Ninepoint Fixed Income Strategy

Monthly commentary discusses recent developments across both the Diversified Bond and Credit Income Opportunities Funds.

On May 10^th, we launched a new fund, the Alternative Credit Opportunities Fund, a simplified prospectus-based fund with an ETF series purchase option and daily liquidity. Starting next month, this commentary will also discuss the developments within this new Liquid Alternative fund.

Macro

In most of the developed world, the Covid-19 vaccination programs continue to accelerate. Several countries such as the US and the UK are now reaching vaccination levels consistent with a prudent reopening (Figure 1). Closer to home, vaccinations have also increased rapidly, and at the current pace, we should reach about 50% of the Canadian population having received its first dose by the end of May. While it remains to be seen where the vaccination rates will peak, survey-based data suggests that a large share of Canadians are fairly receptive to getting vaccinated. The same cannot be said about the US, where vaccine hesitancy has already led to a lower daily pace of vaccination and a pile-up in vaccine inventories.

Nonetheless, several US States are loosening restrictions, so after months of anticipation for extremely strong economic activity in the spring, all eyes are now on the actual economic data releases. Will the recovery be as strong as some forecast, or will it take some time for those who have lost their jobs to come back to the labour market?

Expectations for the strength of the “reopening” are very high; after a blockbuster jobs report in March (over 700k jobs added), the April report was widely anticipated to result in a further 1 million increase in employment, with some even suggesting as much as 1.5 million. Such a pace of hiring would have gone a long way to solidify the expectations for a return to full employment by 2022.

Unfortunately, the results were rather disappointing, with less than 300k net new jobs added during the months. This is obviously perplexing, given the reopening of many states, one would have expected to see a lot more hiring activity. Despite all the discussions surrounding seasonality adjustments and other technical factors, there is no doubt that this was a weak report. The unemployment rate increased from last month, while at the same time other indicators of labour demand show that firms have had a hard time finding employees to fill positions. Certainly, given the largesse of government benefits coupled with fear of the virus, some unemployed workers are probably choosing not to return to work. If this dynamic persists, it might take more time for overall employment to reach levels consistent with the Fed’s new framework.

Accordingly, the bond market has started to re-adjust downward its expectation for Fed rate hikes. As shown in Figure 2 below, since the end of March, the market has already repriced by about 30bps. This is a tricky situation for policy makers; the Fed has a mandate of full employment “before even thinking about raising rates”, but fiscal policy is creating an environment where workers are disincentivized to rejoin the workforce. Would rising wages help to motivate them? To what extent? Certainly, these dynamics if they persist, will continue to fuel the inflationary narrative. Will the Fed, which characterizes the current inflation increases as temporary (i.e. due to base effects and supply chain disruptions), look through this as well, or reassess where the level of full employment really is? The situation remains very fluid, and it will take time to disentangle noise from signal, but one thing is certain: the trajectory of the economy is not as obvious as the market consensus seems to assume. The higher expectations are, the more likely they are to be disappointed.

Credit

Credit continues to perform well, with spreads mostly stable in April. While we are still about 10bps from the lows of February, the tone in the market is strong again. New issues are very competitive, resulting in order books that are routinely 4-5x oversubscribed. Earnings have been solid so far in Q1, with several companies focusing on debt reduction (oil and gas for example) and balance sheet management. With the summer approaching, we expect new issuance to slow down somewhat, which should be supportive for the credit market.

Diversified Bond Fund (DBF)

April was a good month for the DBF, returning 40bps. Stability in credit and interest rates allowed the fund to earn its carry, uninterrupted. We continue to reinvest our short-dated investment grade (1-3 years) into the belly of the curve (7-10 years), where we are finding much better all-in-yields. Accordingly, the portfolio duration edged up slightly to 4.2 years (spread duration 5 years). Over the coming weeks, we expect to slightly increase our allocation to high yield, mostly due to investments in short-dated or called HY bonds (at yields of about 2%) and new investments in hybrid securities as preferred shares slowly get called away (note the declining portfolio weight).

Credit Income Opportunities Fund (Credit Opps)

It was another good month for the Credit Opps, returning 71bps. Like last month, slightly wider credit spreads were more than offset by the income the fund generates, and with its very low duration, performance was not materially impacted by rates.

The High Yield allocation is up to 40%, mostly reflecting purchases of called bonds with attractive yields to call (2%). Like the DBF, some of our preferred shares are now being called, as expected, thus reducing our allocation. Leverage is up modestly to 1.37x, reflecting the constructive credit environment and strong company fundamentals. Given some of the new opportunities we are seeing in credit we would expect leverage to stabilize around 1.5x in the coming months.

Conclusion

Despite the volatility in the economic data, the commentary from companies’ Q1 earnings has been strong and mostly credit positive. We continue to be cautiously optimistic about the outlook, and as such are positioning the portfolios to benefit from this environment.

Mark & Etienne
Ninepoint Partners