Monthly Commentaries
Who Broke the Bond Market? | May 7, 2015
Financial headlines are usually the domain of stocks and currencies, but lately it has been the bond markets that are making the news.
On April 17th, German 10 year bond yields hit a record low of 5 bps. A mere 20 days later, they touched 75bps. I can’t recall bond yields of any sort ever multiplying so rapidly. Over the same period, Canadian and U.S. 10yr bond yields have climbed 40bps.
Before panicking over the recent moves, one should consider the starting point. For the past six months, yields have trended lower as the bond market became enamoured with the idea that deflation was a significant risk. The herd managed to convince itself that lower oil prices would lead to negative CPI numbers, which would start a vicious cycle where consumers would stop buying things in hopes of lower prices in the future. The ECB poured fuel on the fire when they launched their quantitative easing program, confirming the existence of deflationary pressures.
This is where the ‘greater patsy’ trade erupted, as traders started buying bonds in order to sell them at much higher levels to the next ‘patsy’, namely the ECB. With a clearly identified buyer, investors even played the game in longer dated securities which have the greatest sensitivity to inflation. The whole purpose of QE is to raise inflation, so what in the world were 10 year German yields doing at 5 bps?
In the past few days, we saw positive inflation figures out of Europe which got people thinking that perhaps the ECB would stop QE early. With fears that the ‘patsy’ might leave the game, smart money started looking around for the next ‘greater fool’. With no one stepping up to play that role, the rout was on. Canadian and U.S. yields, which were dragged lower by the game in Europe, naturally got side-swiped in the reversal.
I don’t think this means we have started a meaningful move towards normal rates. The ECB for the time being remains committed to a €60 billion a month asset purchasing program through September 2016, which implies that the game of hot potato will at some point commence again. My guess is that point is close.
The take away from the recent move is that investors need to think carefully about the interest rate sensitivity in their portfolios. The volatility of the last 20 days hasn’t been kind to traditional asset classes. Imagine what a sustained move to more normal interest rates would do to your portfolio.
Firing on all Cylinders | May 2015
“I fear the Greeks, even when they bring gifts.”Virgil
The Fund
Along with the warmer and longer days that mark the beginning of patio season, May brought with it a host of challenges for investors to grapple with. The prospect of a Fed hike coupled with the volatility in European bond markets and the exasperating negotiations between Greece and its creditors caused jitters on both sides of the Atlantic. In light of these conditions, we cautiously allocated our capital and diligently controlled our overall exposures. This conservative approach placed more emphasis on our core carry and relative value strategies which performed faithfully, while ample active trading opportunities in both credit and rates contributed excess returns.
As we head into June, we can only hope to find closure on Greece. Given the time constraints and how little either side is willing to bend, the risk of an accident appears to have risen materially. In some ways, I think the best outcome could be for Greece to default and then let things play out as they may, since any agreement at this stage will merely kick the can further down the road as it has been so many times before. A default might put Greece onto a sustainable economic path. The uncertainty should be put to rest once and for all and not delayed any further. While the financial markets could become unglued in the short term, I think they would settle down in fairly short order as Greece’s odyssey draws to a close.
Credit
May saw the return of the ‘borrower’, with corporate new issue supply reaching $8.1 billion. After an onslaught of Canadian bank debt, it was good to see a more diverse array of issuers, including a $1 Billion US Maple deal. For the most part deals continued to be well received, however secondary market performance was not as strong as earlier in the year. We expect to see the recent pace of issuance extend into June as several companies are in the process of wrapping up roadshows, which generally culminate in deals being announced. We believe that institutions with vast distribution engines (banks) continue to see strong inflows into their fixed income funds and remain aggressive technical buyers, while smaller accounts are becoming more selective. With these factors in mind, we remain wary of a widening in credit driven by supply fatigue.
Rates
After sitting on the sidelines for the bond market sell-off in April, we couldn’t help ourselves and joined the party. We established a modest short position in rates, and took profits once the market hit our target levels.
The 0.6% drop in Canadian Q1 GDP was much weaker than anyone expected, sparking the market into pricing a healthy chance of a further rate cut. With commodity prices in a funk, and provincial tax hikes offsetting federal tax cuts, it is difficult to see how job creation will take hold in the short to medium term. Although I feel like “waffling”, I will stick to my original call that the Bank of Canada will remain on hold for the balance of the year.
