Credit Income Opportunities Fund

The Sprott Credit Income Opportunities Fund (Series A) was up +0.50% in Q2 2017, +2.10% YTD.

After years of easy monetary policy, central banks around the world are positioning themselves to remove the excess stimulus and raise interest rates. The puzzling dilemma, though, has been the inability of the government bond market to let yields go sensibly higher. Despite the lack of any major economic catastrophe or political surprises, global government bond markets have rejected what looks to finally be an improving environment. Despite an eagerness by central banks to initiate the removal of stimulus they provided through 2015  and early 2016,  longer dated government bond yields haven’t moved higher than they were last November. This has created a significant flattening of yield curves in the US and Canada, which tends to imply a looming recession. Typically the response by riskier assets – equity and credit – to a flatter yield curve, is to re-price securities lower to reflect greater risk premium and a higher probability of recession. Regardless, equity markets, high yield bonds and investment grade credit, throughout the world, have been fairly stable, implying confidence in global economic growth. It appears, for now, the markets are becoming more upbeat on economic conditions and happy to stand pat.

For the first time in 7 years, the Bank of Canada raised interest rates by 0.25%  in July. When this intention was initially telegraphed to the market back in June, it came as a bit of a surprise, considering there had been a consistent BOC narrative of accommodative monetary policy and a desire for a weaker currency. The assessment  of this reversal by the BOC was interpreted to be abrupt and premature, given the persistence of weaker oil, a low inflation rate and the financial vulnerability of borrowers in our frothing housing market. The BOC felt that the continued strength of the Canadian economy and a low unemployment rate justified “the removal of the 2015  insurance policy.” Yields on longer dated Canadian government bonds are higher now, but not above where they were last November. Consequently, the yield curve here in Canada has flattened. The government bond market isn’t convinced, yet, that better economic times are here or that higher interest rates are justified. It’s a similar situation in the US. After 3 rate increases by the US Federal Reserve, 10 year interest rates are below where they were last November and their yield curve has flattened, consistent with our experience here in Canada.  And this September it’s expected that the FED will start to sell off $2 trillion in assets  from its balance sheet. So they will no longer be a buyer of treasuries and mortgage bonds. It’s a complicated conundrum, as improving global economic growth, lower levels of unemployment and the defeat of deflation, will require tighter monetary policy and with that higher interest rates across the curve. Yet the ever cynical government bond market isn’t buying in. I agree yields have been affected by the absence of inflation – that’s a mystery and a complicated issue. It might be the method that’s used to measure inflation. Perhaps it’s the impact of disruptive technology or demographics, but I’m prepared to wager inflation will return as interest rates return to normal levels. Global growth is increasing and with that there will be better demand for commodities, which will be very positive for the Canadian economy. Tax cuts and infrastructure spending initiatives should eventually happen in the US, probably not till 2018.  There’s more planned rate increases by the BOC and the FED. Time will tell, but I stand by my conviction to higher interest rates – US 10 year treasuries probably trade closer to 3.0% by year-end, and Canadian 10 year bonds around 2.50%.

Canadian investment grade spreads have remained fairly stable. It’s been one of the most uneventful quarters for the corporate bond market in years. The credit spread on the Merrill Lynch Canadian Investment Grade Index narrowed in a miniscule 1bp to 113bps,  tighter by 16bps YTD. From a valuation perspective, I think Investment grade credit is fairly priced. Generic BBB credit spreads, the rating bucket I prefer to own, are at 129bps.  One must apply significantly more leverage to produce the same types of returns that were achievable with very low leverage 6 months ago. In this type of environment increasing leverage beyond 1.5 times to produce a higher level of income is an unsustainable proposition – it equates to adding too much risk for the incremental yield. I’ve reduced leverage in our portfolio to 0.6 times, as I believe there will be a better entry point to add more credit and justify the leverage. The best performing 5-year sectors for the  quarter were Insurance, Bank NVCC  and Sub-debt, Energy Infrastructure and Telecom. New issue supply was around $36.3  billion last quarter, $59.8  billion YTD and on track for $100  billion this year, roughly equivalent to 2016’s issuance. Net new additions to our investment grade portfolio were Brookfield Infrastructure Partners, Allied Properties, Home Capital Co., TransCanada Pipelines, CNQ, Intact Financial, Chartwell Retirement Residences, Enbridge Inc., Laurentian Bank and BNS.

The Merrill Lynch Canadian High Yield Master Index closed out the quarter with a spread of 391bps,  tighter by 11bps and in 38bps  from the start of the year. With the high yield index spread at a multi-year low of 391bps  and an all in yield of 5.21%,  I think high yield credit is getting pricey, even with improving credit fundamentals and low default rates. Purchasing bonds that have a coupon of between 5% and 6% isn’t that attractive relative to other investments like loans or equities. And an investor doesn’t have nearly the buffer they had a year ago, to protect against the threat of higher interest rates, an economic shock or an earnings disappointment by a company. The spread on the Merrill Lynch US High Yield Energy Index was at 526bps,  wider by 84bps. Many Energy and E&P bonds have traded in the mid to high 90’s,  which is starting to look somewhat reasonable, but not a real deal considering where they traded in early 2016  and the fact that the equity of many energy companies are down as much as 50%.  I have however seen selective opportunities in secured loans – companies that aren’t ready for the public bond market yet. Secured loans trade at a yield that is double that of high yield, 9.5%  to 12%  and they are secured by assets.  New loan additions to the portfolio are TMAC Resources and Champion Iron. High yield additions to our portfolio over 2Q17  were Parkland Fuel Corp. and Energold Drilling Corp.

Throughout the last quarter, we have increased  our conservative  positioning bias. Our core portfolio has 45% cash, 23% investment grade, 19% high yield, 2% secured loans, and 11% equities – we added a position in Element Fleet Management preferred. The average BBB credit quality of the portfolio hasn’t changed, duration is at 3.0 years and leverage is 0.6 times. The overlay portfolio (the leverage) is entirely investment grade credit with an average duration of 6.3 years, interest rate-hedged with government bonds. From a currency perspective we have continued to maintain a USD weight of 19%.  Our fund’s yield is around 4% and given the low risk characteristics  of the portfolio, I believe it is delivering adequate compensation as we wait to add more credit. Corporate bonds have been on an amazing year and a half run, so some form of a correction shouldn’t be that far away.

The bond market is very comfortable with interest rates that are still uncharacteristically low, despite better economic growth and the removal of ultra-easy monetary stimulus. With the yield curve flattening there’s a greater expectation of recession by the bond market, yet no sign of concern by the equity markets or credit. It’s too early to tell who’s right, but if economic growth does surprise to the upside, validating equities and credit valuations, all will be good. If not, we’ll be in for more volatility and a healthy market correction.

Regards,

Mark