Monthly Commentaries
The Crooked Path Down Memory Lane | February, 2017
“Memory is deceptive because it is colored by today’s events.”
Albert Einstein
Suppose your doctor tells you that you must undergo an uncomfortable medical examination and that there are two choices available.
Option A: 8 minutes of sharp, intense pain and the procedure ends.
Option B: The same 8 minutes of intense pain as Option A, followed by an additional 16 minutes of moderate pain, concluding with some mild discomfort.
At this point, you’re probably considering switching doctors. Oddly enough, despite how ludicrous the second choice seems, it may give you a better memory of the experience.
This is not to say you are a masochist, but this was the surprising result of a study conducted by Daniel Kahneman and UofT’s Donald Redelmeier. They asked colonoscopy patients to rate the intensity of pain at one-minute intervals as well as give an overall pain rating afterwards. Their findings drew an interesting distinction between the experience and the memory of the procedure, offering evidence of a heuristic known as the peak-end rule.
The peak-end rule states that our memory formulates an opinion of an experience based on how we feel at its most intense point and at the end, remaining largely indifferent to the duration and the sum of the individual moments.
For example, Patient A goes through an 8-minute examination with a peak pain of 8 (out of 10) and in the last minute a rating of 7. Patient B experiences the same 8 minutes, and for the next 16 minutes is exposed to varying degrees of pain, finishing with a mild discomfort registering a lowly rating of 1.
When asked to rate the overall experience, Patient A gives it a 7.5 on the pain scale while Patient B gives it a much lower rating of 4.5. This despite the process lasting three times longer and the person enduring a much greater aggregate amount of discomfort.
Thankfully anaesthetics are administered for colonoscopies now, but the peak-end rule has much wider and deeper implications. In the wonderful world of investing, history is often used as a guide to gain perspective. This particular bias leads us to overemphasize market extremes and give disproportional weight to recent events. Because 2008 left an indelible mark on investors; they may find themselves overly referencing this period as well as the most current market events in their analysis.
The problem with this is that it ignores important considerations such as the passage of time, the fact that markets can spend ages at fair valuations, and changes to the macroeconomic fundamentals. Without careful analysis and thought, there is a significant risk of jumping to erroneous conclusions.
When we base investment decisions purely on gut-feel or intuition, we are relying heavily on our memory. Unfortunately, the peak-end rule and a host of other biases indicate that our memory is not ‘all that it is cracked up to be.’
The Fund
Credit spreads continued to tighten in February with ongoing demand for higher-yielding names. Domestic bank subordinated debt (NVCC) outperformed, and the fund benefitted from this. New issue activity was abnormally light to start the month but bounced back strongly in the second half. Deals were priced with no concession (and in some cases negative concessions) to existing secondary levels. Despite this, the new deals performed extremely well. Amongst this supply, two energy focused names came to market as Canadian high yield issuers continue to offer a steady stream of new financings. Notably, domestic banks were absent from the Canadian primary market after their earnings season. They chose instead to finance in international markets.
Although we maintained a modest exposure, the narrowing of credit and interest carry contributed to a solid 1.30% gain in February.
Year | Feb | YTD |
---|---|---|
2017 | 1.30% | 3.05% |
2016 | 0.19% | 23.15% |
2015 | N/A | 15.86% |
The Credit
The adage that ‘March comes in like a lion’ also applies to new issues. Given the sustained demand for credit, deals should continue to perform well. Increased primary activity often creates good opportunities in secondary product as investment managers attempt to reposition portfolios, and bond dealers manage their inventories. Despite the positive tone in credit markets of late, we are taking a more cautious approach. Moderate risk positioning and an increased focus on sector and security selection seem appropriate to us.
The Rates
Despite some recent strength in Canadian employment figures, the Bank of Canada preferred to highlight that the economy faces a material degree of excess capacity. As such, Governor Poloz is likely to remain on hold for the balance of 2017. The caveat being any adverse impact from US fiscal policy that would warrant further easing.
