose $900 for sure OR take a 90% chance to lose $1000 and 10% chance of losing nothing

Despite being mathematically equivalent, most people would take the $900 in the first scenario but gamble in the second. This is because when presented with the opportunity to recoup our losses, we become inclined to take risks that would otherwise be unacceptable to us.

The simple point is that our emotions can sway us to the extremes of becoming overly loss averse or aggressive, to miss opportunities or go chasing them. The important thing is to recognize these influences within ourselves. As whether markets go up or down, it is better to proceed rationally rather than emotionally.

The Fund

When we launched our fund last February, we could not have guessed how strange the journey would be. After three or four months of robust credit markets, things got ugly. For the last half of 2015, credit spreads steadily widened, especially punishing anyone who dared to own 30 year corporate debt.

With equities dropping 10% in the first two weeks of 2016, the trend to wider credit spreads continued unabated. The Fund’s gain in January can be attributed to continuing our December strategy of holding very short dated securities and capitalizing on a few active trades.

After avoiding the oil sector for most of last year, the recent dip in crude and the ensuing carnage in the bonds of many Canadian investment grade issuers means we will re-evaluate the risk/reward trade-off in these securities.

Credit

The negative sentiment of global markets and the drop in oil pervaded domestic credit markets, taking spreads wider through the month. Bank NVCC debt struggled in the difficult environment, widening +25bp through January, while the oil and gas sector continued to get pounded as crude dipped below $30bbl. JP Morgan’s decision not to call their C$ sub-debt caught investors off-guard with an instant $3 dollar drop in the bonds leaving a mark. We have avoided holding callable fixed/floater subordinated bonds from foreign issuers for precisely this reason.

2016 is off to an exceptionally slow start as far as Canadian bond supply is concerned. With just C$5bn issued so far out of an expected C$100bn this year, the market is well behind schedule. Hopefully deal flow picks-up in February, particularly as redemptions and delayed transactions force corporate issuers to market. In the US, the AB InBev (US$46bn) transaction was one of the largest of all-time, which by amusing comparison amounts to more than half of the total expected C$ corporate supply for the year.

Rates

Amidst the equity volatility and deteriorating economic prospects, Canadians were bracing themselves for another rate cut. The Bank of Canada decided not to lower rates, choosing instead to allow the weak loonie and promised fiscal stimulus some time to work. Given that the low dollar has yet to benefit the struggling manufacturing sector, we believe that additional monetary accommodation may be required, although one shouldn’t expect to see any action until after the federal budget.

South of the border, the next hike has been pushed out like a carrot on a stick. US 10yr yields are significantly lower than where they were around the December rate hike, so bond investors clearly disagree with the Fed’s improbable outlook of 4 hikes in 2016. That said, we believe that yields have overshot to the downside, and the risk now is that they snap sharply higher on the slightest bit of good news.

Regards,
The Algonquin Team

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“It is always wise to look ahead, but difficult to look further than you can see.”
Winston Churchill

After a difficult 2015, which saw the TSX down over 11% and jokes of the northern peso surfacing, Canadians are undoubtedly hoping for a sweeter 16. While we are not in possession of a crystal ball, we believe that the year ahead will be a challenging one for investors.

The ulcer inducing volatility that characterized the second half of 2015 is likely to persist for several more months. The uncertainty surrounding the Chinese economy, the pace of rate hikes by the Federal Reserve, the path of commodity prices and the gnawing suspicion that global growth has somehow been permanently impaired will conspire to send equities see-sawing in all directions.

By comparison, the bond markets ought to remain awfully dull. The Federal Reserve will likely sneak in one or two more rate hikes if they can, while the Bank of Canada will fret over the price of oil as they deliberate on whether another rate cut or other unconventional stimulus is required.

