December 31, 2023
Commentary
Monthly Update
Given that we have already published our 2024 Outlook last month, we will focus this monthly commentary on our 2023 performance attribution. As discussed in our Outlook, we split the portfolios into four general categories or building blocks. We will therefore present performance attribution using those same groups in Table 1 below.
As a reminder, for simplicity, at this point in the cycle, we divide our portfolios into four building blocks:
1. Short-Term High-Grade Credit (under 3-years, A- average rating) as our anchor and main source of income,
2. LRCN/Hybrid Bonds of Canadian Investment Grade issuers, as they are very cheap and offer good upside with low risk of default,
3. Long-Term Government Bonds, as a safe-haven asset, they tend to perform very well in a challenging economic environment,
4. Credit Hedges, primarily through a short position in US High Yield ETFs, because they are the most vulnerable in an economic downturn and are currently priced to perfection.
As expected, our short-term corporate bonds, which make up most of the portfolios, contributed the vast majority of the return. For the Alternative Credit Opportunities (NACO) and the Credit Income Opportunities (Ops) funds, the return is illustrated net of funding costs (i.e. the cost of leverage). For the foreseeable future, we expect this segment of the portfolios to maintain similar weights to last year (~80% for DBF, ~170% for NACO and Ops). With the Q4 rally in both rates and credit spreads, the overall yield of this segment of the portfolio has declined somewhat, but remains above 6%, providing us with a solid starting point for 2024.
LRCN and Hybrid Bonds had a volatile year, selling-off hard with the banking stress of March, and recovering only later in Q3 and Q4. Given our outlook for a softer economic environment in 2024, we expect that segment of the portfolio to contribute its cash yield (about 5.5%), but price gains to be limited. Why not more downside, given the credit sensitive nature of those bonds? If we do get a recession, interest rates will be cut by the Fed/BoC, probably by about 200-300bps. That should be enough to offset the spread widening of these bonds, keeping their prices roughly unchanged. Given the recent rally, we have taken some profit, reducing our weight on these securities by a few percent across the funds.
For the full year, our position in long-term government bonds was a small benefit to the performance of the DBF, and a small net detractor to the performance of NACO and Ops. At the worst, towards the end of October, they detracted by as much as 2.5% from performance, only to reverse that loss as long-term bonds rallied in the last two months of the year. With the magnitude of the rally in late 2023, we expect a period of consolidation, particularly given the overly ambitious market expectations for interest rate cuts as early as March. But, as the economy gradually loses steam and the prospect for rate cuts becomes imminent, we expect the rally in long-term government bonds to resume. We are primarily exposed through option positions on the TLT ETF (30-year US government bond ETF). We sold put spreads to buy call spreads, spending no premium by design. With our current positioning, a further rally in the U.S. 30-year government bond to 3% (from the current rate of ~4.2%) would contribute about 3 to 4% of NAV, depending on the fund. We do not intend on increasing this position, but we will keep rolling it forward as options expire.
The funds returned between 6% to 8% in 2023, and most of that return was driven by the core income position, short-term corporate bonds. The backdrop going into 2024 is quite similar to last year, and we expect that portion of the portfolio to continue to generate the bulk of our returns.
The last building block of our portfolios is credit hedges. As of year end, we have a short position in US High Yield ETFs (HYG and JNK). Earlier in 2023, we also had payer spreads in CDX IG (think put spreads on pure US credit spreads), which were monetized with the March credit sell-off. On net, our credit hedging program detracted from performance by about 30bps for DBF, and 50-60bps for NACO and Ops, respectively. In such an uncertain economic environment, this was a fair price to pay for extra ballast, and with HY spreads as tight as they are now (back to 2021 levels, when we had 0% rates, QE and fiscal easing), we view this as a highly asymmetric hedge, and therefore do not plan on reducing it. In a recession scenario, HY credit spreads could widen to around 800 to 1000bps, not stay at 350bps where they are now. We therefore see a lot of upside to this short position, if our recession scenario is to materialize.
Conclusion
The funds returned between 6% to 8% in 2023, and most of that return was driven by the core income position, short-term corporate bonds. The backdrop going into 2024 is quite similar to last year, and we expect that portion of the portfolio to continue to generate the bulk of our returns. But, whereas our long-term government bonds and credit hedges contributed very modestly or even detracted from performance last year, 2024 could be the year where they deliver, and help drive higher returns.
This situation is very similar to what happened to us in 2019 and 2020. We were defensive all year in 2019, as the global economy weakened. Little did we know that a global pandemic was coming, but our models were pointing to a downturn nonetheless. We underperformed in 2019, but in 2020, our defensive positioning paid off, hedges were monetized, and we acted from a position of strength. We are following a very similar playbook.
We will remain defensively positioned across the portfolios for the foreseeable future. If we get a hard landing, we should benefit handsomely. And, given how far credit spreads have already rallied, even if we do not go into recession, we believe that there is not much gas left in the tank should the soft-landing scenario materialize. Markets are already fully pricing that in.
Happy New Year!
Mark, Etienne & Nick
Ninepoint Partners