US data has been uninspiring to say the least. The Q2 data hasn’t bounced back to the extent people were expecting after a lousy Q1. From what I can tell, US consumers are saving the windfall of lower gasoline prices rather than spending it. Despite seemingly lacklustre numbers, I believe the US economy is on a good track which means that a Fed Funds rate of nearly zero is no longer warranted. I still expect the first hike to come in September with subsequent increases coming at a slow pace.
The Pause that Refreshes | April 2015
“Luck is a matter of preparation meeting opportunity”Lucius Annaeus Seneca
The Fund
Coca-Cola used the slogan “the pause that refreshes” to sell Coke 85 years ago. Today, it serves to remind me that when pursuing a goal, it makes sense to pause every now and again to assess one’s progress. As fate would have it, we launched the Algonquin Debt Strategies Fund on the very day that Canadian 10yr bond yields hit their record lows at 1.23%. Buyers of Canadian 10yr bonds on February 2nd would be facing a capital loss of more than 3% at April month end. On the other hand, investors in the Algonquin Debt Strategies Fund have enjoyed a return in excess of 6% over the same period.
So, have we just been lucky? The environment into which we launched the Algonquin Debt Strategies Fund was no doubt favourable to our cause as credit spreads had widened significantly in the fall, new issue activity had been light, and investor pent up demand was ravenous. As Lucius Seneca pointed out 2000 years ago, one needs to be ready when opportunity knocks. In our case, the setting allowed us to utilize not only the trading skills we have honed as market makers over the years, but also the relationships we have fostered with sales people, traders and syndicate folks on Bay Street. So the answer to the question is both a resounding “yes” and a resounding “no.” While we were lucky to have a target rich environment, we had the skills and
knowledge to exploit it.
Credit
Even Usain Bolt must take a rest between sprints, so I wasn’t terribly surprised when after a record breaking Q1, Canadian bond supply fell below historical averages in April. The good news for investors was that this allowed for an orderly transition of recent issuance into stronger hands, resulting in modest spread performance in bank deposit notes, energy related bonds and across most of the REIT space. We maintained a light credit risk profile early in the month due to renewed tensions surrounding Greece’s negotiations with their creditors, and increased our risk once it was clear that the proverbial can had been firmly kicked into May. With the flood of new issues digested, I believe the market is ready for supply once more, and we have positioned the portfolio so that we can actively participate in any attractive primary deals that may come
along.
Rates
The economic data throughout the month did little to change our view that the Bank of Canada will not cut rates any further this year, and that the Federal Reserve will hike rates in September. We went into the April Bank of Canada meeting with a tactical outright short position in two year bonds, which were effectively priced for a 25bps cut at the time. We unwound the trade shortly afterwards for a profit as the front-end yields rose when the Bank of Canada kept rates unchanged. Over in Europe, we were surprised at how quickly the mood changed as the capitulation in German Bunds prompted a global sell-off in fixed income. I’m kicking myself for missing an opportunity to establish a short position further out on the yield curve. At least we maintained a well hedged portfolio throughout the downturn, so the only damage done was to my ego. That being said, the recent volatility in interest rates has been striking and at times even dangerous. From a capital preservation standpoint I see no harm in waiting patiently on the sidelines for the dust to clear. We will concentrate on our core credit strategies instead.
Will Tsipras Fold? | March 2015
“The beautiful thing about poker is that everybody thinks they can play.”Chris Moneymaker
The big story these days is whether or not Greece will default, and if so, what implications that will have on financial markets. For the life of me, I can’t figure out if Alexis Tsipras is a genius or a neophyte. He most certainly is testing the patience of the seasoned Eurozone administrators, who appear to be baffled by his game. Perhaps he is like the poker amateurs, who from time-to-time win big tournaments because they don’t bet like the pros. They stay in hands that should have been folded a long time ago, and then get lucky on the “river”. On the other hand, perhaps he knows how the pro would bet and strategically bets against common wisdom in an effort to get the pro to fold winning hands. Only time, and perhaps a favourable biographer, will tell the story, however, I’m certain about one thing: a default by Greece will cause a high degree of pain in the markets.
We will continue to keep a vigilant eye on Greece and maintain a liquid portfolio that can be swiftly reduced if required. Over our long trading careers, we have learned the value of keeping some dry powder on hand in order to take advantage of the “babies” that will surely be thrown out “with the bath water” should Greece default.
Credit
I thought the supply in February was crazy, but the frenzy continued into March. By the time the dust settled, the quarter saw $35.7 billion of new corporate issuance, eclipsing the old record of $31.9 billion.