Corporates will need to raise about the same amount of money in the bond market this year as they did in 2015. A wild card will be how much issuance banks do outside of Canada. If the banks choose to raise a significant amount abroad, it should be constructive for domestic credit spreads. The slide in equities and commodities will keep a lid on interest rates so fixed income funds ought to continue to see inflows, which could also be supportive for corporate bonds. That said, there doesn’t seem to be a catalyst for a significant narrowing of credit spreads in the near term.

As always, the future is unpredictable and successfully making decisions amidst uncertainty requires hard work, skill and bit of luck. We therefore wish all of you the best of luck for the New Year.

The Fund

Last January, we were preparing to give birth to our first fund. As with all new parents, the first year was full of new challenges, sleepless nights, plenty of learning and the occasional tears. That said, the transition from bachelor bank traders to parents of a fund was much smoother than anticipated. With many of the sell-side distractions removed, there was more time to watch trade flows unfold from a favourable vantage point. This enabled us to better identify and take advantage of superior risk/reward opportunities, leading to a return of 15.86% for the year. Furthermore, our relationships with the street and our knowledge of how the bond market operates proved particularly useful when navigating the treacherous waters of August and December.

All in all we are happy with our baby’s development and growth over the first year. As a team, we have put in a lot of hard work and had a lot of fun working together. We look forward to a lot more of the same, both the ups and the downs, but are obviously hoping for many more ups.

Market Notes

Like many other investors we noted that asset markets are now highly correlated. Global equity indices seem to move in lock-step (except for the damned TSX which only seemed to go down). Meanwhile bonds, which are supposed to offer diversification, also generally moved in the same direction as equities. We were pleased to see that on days that equities moved 1% to 2%, credit spreads would move in much smaller increments if they moved at all. This type of behaviour certainly supports our view that the fund offers investors excellent portfolio diversification advantages.

The other thing we noted was how frequently portfolio managers complained about the drop in bond market liquidity. Although there was much hand-wringing and moaning, there was precious little in terms of ideas on how to deal with it. Most of the comments seemed to be a form of nostalgia along the lines of, ‘in my day prices were reasonable and children respected their elders.’ Our view is that liquidity has changed and will continue to change. Asset managers must therefore alter their execution strategies. Those that find a new way to operate will be rewarded during difficult conditions, while those who cling to the past will likely generate sub-standard returns.

Looking Ahead

As wise investors have discovered, it is important to know what you don’t know. With that in mind, we are going to disappoint those looking for forecasts for the year ahead. What we do know, is that when the pendulum swings from despair to euphoria and back as fast as it is, that a myriad of opportunities are often unearthed. Accordingly, we go into 2016 optimistic, cautious and above all, ready.

Regards,

The Algonquin Team

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“The luck of the third adventure is proverbial.”
Elizabeth Barrett Browning

After seven years at zero and nine years since the last hike, ‘Lady Janet of Brooklyn’ is poised to move interest rates higher tomorrow. Recent history suggests that the various asset classes ought to tremble with fear.

In 2013 when ‘Helicopter Ben’ Bernanke announced he would end his quantitative easing programs, the result was the ‘Taper Tantrum.’ Investors dumped their bonds, and equities slumped 7%. After a couple of months, people realized that the Federal Reserve was still a long time away from raising rates and promptly took bonds and stocks to higher prices.

Just this summer, Governor Yellen made it painfully clear that she felt the Fed would raise interest rates in 2015. That helped drag the TSX and S&P down by 10%. This time it took only a month or so for US stocks to recover handsomely, while the feculent TSX only managed to claw back a few percentage points.

In November it seemed as if everyone adopted the British WWII slogan, ‘Keep Calm and Carry On.’ Despite the odds of a hike at 80%, the shocking attack in Paris and rising tension between Russia and Turkey, the TSX, S&P and bond yields barely budged.

Perhaps investors have concluded that this is not their father’s tightening cycle with a series of successive rate hikes to come, and are confident that the Fed will be patient in their approach. Or perhaps, it’s just that the third time is a charm.