Governor Yellen and her colleagues at the Federal Reserve have made it clear that a rate increase in March is nearly a done deal. Should the US economy continue to strengthen, the Federal Reserve will probably hike two more times, bringing the 2017 total to 75bps. The measured pace of hiking coupled with on-going quantitative easing by the European Central Bank and the Bank of Japan makes it difficult for yields to rocket higher. Instead, the bond bears will have to be content with a painfully slow rise in interest rates.
Regards,
The Algonquin Team
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The Hitchhiker’s Guide to Trump | January, 2017
“DON’T PANIC.”
Douglas Adams,‘The Hitchhiker’s Guide to the Galaxy’
Through the early days of Trump’s presidency, we found ourselves reminded of Arthur Dent; regular Earth-person and protagonist of ‘The Hitchhiker’s Guide to the Galaxy.’ After discovering that both his house and planet are to be destroyed, Dent must negotiate a series of increasingly unpredictable and bizarre events.
Following some of the President’s more controversial first moves, many earthlings may even empathize with another of the book’s characters, Marvin the depressed robot, who held the view: ‘Loathe it or ignore it. You can’t like it.”
From an investment perspective, perhaps the relevant line is: ‘Like it or loathe it. You can’t ignore it.’ Or can you?
The investors’ predicament is a difficult one, and they don’t have the benefit of a handy guide for navigating the new administration. On the one hand, lower corporate taxes, deregulation, and fiscal stimulus bode well for business confidence. But against this backdrop are the President’s unpredictability and the potential for trade wars between the US and, well, the rest of the world.
Should the US employ trade tariffs, the reaction of the affected countries is impossible to predict. And while it may be ‘America First,’ the law of unintended consequences could cause ‘the First’ some pain. Business leaders don’t like uncertainty. So despite the government’s efforts to create jobs, companies may decide to ‘hunker down,’ and wait out the storm.
We expect all of this to lead to a challenging and volatile environment. Perhaps the best course of action is to ‘Ignore it or like it.’
Those following passive strategies can ignore the asset price gyrations and simply enjoy the circus show. After all, the markets have managed to deal with far more turbulent periods and have rewarded the long-term, patient investor, very well.
Active managers may face a dizzying array of opportunities and risks to manage. The opportunities should present themselves not only in general market levels, but also within sectors and individual companies. Events ranging from ‘twitter-attacks’ to changes in the tax code, regulations and trade agreements will change the playing field for many businesses. In this type of environment, with the potential for market overreactions, astute investors will likely be able to pick up a bargain or two.
The risk is that this is much easier said than done. It requires analytical rigour, objectivity, and a strong stomach, as ‘mistakes’ will be unavoidable. And when in doubt, or just dumbfounded, don’t panic, remember the answer is 42.
The Fund
We started the year with our analysis providing a conflicting view on domestic credit markets. While the technicals and sentiment were supportive of credit spreads, the rally into year-end and the outright levels indicated that caution was warranted. Accordingly, we adopted a medium risk posture and remained on high alert for any indications of weakness.
In the end, it was like carrying an umbrella on a cloudy day with no rain. Our caution, while perhaps prudent, was proven unnecessary. With new bond issues well oversubscribed, portfolio managers were forced to do their buying in secondary markets, pushing spreads tighter. We were able to add to the returns from carry and credit spread tightening through tactical trading to end up with a 1.73% gain for the month.
Year | Jan | YTD |
---|---|---|
2017 | 1.73% | 1.73% |
2016 | 0.19% | 23.15% |
2015 | N/A | 15.86% |
The Algonquin Debt Strategies Fund LP was launched on February 2, 2015. Monthly returns are based on ‘Series 1 X Founder’s Class’ NAV as calculated by SGGG Fund Services Inc. and are shown in Canadian dollars, net of all fees and expenses.
Credit
We continue to be cautious around credit spreads, mainly because we can’t make the case that they are cheap. However, it is just as difficult to make a case that they are very expensive. Portfolio managers seem to have cash to put to work, the new issue calendar is unusually light, and higher rates are attracting yield starved buyers. The situation is ideal for corporations who are able to raise debt without paying a concession.
