Monthly commentary discusses recent developments across both the Diversified Bond and Credit Income Opportunities Funds.
With 2019 now behind us, we are left pondering what to expect for 2020 and how that will guide our portfolio decisions. The global economy has slowed, but for now has stopped deteriorating (Figure 1). The prevailing view amongst market participants is that lower US/China trade tensions and the lagged effects of more accommodative monetary policy across the globe should lead to a pick up in economic activity, probably pushing recession out to 2021.
Equity and credit markets are already discounting better growth and earnings; the S&P 500 price-to-earnings ratio is back to its pre-tax reform high (Figure 2a) and corporate credit spreads (adjusted for duration) offer investors very slim risk premiums (Figure 2b). Closer to home, Canadian credit also feels stretched, new issues come with very little concessions and still attract large amounts of buyers. Secondary trading is mostly one-sided as buyers can’t seem to find enough bonds to satisfy their appetite. Overall, the market seems a little stretched, assuming that the data will inevitably turn for the better. Given that the potential improvement in global growth has already been reflected in asset prices, we continue to prefer a defensive stance, keeping risk low, portfolios liquidity high and our powder dry.
Given the positive tone around growth, yields on long term government bonds have been drifting higher. Interestingly, most of the increase in bond yields has been driven by inflation compensation. Real yields have remained very low (Figure 3), suggesting that the government bond market does not yet share the enthusiasm reflected by equity and credit markets.
Accordingly, we have significantly reduced our duration by selling most of our government bonds. We remain on the sidelines as we await more direction one way or another, avoiding the volatility higher duration brings. We feel interest rates probably continue to drift higher to start the year as the market responds to excess monetary stimulus, a de-escalation in US/China trade tensions and remote recession fears.
In terms of what we are keeping an eye on in 2020, the US presidential election is top of mind. Trump’s approval ratings are relatively low (mid-40%) and the Democratic Party’s presidential nomination process will kick into higher gear this spring. Several candidates support less market friendly policies and all of them have indicated their intention of rolling back the Trump tax cuts to pay for their political promises. Accordingly, it is not out of the question that 2019’s trade uncertainty be replaced with domestic political uncertainty in 2020, paving the way for a more sluggish growth outlook than what is currently discounted.
Of course, US trade policy will also be on our radar. Assuming the Phase 1 deal with China goes through as planned in January, we expect that Trump’s focus will then turn to the more challenging and contentious Phase 2 deal. Also, of significance, some US officials have signaled that the trade relationship with Europe might be tackled next.
After a busy year cutting rates, we expect that most central bankers will wish to remain on hold this year. At the Fed, officials will want to assess the impacts of their three “insurance cuts”. The bar is high for them to cut again and they would need to see a “material deterioration” to act. However, the bar is even higher for them to hike, with inflation below target and inflation expectations having drifted lower, they are in no hurry to raise rates.
In Europe, the ECB has already deployed as much stimulus as it can, reactivating QE and lowering rates close to the effective lower bound. There again, policy makers are in wait-and-see mode and will instead focus on their recently announced mandate review.
In Canada, Governor Poloz has so far resisted the urge to lower rates, even though the Canadian economy has been steadily losing steam throughout 2019. His reticence to act can be primarily attributed to financial stability concerns; the Canadian consumer is still heavily indebted, and they want to avoid spurring another borrowing spree. But, with Poloz stepping down in early June, we could see the BoC under a new Governor take a different approach. Given the apparent reticence to ease policy for financial stability considerations, we remain of the view that the BoC is likely to be behind the curve, and that when they do finally decide to cut rates, they will have to cut quick and hard.
The Diversified Bond Fund returned 4.3% in 2019, net of fees. The bulk of the return this year can be attributed to our investment grade holdings. As discussed earlier, credit spreads across North America had performed exceptionally well in 2019, finishing the year close to cycle tights.
As opposed to 2018, we did have an allocation to government bonds throughout the year, which contributed about 85bps to the fund. As regular readers would recall, we started allocating to European sovereign bonds (France and Germany) in March. At the time, we felt that Europe would be the hardest hit from a continuing slowdown in China and a potential intensification of the trade war, making those bonds a good insurance policy. Later in the summer, as things deteriorated further between the US and China, we added 10 and 30 year US treasuries as well as 30 year Canadian government bonds, taking our government bond allocation to 28% at the end of September. Since then, trade tensions have improved and the world economy has stabilized, prompting us to reduce the fund’s duration. As of the time of writing, the only government bonds left in the diversified bond fund are German and French bonds, and duration has been reduced to 4.3 years.
For the full year 2019, the Credit Opps returned 6.3%, net of fees. Like the DBF, the Credit Opps benefited from strong performance in credit. Throughout the first half of the year, we harvested profits on high yield positions, taking the sector’s weight from 24% in December 2018 to 16% in June 2019. In the summer, we also entered credit hedges through the HYG ETF, further reducing the risk of the portfolio.
Leverage was relatively constant, oscillating around 1x for most of the year. One change we made to the overlay was reducing the term of the bonds we own, thereby reducing risk and volatility (i.e. instead of buying 5-10 year corporate bonds, the overlay was mostly composed of 3-5 year bonds).
Due to the exceptional circumstances brought about by the US/China trade war, we felt it was prudent to add US treasuries to the Credit Opps in July. We eventually exited the position in December, with a net gain to the fund of about 30bps.
Credit spreads on investment grade and high yield have moved tighter, as money continues to pour into bond funds. As we screen for securities across sectors and within ratings buckets the opportunities are few and far between. If we don’t see an economic slowdown, duration won’t be much help as interest rates, for now, don’t appear to be heading much lower. Although its early in the year, our expectation is that this will be a tricky year for bonds. With risk-reward as marginal as it is, being sensible about positioning, credit exposure and liquidity will be key. We remain confident that our conservative posture will payoff when markets become more rational.
Until next month,
The Bond Team: Mark, Etienne and Chris
1 All Ninepoint Diversified Bond Fund/Class returns and fund details are a) based on Series F units; b) net of fees; c) annualized if period is greater than one year; d) as at December 31, 2019 1 All Ninepoint Credit Income Opportunities Fund returns and fund details are a) based on Class F units (closed to subscriptions); b) net of fees; c) annualized if period is greater than one year; d) as at December 31, 2019.
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