The Fund

With only $2.9B of new issue supply, and government bonds trading in a narrow range, we looked for active trading opportunities to generate returns beyond the carry component of the Fund. We took advantage of momentum as portfolio managers capitalized on the quiet market to add to their portfolios, and enjoyed solid returns from the telecom and REIT sectors, which had fallen heavily out-of-favour in the summer. Furthermore, our VW and ABS positions performed well enough for us to take our profits.

December is typically a good month for credit as the first two weeks are often busy with issuers trying to get deals out the door before things quiet down around year end. The result is that credit spreads normally narrow quite nicely. We remain cognizant that events could unfold differently this time, as people ponder the weakness in commodities, the removal of stimulus and a slowdown in China.

Credit

After several months of steady widening, Canadian investment grade credit spreads responded to the dearth of supply and generally performed in November. The BBB sector, which had been a laggard for most of the year, showed signs of life with REITs and telecoms leading the charge. Meanwhile, the bank NVCC sector continued to underperform as investors braced for potential supply after bank earnings season. By our calculations, the borrowing environment in the US market is attractive for Canadian banks, which means little in the way of bank deposit note supply in December.

On a regular basis, a variety of folks ask us about high yield bonds. Other than one position, which matures in nine weeks, we have avoided this market due to concerns over poor liquidity. Our conclusion is that the catastrophic destruction of wealth in commodity related debt poses contagion risk to other high yield sectors. As a result, we will continue to avoid this asset class for a while.

Rates

The Federal Reserve is largely expected to raise rates 25bps tomorrow. We believe the accompanying statement will be chock-full of ‘wait and see’ language as Ms. Yellen elaborates on what exactly she means by a ‘moderate pace’. Under this hawkish/dovish scenario, it shouldn’t be surprising to see bond yields dip post meeting. After a couple of days of bouncing around, the bond market ought to settle into a narrow range for the holidays.

The domestic economy continues to grapple with lower commodity prices. Despite a steady decline in the ‘loonie’, the export sector hasn’t given the economy a serious boost yet. Governor Poloz is undoubtedly weighing the need to add further stimulus, however he will likely be patient until the federal government unveils further details on their spending plans. Although the Federal Reserve will likely continue to hike in 2016, we believe the Canadian yield curve will remain anchored near current levels.

Regards,

The Algonquin Team

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“Adventure. Excitement. A Jedi craves not these things.”Yoda

Not so long ago, in a galaxy not far, far away, equity markets shed more than 10% of their value. It was a period of great terror and despair. Investors lived in fear of a slowing global economy and the Empire unleashing their much dreaded weapon, the Fed rate hike.

But in the early days of autumn with the Fed unexpectedly turning dovish, and China and Europe reaffirming their commitments to further monetary stimulus, optimistic investors managed to regroup, force the ‘bears’ to retreat and take equities back to the levels from where they had fallen.

Easy it would be to get excited by this victory and the dramatic drop in market volatility, but as students of master Yoda, we exercise patience and prudence. After all, many of the factors prevalent in August remain the same. The Federal Reserve is once again poised to raise rates, China continues to grapple with the transition from being an export-lead to a market-based economy, and commodity prices are in a funk, which continues to exert a drag on domestic growth.

At the end of September we felt the market had priced in a significant amount of bad news. At current levels we feel greater prudence is in order, as we wouldn’t be surprised to see further volatility as sentiment waxes and wanes.

The Fund

The Fund had another strong month, although the path to success was not a particularly straight one. Early in the month we were caught off guard when BMO spooked the market with a C$600mm placement of 5-year rate reset preferred shares with a 5.85% coupon. The deal was extremely cheap, which sparked a dramatic widening of bank NVCC bonds. We were long TD NVCC bonds and decided to liquidate the position as the volatility of the securities became too great for our comfort. This position resulted in a loss of 35 bps for the fund.

Fortunately, our investment in VW C$ bonds more than offset this loss. A couple of days after the initial scandal was reported, we felt that VW bond prices had fallen too far. We purchased one and two year bonds which performed strongly in October. Gains on this position coupled with an improved tone in credit and a myriad of opportunities to trade actively contributed to a net return of +1.71%.

