Monthly commentary discusses recent developments across both the Diversified Bond and Credit Income Opportunities Funds.
The bullish tone established in markets over the past few months has carried over into the summer. At the time of writing, the S&P 500 is within reach of all-time highs and credit spreads have retraced about 90% of their March/April widening. Globally, economic data has surprised to the upside, even though the pace of new infections in the US has continued to increase throughout the summer (Figure 1) and most states have either stopped or reversed their re-openings. Elsewhere in the world, Covid infections seem under control and new clusters are being effectively dealt with.
For now, at least, it seems that even if things don’t go back to “normal”, the odds of going back to full lockdown are very low. The real question for us remains what does the new normal look like and, once the initial bounce in the data from getting out of the full lockdown is behind us, how fast does the world economy return to full capacity?
Even assuming vaccines are approved and in widespread circulation by 2021Q2, that is still a full year away. There must be a limit to how long fiscal policy can keep the millions of people and small business with no income or revenues afloat. Undoubtedly the damage to the demand and supply side of the economy will be important if we have another 12 months of this. And unfortunately, the sectors most affected by this situation (services, accommodation, tourism, etc.) are also those that are most vulnerable (SMEs and low wage workers). Until now, those who have lost their jobs have benefited from generous emergency support from governments (e.g. CERB in Canada, enhanced unemployment benefits in the US). However, that cannot go on forever; federal budget deficits for 2020 are already forecasted to be 11.2% of GDP in Canada and 17.4% in the USi. Canada’s credit rating has already been downgraded one notch by Fitch, a rating agency. At the same time, if those benefits expire, what will these people do? The various small businesses where many lower income earners work have either disappeared or don’t have the same level of business as they used to. Are we throwing good money after bad by keeping many of these businesses afloat, even if the business model doesn’t work in the new normal? We do not know what the answers to these questions are, and no doubt policy makers across the world are pondering what to do next. It seems that either way, these policy choices boil down to a gigantic intertemporal trade-off: suffer sharper pain now (i.e. let benefits expire) or avoid immediate pain and suffer for longer later (i.e. massive debt overhang).
Our hunch is that politicians facing re-election will be happy to kick the can down the road and keep spending to keep the economy artificially afloat, particularly when central banks, implicitly or explicitly, have seemingly unlimited room to buy government bonds and expand unconventional monetary policy. The US election in November is complicating this process, but ultimately no political party will want to be held responsible for the consequences of stopping assistance. While we absolutely disagree with the premises of the current market narrative, this probably means we remain in this risk-on, nothing-can-go-wrong paradigm for a little while longer.
In credit, the song remains the same. Low primary issuance (supply) coupled with record low interest rates (hunt for yield) and strong industry inflows (cash to be deployed) has created a very solid technical backdrop. In the US investment grade market, we have now retraced 90% of the Spring widening. In Canadian IG, the market never widened as much as the US as its always a bit slower to react, so the same figure now stands at 75%ii. Still, spreads are about 40% wider than the cycle tights we reached in January (Figure 2), making investment grade bonds attractive, on a relative basis. Barring an external shock, we expect this technical backdrop to push spreads tighter into the fall, but perhaps at a slowing pace.
The DB fund performed well in July, returning 1.4%. The portfolio composition continues to be relatively stable. We have maintained our short position in HYG, monetizing the calls we owned against it. Duration edged slightly higher as we bought a few US 30-year government bonds to round up our Government Bond exposure to 10%. In high yield, we continue to favour a defensive approach, sticking with higher quality crossovers and fallen angels. We are content with the current portfolio positioning, as it provides a good balance between credit exposure (which is benefiting from the factors mentioned above) and defensive positions (i.e. government bonds and short HYG).
The Credit Opps continues to perform very well, with the fund returning 3.37% in July. As mentioned last month, we have started to slowly reduce credit risk in the portfolio, taking HY down to 20% from 28%. Leverage is also mildly lower, at 1.61x; expect us to continue to decrease leverage in the coming months. Over the last quarter we added two loans to the portfolio. In this environment loans have become very attractive investments as they earn roughly double the yield on a high yield bond and we are senior secured in the capital structure.
Given the current backdrop, the Credit Opps is uniquely positioned to deliver a solid year to investors. The fund yields 7.1%, has very low duration risk and benefits from credit hedges (HYG short) to protect the downside, should credit volatility increase in the coming months.
Enjoy this beautiful summer and until next month.
Mark & Etienne
i Source: Bloomberg Private Forecaster Consensus Estimates, as of August 11th 2020.
ii These figures are calculated using the ICE Bond Indices for US and Canadian Corporate Investment Grade Indices.
1 All Ninepoint Diversified Bond Fund 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 July 31, 2020 1 All Ninepoint Credit Income Opportunities Fund returns and fund details are a) based on Class F units; b) net of fees; c) annualized if period is greater than one year; d) as at July 31, 2020.
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