In spite of these positive fundamentals, the market may be a ‘tweet’ away from a sharp ‘Trump Dump,’ and given our desire to retain flexibility, maintaining a medium risk posture continues to be an appropriate course of action.
Rates
US economic data still points to a strengthening economy, which coupled with fiscal stimulus, keeps the Federal Reserve on track to raising rates at least two more times this year. For the most part, bond yields seem to have settled into a new trading range, although the risk remains that US yields will drift higher. As long as the European Central Bank and the Bank of Japan continue with quantitative easing programs a sharp rise in yields is highly unlikely.
As expected, the Bank of Canada left the overnight rate unchanged in January. Without any clarity on US policy, Governor Poloz has no choice but to patiently wait for the impact on the Canadian economy to unfold. If US policy severely curtails Canadian exports, the Bank of Canada might need to utilize monetary stimulus while the economy adjusts to a new reality. Should this scenario unfold, a significant drop in interest rates would occur.
Regards,
The Algonquin Team
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Do You Feel Lucky, Punk? | December 2016
“The more I practice, the luckier I get.”
Arnold Palmer
We grow up learning that success is the product of hard work and skill. What often gets overlooked is the role that luck can play; a factor that some economists believe has become increasingly important in our globalized, winner-take-all marketplace.
Effort and talent are certainly prerequisites for success, but with so many hard working and highly skilled individuals competing for the prize, the ‘ big winners’ are often also the luckiest. Take, for example, the world of sports, where a fortuitous bounce can be the difference between a champion and the ‘first loser.’
How much influence luck has depends on the endeavour you are pursuing.
At one extreme there is the lottery, requiring minimal ability and a ‘helluva’ lot of good fortune. On the other end of the spectrum, we have running and chess. It doesn’t matter how lucky you are; it’s highly unlikely that you’re beating Usain Bolt in a 100m dash or Kasparov at his game.
In between these two poles are the pursuits involving varying degrees of effort, ability, and providence. Take, for instance, poker; where with the right cards an amateur can take a few hands off a world champion. But over several hands or games, we would expect the professional’s expertise to win out.
While the champ can use her skill to dominate the amateurs, she better hope to have lady luck on her side at the final table. With so many highly skilled and evenly matched players, a good break can easily be the thing that leads to the final pot. This phenomenon has been dubbed ‘the paradox of skill’; the more highly trained and equally skilled the competition, the bigger fortune’s influence.
Like poker, investing is full of probabilities and uncontrollable factors. Also like poker, the outcomes are definitive and quantifiable, and in the short term can be determined by chance. Fortunately, investing is not a ‘point in time’ competition with clear winners and losers. Instead, it is a process where results should be measured over a longer period. Hard work, consistency of analysis, patience and discipline are key to moving an investment further away from a lottery and closer to a game of chess.
It is, therefore, the investor’s task to untangle luck from skill, to focus on the process rather than the immediate outcome. Unfortunately, this is a rather difficult proposition. We are naturally wired to seek out and link causes and effects, even where chance has been at play. The media is always ready to feed this desire, with a tidy story to explain every market move. And after something has occurred, a good narrative can make it seem as if what happened was always inevitable. Adding further static to the feedback loop is our inclination to assign luck the blame when things go wrong and ignore it when they go our way.
While difficult, separating luck and skill is a worthwhile endeavour, as it helps us to identify where our energy should be focussed. When skill is the dominant factor, as in golf, deliberate practice is the key. Where luck is involved, the focus should be on process and probabilities over results.
As an added bonus, studies have shown that those who can identify luck in their lives tend to be more grateful, likable and happier. We therefore not only wish you good luck for the year ahead but also the wisdom to recognize it.
The Fund
The ‘Trump Bump’ continued into December. New issues were dominated by banks; however, notable deals we participated in included Fairfax, Inter-Pipeline and Fortis. As some issuers pushed transactions into 2017, portfolio managers continued to pick away at secondary product, forcing credit spreads narrower. The fund benefited from a high exposure to credit and from the performance of the new deals to produce a monthly return of 1.62%, bringing the full year result to 23.15%.