Credit

Although credit spreads continued to widen at the start of the month, once it became apparent that the new issue supply would be limited, market tone improved considerably. Liquidity generally improved as dealers felt more confident making markets in a calmer environment. Autos and Telco’s performed very well, while TransAlta (a name we consistently avoid) widened dramatically. Bank NVCC spreads were extremely volatile, widening 30 bps before staging an impressive rally to finish the month unchanged.

We continue to see reasonable value in corporate debt at current levels, especially since the potential for new issue supply remains fairly low. Given our concern regarding bouts of volatility, we prefer shorter dated notes over longer maturities bonds.

Rates

The Bank of Canada left the benchmark interest rate unchanged at 0.5% and revised growth and inflation forecasts lower. The C$30bn fiscal deficit the new Liberal majority government intends to run over the next three years should provide a modest dose of fiscal stimulus that reduces the need for an additional rate cut from the Bank of Canada. As a result, we expect short rates to drift slightly higher in the coming weeks as bond investors adjusts to a neutral central bank.

With respect to the US, the FOMC removed language from their October policy statement which pointed to a stable global economy as a precondition for hiking rates. Ms. Yellen and company are certainly setting the stage to raise rates in December. We expect the Fed to hike 25 bps in December, barring another bout of hysteria in the markets. That said, we believe the Fed will move very slowly and deliberately in 2016.

Regards,

The Algonquin Team

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“You can observe a lot by just watching”Yogi Berra

What you observe depends on what you are watching. Those watching the Blue Jays were treated to a thrilling ride en route to their first American League Championship Series appearance in 22 years. Those watching their investment account balances and the markets in September experienced a different sort of thrill ride. After a terrible August, the end of the quarter brought its own set of challenges. While the turbulent markets and the Volkswagen scandal led to indigestion on the part of investors, they provided sensational headlines and plenty of fodder to lather up a bearish sentiment. Rather than add to the fear mongering, we thought it best to step back from the noise and look at the markets from a distance. With that in mind, we would like to share some observations that might suggest that the sky isn’t falling just yet.

Although oil traded violently, at times moving 8% in a day, it ultimately didn’t go anywhere and closed where it opened at around $45 per barrel, which may indicate that it has finally found a support level. Secondly, even though the TSX was down 4% on the month, it finished almost 2% higher than the lows of late August. Lastly, despite weaker economic data and a reluctant Fed, Canadian bond yields were virtually unchanged.

While these observations provide some perspective and perhaps comfort, they by no means suggest the worst is behind us. Rather, our read of the tea leaves is that the markets have justifiably priced in a substantial amount of negative information, and are likely to continue to move sideways until a clearer picture of the health of the global economy is formed. We’d like to see daily stock market moves of less than 0.5% before we can be comfortable that the worst of 2015 is behind us. In the meantime, perhaps the best course of action for long-term investors is not to watch the market. As history has shown, overreacting to noise and deviating from one’s plan rarely serves one’s investment objectives. And with the Blue Jays providing the thrills, it is easy to stay distracted.

The Fund

Even though spreads generally widened, there were decent opportunities to actively trade credit in September. We played an aggressive game, but instead of swinging for the fences, we choked up on the bat and looked to hit singles and doubles. In particular, Volkswagen’s debacle provided us with a unique occasion to trade their credit from both the short and long side. We also pounced on the solid tone in long dated utility and pipeline bonds, actively trading a couple of positions that contributed handsomely to September’s performance. These timely hits coupled with an effective defence lead to a +1.68% return for the month.

The old adage ‘you can’t win ball games without good defence’ is our mantra for October. The tone in credit markets remains weak, so caution is the order of the day.