Despite the deluge of supply and a minor widening of credit spreads south of the border, Canadian credit remained surprisingly resilient. With yields so low, bond funds were eager to foray into riskier securities in an effort to at least cover their MER. I was amazed at how long it took to satiate their voracious appetite. Only towards the end of March did it appear that the buyers were becoming more selective.
I expect the supply machine to be rather quiet at the start of the next quarter which should allow the market to digest the recent supply and lead to a modest narrowing of credit spreads. Given the seemingly endless poker game in Europe, we have concentrated on highly liquid, shorter maturity bonds in order to remain nimble.
Rates
Governor Poloz continues to make central bank watching an entertaining pastime. I find his communication style interesting, albeit confusing, in a world where central bankers have become increasingly bland. Admittedly it is a close call, but my view is the BoC will not deliver further rate cuts this year. I think the front end of the yield curve (out to 5 years) is absurdly expensive, however, maintaining an outright short position will be tiresome, as international buyers continue to buy any dips. Recent changes to the Government of Canada bond auction schedule, which increase the size of benchmark issues, might allow a modest rise in front end yields.
In the US, the removal of the word ‘patient’ from the FOMC’s March statement was not taken as a pre-commitment to a summer rate increase, but rather as a restoration of policy flexibility. It is clear that the Fed will remain data dependent, as they have reiterated time and again, and in that context we see room for the economy to improve before any action on the part of the Fed is justified, particularly while the dollar strengthens, wage growth remains tepid, and geopolitical risks linger in the headlines. We expect the Fed will remain on hold through the summer with the first potential rate hike coming in September at the earliest.
While any hawkish action on the part of the Fed will exert upward pressure on short rates, we don’t expect much of an impact further out in the curve, particularly while the ECB and BoJ continue with substantial QE programs. Faced with either negative or zero yields, Canadian and U.S. bonds will continue to look attractive to investors in those regions.
The Fund
March was another strong month for the Fund generating 2.51% for our investors, bringing the compounded two month return to 4.86%. While our core strategies continued to perform well, we were able to generate excess returns from trading Telus bonds. Telus had been on our radar for a while, as our analytic model indicated that the telecomm sector was attractive and that Telus was particularly cheap. However, we elected to be patient, as we felt that the market would widen telecomm spreads in the face of significant supply following the wireless spectrum auction. With the Telus $1.75bn multi-tranche offering, we saw our opportunity to enter the market and then enjoyed some solid spread performance for the balance of the month. Once spreads reached fair value according to our model, we exited the position capturing over 50 bps of performance for the fund.
Algonquin Debt Strategies Fund LP | February 2015
The Fund
February’s markets created an ideal environment in which to launch the Fund. We took advantage of wider corporate bond spreads to establish positions in various sectors such as REITs, energy infrastructure and financials. The robust new issuance market provided significant opportunity to diversify the portfolio at attractive levels. The portfolio consists primarily of investment grade corporate bonds, along with a modest allocation to high yield credit. Interest rate exposure, as of the end of
February, was largely hedged out to focus primarily on opportunities in credit.
Rates
The surprise rate cut by the Bank of Canada in January pushed short-term interest rates to historically low levels as the market positioned for further cuts in Q1. Although some of this move reverted following the Bank of Canada’s decision to leave target overnight rates unchanged on March 4th, we still find that short-end yields remain unjustifiably low. Although yields are likely to move modestly higher,
our view is the Bank of Canada will not raise rates this year as the Canadian economy is still adjusting to low oil prices.
In terms of the US market, the debate as to the timing of “lift-off” continues. We believe that the Federal Reserve will remain cautious in its approach to raising rates as the stronger US dollar, tepid wage growth and subdued inflationary pressure provide ample cover for the Fed to move slowly. That said, we expect job growth and consumer demand to remain strong, which will likely compel the Federal
Reserve to raise rates during the second half of the year.
Credit
Following a slow start to the year, Canadian credit markets improved significantly in February. Through the month we saw C$ 16 billion of new investment grade corporate bonds issued, bringing the year to date total to C$ 18 billion. The largest Canadian corporate bond offering of the year (so far) was a huge C$ 2.25 billion deal from RBC in 7 year senior funding. This will be an active year for domestic banks in
raising capital and term funding both at home and abroad. Corporate issuance should remain strong in March, although price concessions will likely diminish due to high demand. Barring negative developments in the ongoing “Greek Tragedy” we expect the demand for credit to remain robust.