Year | Dec | YTD |
---|---|---|
2016 | 1.62% | 23.15% |
2015 | 0.87% | 15.86% |
The Algonquin Debt Strategies Fund LP was launched on February 2, 2015. Monthly returns are based on ‘Series 1 X Founder’s Class’ NAV as calculated by SGGG Fund Services Inc. and are shown in Canadian dollars, net of all fees and expenses.
Credit
In a nutshell, 2016 was a wild year for credit. After gapping wider 30 or 40 bps in January, credit spreads staged a remarkable recovery and ended, on average, 35 to 45 bps narrower on the year. Oil & Gas and Pipelines were the best performers while Retail underperformed largely due to Sobeys.
Looking ahead, domestic new issuance for 2017 is estimated to be between $85 – 95B. In the near term, the technical picture and investor sentiment support a modest narrowing of credit spreads. With the ‘policy-by-twitter’ strategy of President-elect Trump, we expect a fair degree of market volatility which should make for attractive trading opportunities.
Rates
Governors Poloz and Yellen certainly have their hands full. Dr. Yellen will have to guide US monetary policy amidst a potentially significant fiscal boost from the GOP. Given an already tight labour market, US core inflation ought to drift higher, allowing the Federal Reserve to tighten two or three times. As the sky didn’t fall after the first two hikes, the next couple should easily be digested by the markets.
Governor Poloz has greater challenges in store. Elevated housing prices and household indebtedness remain major risk factors for consideration. The uncertainty surrounding NAFTA, looming across-the-board tax cuts in the US, and the recent rise in Canadian bond yields likely mean the Bank of Canada will remain on hold for quite a bit longer. Perhaps Canadians will get ‘lucky’ and enjoy a much stronger economy given higher oil prices and improving growth across the world.
Regards,
The Algonquin Team
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Rates They Are A-Changin | November 2016
“You don’t need a weatherman to know which way the wind blows.”
Bob Dylan
As the world tries to figure out what to expect from a Trump presidency, it appears the market has reached its conclusion. With US 10y bond yields up 0.60% in November, the expectation is for stronger growth and higher rates.
Investors, shocked with losses of 2% in their fixed income portfolios, have been wondering what happened and what’s next?
To answer these questions let us begin by looking in the rear view mirror. Historically, government debt has yielded 1% to 2% above inflation. When US 10 year notes traded at 1.75%, one could assume that people expected changes in consumer prices to be roughly zero for a decade. This seemingly bold bet suddenly appeared to be a silly one, prompting people to hit the sell button.
What drove the panic selling?
The anticipation of a substantial supply of new bonds and inflation.
As the Dylan song goes, “Come senators, congressmen, please heed the call.” With Republican’s in full control of US policy, the door is open to significant tax cuts and infrastructure spending. Since such policies would need to be financed with an abundance of debt, investors are rightfully demanding a higher return as compensation.
Donald and friends have also raised the inflation spectre. With US unemployment at 4.9% and a tough stance on illegal immigrants, there may be a limited amount of labour to meet the demand created by fiscal stimulus. This could lead to a substantial rise in wages to attract employees.
Further stoking the inflationary flames is the potential for a trade war. There have been forecasts showing that the imposition of 15% tariffs on Mexico and China could add 1% to US consumer prices.
This combination of rising wages and prices would push the Federal Reserve to steadily hike rates through 2017, forcing bond prices lower. As long as the promise of fiscal stimulus remains, US yields will likely remain under upward pressure. The path won’t necessarily be a straight one; however, it does seem that the ‘bottom’ is in.
What about O Canada, our home and native land?
Unlike the Federal Reserve, we expect the Bank of Canada to remain on the sidelines for the foreseeable future. This will keep short end rates anchored, but longer-dated yields have to adjust higher in sympathy with the US in order to entice global investors.
So how much higher will Canadian interest rates go?