Credit

After the dismal performance of credit spreads in August, we looked forward to a strong recovery in September. It turns out credit batted ‘five hundred’. Spreads did narrow early in the month in spite of a wall of supply, but reversed course as time wore on, closing modestly wider over the period. Contributing to the reversal were unanticipated events surrounding Molson’s and Volkswagen. To be fair to Molson’s, their bonds got sideswiped over the potential merger between AB InBev and SAB Miller, while Volkswagen got caught trying to steal a base.

While the month did see an increase in bond supply, new issues were priced with extreme concessions, which adversely affected secondary market spreads. As an example, we sold 8 year Bell Canada bonds at a credit spread of +188. Two days later, Bell announced a new 7 year bond at a spread of +195. By the end of the deal, the 8 year bonds we sold were trading around +205.

With a great deal of the year’s new issue supply out of the way, we expect that spreads will stabilize near current levels. Having said that, we do remain wary of the fragile tone in credit markets.

Rates

The fact that the Federal Reserve chose to keep rates unchanged was not a total surprise, however, the ‘dot plot’ revealed that one voting member felt that an ease into negative territory was warranted. This bombshell helped spark another kerfuffle in equity markets, resulting in Janet Yellen clarifying her stance on the matter. While she still foresees a rate hike in 2015, the market currently disagrees with that view and is pricing the odds of it happening at less than fifty percent. As far as the Bank of Canada is concerned, we don’t believe 3rd quarter GDP results will sway them one way or the other. It makes far more sense for the BOC to wait and see which party forms the next government and understand the impact of the fiscal policies they will pursue before making their next move. Our view is that the Bank of Canada will remain on hold, and that short end rates will drift slightly higher over the next six months.

Go Jays Go!

The Algonquin Team

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“Everyone has a plan until they’ve been hit.”Joe Louis

Those that have seen Ronda Rousey fight (she won three UFC title defences in a combined total of 64 seconds) or have witnessed the ferocity in her eyes cannot fathom why anyone would be willing to step into the ring with her. We suspect many investors felt the same way about putting capital to work in August. The sheer magnitude of the moves and subsequent knee jerk reactions in stocks and bonds made it virtually impossible to navigate a sensible course without suffering a bit of bruising.

The heart of the matter lies squarely with perceptions surrounding the health of the Chinese economy. For as long as we can recall, few people have trusted China’s official economic statistics and have looked to other indicators such as commodity prices, electricity consumption and satellite imagery to get an objective sense of the nation’s economic health. When China devalued the Yuan, they caught the market by surprise and sparked fears that policymakers were beginning to panic about the true state of the economy, triggering a violent international sell off across financial assets.

The Fund

We anticipated that August would provide little in terms of active trading opportunities, so we decided to employ a bond trader’s version of the ‘rope-a-dope’ strategy that propelled Muhammad Ali to victory over George Foreman. We increased our holding of short-dated bonds with the belief that interest earned would exceed losses from credit widening. For the first two weeks, we slugged it out toe-to-toe with the market with the yield from the bonds offsetting the losses from the gradual widening in credit spreads. The turning point came when China devalued the Yuan. In the days that followed, we endured a relentless volley of head-shots as equities melted and the appetite for investment grade credit seemed to evaporate. The street had no interest in buying securities, and market makers dramatically lowered their bids in order to discourage further selling. Even the typically stable front end of the credit curve was hammered, leading to a modest loss for the fund this month (-0.25%). While we are greatly annoyed with ourselves for missing an opportunity to reduce our risk further, in a month where the TSX was down 4.2% and the Canada Universe Bond Index lost 1%, we won’t beat ourselves up too badly.

Looking ahead, we do think credit spreads at their current levels offer tremendous value for patient investors. Market dislocations often create a myriad of opportunities that can be exploited once volatility dissipates. We look forward to a very interesting September.