To answer this, we revert back to our trusty rear view mirror. The Bank of Canada has successfully managed to keep inflation at roughly 2% for the last 25 years. Assuming history is a reasonable guide and rates normalize, one can expect 5 and 10 year yields to reach somewhere between 2.5% and 4%. These levels are more than double today’s yields, meaning more losses from traditional fixed income could be on the way.
How long will it take for rates to reach these levels?
‘The answer, my friend, is blowin’ in the wind.
The answer is blowin’ in the wind.’
The Fund
Given the uncertainty heading into the election, we significantly reduced our risk posture by liquidating most of our lower rated securities and hedging the portfolio with a selection of short positions. As the election results poured in and Dow futures plunged 800 points, we were happy to have gotten out of the way and wished we had put on a bigger hedge. The rapidity with which the market stormed back completely caught us off guard. As a result, we elected to ‘sit on our hands’ for a couple of days and watch.
After concluding the “the Trump bump” had legs, we aggressively increased the fund’s risk posture, including adding to bank NVCC and midstream energy positions. NVCC performed well on the speculation that less regulation and a lower cost of business will boost bank profits. Our energy exposure also performed well, with the last remaining position benefiting from a fortuitous bounce when OPEC decided to cut production.
Having hedged against the rise in interest rates and capitalized on the narrowing of credit spreads, the fund generated a return of 1.60% in November.
Year | Nov | YTD |
---|---|---|
2016 | 1.60% | 21.18% |
2015 | 1.37% | 15.86% |
The Algonquin Debt Strategies Fund LP was launched on February 2, 2015. Monthly returns are based on ‘Series 1 X Founder’s Class’ NAV as calculated by SGGG Fund Services Inc. and are shown in Canadian dollars, net of all fees and expenses.
Credit
December is typically a favourable month for credit since new issue supply is often light. The issuance calendar seems abnormally empty as it appears that very few corporations need to borrow money, especially those rated BBB. Without a clear reason to worry about credit spreads, we continue to maintain a reasonable posture heading into the holiday season.
Rates
It is a foregone conclusion that the Federal Reserve raises rates on December 14th. The only unknown is their outlook for future hikes. The Bank of Canada, noting significant slack in the economy, will remain on hold for quite some time. Because interest rates ought to remain volatile, we will maintain tight hedges on the portfolio.
Regards,
The Algonquin Team
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Gesundheit | October 3, 2016
Deutsche Bank (DB) has been making headlines and causing tremors in the markets. With flashbacks of the Lehman fiasco and concerns over contagion, investors are justifiably anxious.
We thought we would wade through some of the noise and share our thoughts on the situation.
Base case scenario
Typically, the Department of Justice (DoJ) floats a very large fine, the banks negotiate and eventually pay a much lower number (single digit billions). The initial number from the DoJ was $14bn, but rumours surfaced on Friday that the DoJ and DB could be agreeing to a $5.4bn fine. If this turns out to be true it should relieve the pressure on DB. We believe it is possible that the German and American governments are having backroom discussions to expedite the process in hopes of avoiding a major problem.
The Risks
Ironically, the post-crisis regulations intended to make banks safer might just be making the situation worse. Firstly, European regulation prevents a government bailout until creditors have been hit with losses equal to 8% of liabilities. In DB’s case, this could be €139bn which could significantly damage confidence in the financial system. Furthermore, Germany hasn’t been particularly sympathetic towards Italy’s bank problems, making it difficult for Chancellor Merkel to skirt the rules.
Secondly, the increased transparency and reporting of the leverage ratio can cause a negative spiral. There are some signs of creditors shying away from lending to DB, which makes it more difficult for them to maintain their leverage ratio (unless they aggressively sell assets). If lenders see a deterioration in the ratio some may decide not to lend and so on. The problem is that banks still rely heavily on short term funding and typically maintain only 30 days of liquidity, so this downward spiral can get out of hand quickly.
Our Approach
We have been reducing risk as Deutsche adds to other concerns that will affect the market in October such as the US election and continued worries over the Fed. In particular, we have reduced exposure to bank debt to provide flexibility should the opportunity to re-establish positions present itself.
We continue to watch closely as the situation develops and are holding a modest risk profile until we have further clarity on DB’s outlook.
Extra! Extra! Read All About It! | October 2016
“The man who reads nothing at all is better educated than the man
who reads nothing but newspapers.”
Thomas Jefferson
Every day we are bombarded with a barrage of news, delivered to us at breakneck speed. In theory, all this access to information should leave us more informed and better equipped to make decisions. But as the Trump campaign has reminded us, theory and practice are two very different animals.
Take for example the research done by psychologist Paul Andreassen in the late 1980s. In his experiments, investors without access to financial media earned higher returns than those that did. The group following the news closely was guilty of overtrading and overreacting to the latest headlines, thus impairing performance.
Fast-forward to today and some argue that the information overload is just too much. And in the pursuit of speed and brevity, veracity and quality have been sacrificed. Whether you ascribe to these theories or not, the reality is that it’s very difficult to get an accurate view of the world through headlines. This is because the media is limited to reporting what happens and what is newsworthy. We have yet to see a special report on a company performing as expected or another peaceful day in the city.
This is why, as Newt Gingrich put it, people ‘feel’ the world is a more violent and unsafe place despite the facts indicating otherwise. As sociologist Barry Glasner notes: “Between 1990 and 1998, the murder rate in the United States decreased by 20 percent. During that same period, the number of stories about murder on network newscasts increased by 600 percent.”
Similarly, ask anyone what they think is a more likely cause of death, shark attacks or lightning strikes. They will probably be shocked to learn that it is lightning and by a factor of 30 to 75 times. With a little analytical thinking this makes sense. Shark attacks can only occur on the coast, whereas lightning can strike anywhere. But sharks make for exciting stories and great movies, making them easier to recall.
On top of delivering us the news, the media also like to trot out expert panels to opine on everything from the price of oil to tomorrow’s hockey game. Not only are there many studies showing how simple algorithms can provide better predictions than the experts, but there is also evidence that media fame reduces the accuracy of their forecasts. This is usually attributed to overconfidence and the need for these personalities to have extreme and definitive views. After all, nobody is tuning in to hear that the price of oil could be between $30 and $70 next year or that their team has 50/50 chance of winning.
At the end of the day, we must remember that it’s not the media’s job to make us better investors and voters. They get paid for clicks and eyeballs. Sadly, sound financial advice and deep political analysis are boring, repetitive and don’t always fit in 140 characters or less. We will keep this in mind no matter who becomes the 45th US president.
The Fund
Heading into October, we were quite concerned with the hype surrounding Deutsche Bank and opted for a fairly conservative posture. When Deutsche was able to find buyers for $4.5B of 5-year senior unsecured bonds, the markets calmed considerably. We reacted quickly to re-establish positions exited in September, generally at cheaper levels. In particular, we took advantage of the widening that had occurred in bank and insurance subordinated debt to enter at favourable prices.
After the OPEC production cut on September 27th, oil prices started firming. We stepped back into one of our favourite names in the oil space and bought CNQ bonds. This position performed extremely well, generating 10% of the monthly return. With Deutsche Bank off the radar and a lower-than-anticipated new issue supply, credit spreads generally narrowed. This coupled with the carry led to October’s solid performance of 1.86%.
Year | Oct | YTD |
---|---|---|
2016 | 1.86% | 19.27% |
2015 | 1.71% | 15.86% |
Since Inception: 38.19%
Credit
If new issue supply remains light, credit spreads ought to grind narrower in November. The lack of investment grade product is putting portfolio managers in a real “damned if you do, damned if you don’t” situation. Those who reduce exposure now, risk not being able to buy corporate bonds should Clinton prevail. If Trump is president, given the market’s disdain for uncertainty and his views on NAFTA, the potential for a “sell Canada” trade to materialize is a real possibility.
Positioning portfolios ahead of next week’s election will be a tricky proposition. The key will be to maintain as much flexibility as possible to react after the event. As such and because of the asymmetric risk/reward profile, we have chosen to err on the side of caution and position the portfolio more conservatively.