Credit

We had to look back to the fall of 2008 to find a period where credit spreads widened as violently as they did in August. The ‘triple B’ space has been in trouble since early summer as the unprecedented growth in supply pointed to the need to re-evaluate pricing, but the dramatic widening in higher rated credit spreads was rather surprising. We suspect that nervous fund managers preferred to increase their cash allocations and ended up selling whatever they could, not necessarily what they should. With bond dealers already full up to their eyeballs in ‘triple B’s’ and an effective buyers’ strike in place, accounts started selling bank paper and short-dated corporates. Volatile equity markets pressured dealers to reduce prices even further in order to avoid increasing their already bloated balance sheets.

While credit spreads are at extremely attractive levels, we remain wary as anxious issuers are lining up to borrow at the first available opportunity. In this environment, any new supply will require hefty concessions in order to whet the appetites of investors courageous enough to put money to work. That said, we intend to be very selective ourselves with respect to how and when we re-enter the ring.

Rates

We may be on the cusp of an extremely important change in global bond markets. Since 2003, China has engaged in an unprecedented accumulation of reserves, buying almost 4 trillion of foreign assets mostly in the form of bonds. This buying has essentially been a form of quantitative easing and has also been blamed as the cause of the ‘Greenspan Conundrum,’ as well as significantly contributing to the decline in real yields. Now that China has turned its attention to managing and defending its currency, it has started selling foreign assets. There are estimates suggesting that China sold 100 billion of US treasuries in August. Should China need to continue to defend its currency, we could see a prolonged trend where real yields continue to rise irrespective of actions by the Bank of Canada or the Federal Reserve.

On the topic of central banks, we think the Bank of Canada will be patient with rates. They will assess a few months of data to determine whether a weaker currency will offset weaker commodity prices. Furthermore, the various political parties have different fiscal plans which the Bank of Canada can only take into account after the federal election. Meanwhile, making a call on when the Federal Reserve will raise rates has become more difficult due to the volatility in stocks. We remain in the camp that ‘lift-off’ is a 2015 story, but acknowledge the Federal Reserve is not married to a particular start date, and will have little difficulty deferring a decision until the market settles down. At this point we see a 50% chance of the Federal Reserve hiking rates in September.

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“A good retreat is better than a bad stand.”Irish Proverb

To use a very technical term, the markets in July can be best described as ‘poopy’. As the Greek saga disappeared from the radar screen, the market shifted its focus to the ever puzzling Chinese stock market. For the most part, many markets managed to shrug off the volatility in China, concluding that an index which surged almost 100% in six months was probably due for a significant correction. Some pundits were keen to link the plunge in Chinese equities to the collapse in commodity prices, however, we note that commodities were struggling when the Shanghai index was rocketing higher. Our view is that the precipitous fall in the commodity complex has more to do with global supply and demand imbalances rather than with Chinese stocks. Whatever the causes may be, the effects were certainly felt at home, wreaking havoc on the TSX and Canadian dollar. In our space, domestic credit was uncharacteristically spooked. Typically, Canadian credit markets are resilient and it takes some sizeable external shocks to impact them. This time things are really different, as Canada managed to underperform most G7 markets due to concerns that recent economic weakness will persist. We worry that the underperformance will continue for quite some time.

The Fund

After taking a very defensive posture through June, we began July by investing in opportunities we had been monitoring and ramped up our market exposure anticipating the return of vibrant markets. Our enthusiasm quickly waned and midway through the month we beat a hasty retreat as tone and liquidity in the credit markets were dreadful. Although credit spreads widened 5 to 10 bps on the month, our active trading allowed us to generate good returns. While we believe that credit spreads are on the ‘cheapish’ side, we remain wary of committing too much capital in August as tone remains poor.

Credit

The post Greece enthusiasm brought out the issuers, and for a short while it appeared that the party had started once again. New issue concessions were generous which meant they performed reasonably well. We noted that only ‘A’ rated credits or better were able to come to market as the ‘BBB’ space still suffered from poor liquidity forcing these issuers to defer deals or issue in the US market. Throughout the month liquidity steadily worsened as dealer inventories continued to grow. We remain hopeful that August will bring a long pause to issuance which might settle the market as we wrap up the summer and head into fall. While we are maintaining a concentration in more liquid high quality names, we look to selectively add certain ‘BBB’ names in short-dated maturities. The challenge for August will be generate strong active trading returns, as bid-offer spreads continue to widen.