Rates
The press has made a lot of noise about yields moving higher, and indeed it has been a lousy month for bond holders. However, fixed income funds are still up approximately 4% on the year. Investors are becoming a little more nervous that the ECB and BoJ won’t increase their quantitative easing programs. Furthermore, it appears that the Chinese economy may be stabilizing, which in turn could lead to higher growth in other parts of the world. The drift to modestly higher yields may continue as people adjust their economic expectations.
The Bank of Canada has managed to confuse people with their language around the prospects of another rate cut. After the dust had settled, expectations gravitated back to the Bank doing nothing for many more months. The Federal Reserve continues to prepare everyone for a rate hike. Barring an unexpected data disaster (and yes, President Trump may qualify) we expect the Federal Reserve to hike rates 25 bps in December.
Regards,
The Algonquin Team
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What Goes Down Must Go Up | September 2016
“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.
Year | Sep | YTD |
---|---|---|
2016 | 1.01% | 17.09% |
2015 | 1.68% | 15.86% |
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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Can You Outsmart a Chimp? | August 2016
“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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From Fixed Income to Fixed Loss | July 2016
A Look at Negative Rates
For as long as we can remember, zero was considered the lowest interest rates could go. Anyone espousing
that they could go lower received as much attention as ‘flat earthers.’ Today, the impossibility of negative
rates has become another myth that modern society has debunked.
There is currently around $10 trillion of debt trading at negative yields, including over $500 billion of
corporate bonds. This past month, CIBC joined the list of institutions getting paid by lenders for the
privilege of owning their debt.
This has left many scratching their heads trying to understand what this all means. We will attempt to make
some sense of the madness.
What do negative rates actually mean?
This is most easily explained with a simple example.
Today you can buy a 5y German Government Bond for €102.50, not receive any coupon interest for 5 years
and at the end get €100 back. Essentially locking in a €2.50 loss over 5 years
How did we get here?
In an attempt to stimulate their moribund economies, the European and Japanese central banks have taken
their overnight interest rate to -0.4% and -0.1% respectively. This is the rate that banks borrow or lend at for
a single day. The idea was to prevent them from hoarding cash and incent them to lend.
The central banks have also embarked on aggressive programs to buy debt. They are doing this to lower term
interest rates and flood the banking system with money. The sheer scale of this buying has also allowed a few
select corporations the luxury of being paid by investors to borrow money.
The theory behind quantitative easing is that it spurs lending and forces people to invest in activities that
create jobs and wealth rather than reap the benefits of simply investing in government securities. There are
many who credit the significant equity rally since the crisis to people seeking higher potential returns than
expected from the bond market.
Why would anyone accept a guaranteed loss?
If you are in Japan or Europe and have idle cash or are mandated to hold a certain amount of “cash”, you are
in a no win situation. You have the choice of earning negative rates by investing overnight with the central
bank or losing less by buying debt. It seems investors are holding their noses and buying bonds. Of course,
there are also traders doing some buying on the bet that yields will go even lower.
What does this mean for Canadian rates?
Compared to a guaranteed loss, our 1% 10y rate represents a juicy yield for foreign investors. With the pool
of positively yielding sovereign debt shrinking, investors have been piling into Canadian bonds. Furthermore,
Canada is one of only 12 countries with a AAA credit rating and is also the second largest AAA bond issuer
(behind Germany whose yields are below zero out to 10 years) which enables meaningful allocations to be
made. International buyers could keep a ceiling on how high domestic rates can drift.
Do bonds belong in a portfolio anymore?
What do you think? We would love to hear your thoughts, as we will be exploring this question in our
upcoming commentary. Please send your response to [email protected]
Regards,
The Algonquin Team
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Should You Still Own Bonds? | July 2016
“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
Year | Jul | YTD |
---|---|---|
2016 | 1.73% | 14.05% |
2015 | 0.73% | 15.86% |
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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No Bregrets | June 2016
“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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Playing with the House’s Money | May 2016
“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