Rates

Canadian yields continued to drop all month as the Bank of Canada cut rates 25 bps in acknowledgement that the oil shock is going to have a longer impact. Currently, the market has priced in another 25 bps cut by year end. We also observed that the debate about quantitative easing has already begun. We feel that the Bank of Canada is still a long way from unleashing this weapon, and would only do so after another 25 bps cut and the use of ‘forward guidance’ is exhausted. At current yield levels, the market is vulnerable to any positive economic news. We suspect that better news is coming as it takes time for the non-commodity export sector to benefit from the weaker loonie which has depreciated approximately 13% since December 31st, the benefit of which will not be felt until early 2016.

The Federal Reserve set a fairly low bar for economic performance over the next six weeks in order to hike rates. It is clear to us that Governor Yellen is keen to raise rates this year (we still think September) so that she can avoid the risk of having to move aggressively in the future. The key will be wage growth. Since the Employment Cost Index was disappointing, the Federal Reserve needs to see good hourly earnings numbers on each of the next two payroll releases. We expect both the bond and equity markets to take the first few hikes in stride, meaning the risk of another ‘tantrum’ is likely a 2016 event.

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“The storm starts, when the drops start dropping. When the drops stop dropping then the storm starts stopping.”Dr. Suess

The Fund

June proved that when it rains, it pours. Investors not only endured heavy rainfall, but also some rather ugly investment returns. The former we will leave to the meteorologists to explain, the latter we attribute to the crisis in Greece and the insanity that is the Chinese stock market. For the month, the S&P/TSX was down 3.07% while the FTSE Canada Universe Bond Index lost 0.56% (so much for bonds providing diversification!). Over the same period, we generated a positive 0.25% return for our investors.

Heading into the month we were skeptical about the negotiations in Greece and apprehensive about the market’s ability to absorb the endless wave of bond supply. Accordingly we upgraded the quality of our holdings and reduced our outright core duration and credit risk as we moved into capital preservation mode.

With the endgame for Greece in sight, and credit cheapening back to levels seen in late fall, we are looking for buying opportunities. That said, we would like to see an improvement in liquidity before becoming particularly aggressive.

Credit

June was a challenging month for BBB sector credit spreads which widened 5 to 15 bps. Not only has there been a deluge of supply, but the downgrade of various Enbridge entities to BBB+ by S&P has resulted in institutional accounts selling BBB bonds to stay within their investment mandates. As a result, dealers who are increasingly reluctant to add to already bloated inventories, have cheapened their offerings and widened bid/offer spreads.

New issues have offered greater price concessions but fresh supply has simply tended to re-price existing bonds cheaper. We believe this is a sign that the current weakness could persist for some time. The market certainly needs several weeks of reduced supply in order to digest the issuance to date. Although we have adopted a defensive posture, with the portfolio invested in short maturity bonds, we anticipate increasing risk as we see interesting opportunities unfold.

Rates

Even though the now famous FOMC ‘Dot Plot’ suggests the Fed is likely to hike rates for the first time in nine years this September, the turmoil surrounding Greece has the US market struggling to decide where rates should be. While we anticipate a September hike, we recognize that the Fed will not hesitate to delay liftoff if the financial markets haven’t settled down by then.

In Canada, the commodity sector continues to exert a remarkable drag on GDP, while lower gasoline prices and a weaker loonie have yet to stimulate other parts of the economy. Following the negative April GDP print, it certainly looks as though the Canadian economy may contract for the second quarter in a row. From our humble office near the lake, we can almost hear the bank economists on Bay Street whispering the ‘R’ word. Following the advice of John Maynard Keynes “When my information changes, I alter my conclusions. What do you do, sir?” we are dropping our view that the Bank of Canada will not cut rates again this year. The odds certainly favour another cut as early as mid-July.

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