Ninepoint Fixed Income Strategy

July 2022 Commentary

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

What a difference a month makes! For the past 6 months, the word on everyone’s lips was recession. Now, with solid employment numbers for July, good Q2 earnings and a seemingly less hawkish Fed at the July FOMC meeting, the narrative seems to be shifting to a rosier outlook.

Such optimism is misguided, as the fight against inflation is not over.

Despite a slight moderation in US headline inflation in July due to lower gasoline prices, the core figures remain high (5.9%) and will take time to decelerate, primarily due to the shelter component (~32% of CPI), which is still accelerating. Moreover, given the volatile geopolitical environment, it seems premature to call the top in energy and food prices. Russia will likely use all the tools at its disposal to inflict maximum pain on Europeans this winter, which will have repercussions for global commodity markets.

Yes, the economy is clearly slowing down, but not enough to have a meaningful impact on consumer demand. Some of this weakness is simply the impact of elevated inflation (inflation tax) on consumers. The full effects of this rate hike cycle probably won’t be felt until later this year or early 2023, as monetary policy acts with a 6-to-12-month lag.

Therefore, it appears to be somewhat presumptuous for the Fed/BoC to be declaring an early victory on their fight against inflation. Over the past few weeks, several Fed officials, some of whom are considered quite dovish, came out in the media to fight back against the idea of a “Fed pivot” at the July FOMC meeting. They are repeating that they are “nowhere near done with inflation”. We agree with this assessment, and as such, expect them to keep going with rate hikes until the end of this year. We believe that the terminal rate for this cycle is still above 3% and that three rate cuts next year is optimistic.

The big question for the Fed (and us) remains: how many rate hikes are required to decelerate growth enough for inflation to be on a sustainable downward path towards their 2% target?

If the front-loaded rate increase strategy works, then they can probably pause the rate hike cycle, increasing the odds of a soft landing. If not, then they will keep hiking, increasing the odds of a recession.

We will not know the answer to this until we get closer to year-end or even 2023. The Fed doesn’t know this either, and cannot declare a victory now, with core inflation still more than double their target. That would be counterproductive.

Either way, over the next several months, the yield curve (10-year minus 3-month) should continue to flatten and eventually fully invert. Figure 1 below shows our U.S. Recession Probability Model, based on the U.S. yield curve. The shaded areas represent actual recessions. At the time of writing, our model shows a 30% chance of recession in the U.S. in 12 months. Assuming that the Fed follows through with a 50 or 75bps rate hike in September, our model will be flashing red then (i.e. odds above 50%).

According to our portfolio positioning playbook, in this decelerating economic environment, we will be increasing portfolio duration, reducing credit risk and adding government bond exposure. Given how attractive the all-in yields are on the corporate bonds we own, for now, we have decided to increase our government bond allocation (and duration) by layering in call options in TLT across all three portfolios. This allows us to dip our toes in the water, adding optional duration to the portfolios without altering overall yield.

So far, we have spent about 15-20bps of premium to buy TLT calls to December 2022, increasing the funds’ duration today by about 0.5 years (exponentially more if government bond prices keep going up). More duration in the long end (10 and 30 years) will act as ballast as the odds of recession increase.

Credit

Almost all risk assets had strong performance last month. In July, the S&P 500 was up 8% while the US corporate bond index was tighter by 18 bps. The notable laggard in this broad-based rally was the Canadian cash corporate bond market which saw spreads only move 3 bps tighter. Canada tends to lag the US when spreads tighten, so we are not overly surprised by this underperformance. July had an immaterial amount of non-financial bond supply, as the month was dominated by bank issuance. Lack of corporate bond issuance coupled with a solid Q2/2022 earnings season (from a credit perspective) generally serve as tailwinds for Canadian credit spreads from both a technical and fundamental perspective. The macroeconomic environment remains highly uncertain, and we continue to capitalize on valuation dislocations across sectors to high-grade the portfolios, improving both credit ratings and liquidity.

Ninepoint Diversified Bond Fund (DBF)

In July, we continued to trim lower-rated investment-grade credits in real estate and consumer focused sectors to move into higher-rated credits at near flat yields. We also participated in a National Bank new issue which carried a ~5.5% coupon for a bond callable in five years with an average credit rating of BBB. We also executed a Ford Motor retraction whereby we sold US$ bonds maturing in 2027 to buy C$ bonds maturing in 2024 while only giving up minimal yield (8bps for 3 years). As mentioned before, the US corporate bond market rallied in July while Canada corporate bonds lagged this move, so we decided to take advantage of this cross-border discrepancy to defensively tweak our exposure to a credit we like. As of month-end, the fund’s yield-to-maturity was 6.5%, and we moved our duration up to 3.7 years (4.1 years after accounting for the impact of the TLT options position).

Ninepoint Alternative Credit Opportunities Fund (NACO)

Like DBF, we continue to look for attractive switches, in addition to participating in a few new issues. One switch trade worth highlighting was moving into Goldman Sachs from Canadian Natural Resources. We liked this switch for numerous reasons including: retracting one year, picking up two credit rating notches, picking up material liquidity, and picking up 42 bps in spread. We continue to see very attractive switches like these due to unique market dislocations and will continue to capitalize on them.

On the new issue front, we participated in a National bank new issue for the same reasons outlined in the DBF section, but also participated in the inaugural Obsidian Energy new issue. While we have been gradually trimming Oil & Gas producer exposure this year (due to very rich valuations, like the CNQ example above), the valuation on this new issue was very attractive (12.5% yield), especially since the bond contains a rare free cash flow sweep (which ensures rapid de-leveraging). As of month-end, the fund’s yield-to-maturity was 9.6% and duration moved up 0.5 years to 2.5 years, entirely due to the new TLT call position.

Ninepoint Credit Income Opportunities Fund (Credit Ops)

We participated in the National bank new issue for the same reasons outlined above while the fund had room to increase exposure to the credit. We also participated in the inaugural Obsidian Energy new issue even though we have been gradually trimming Oil & Gas producer exposure this year (due to very rich valuations) across all three funds. The valuation on this new issue was extremely attractive, especially since the bond contains a rare free cash flow sweep (which ensures rapid de-leveraging). To ensure our HY positioning remained prudent, we sold a Russel Metals HY bond against the new issue. As of month-end, the fund’s yield-to-maturity was 11.2% while we moved duration up 0.5 years to 1.9 years, entirely due to the new TLT call position.

Conclusion

An economic slowdown and potential recession are not necessarily a bad thing for fixed income investors. Duration generally performs well during risk off environments (hence our addition of duration), and the level of yield generated by our funds at this juncture is historically very high, providing a meaningful buffer against any further widening in credit spreads. This might sound premature, but we are quite constructive on our funds’ outlook over the next 12-18 months. Investors could be well served by considering this an attractive entry point.

Please reach out to discuss further.

Until next month,

Mark, Etienne & Nick
Ninepoint Partners

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, 2022 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, 2022. 1 All Ninepoint Alternative Credit 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, 2022.

The Risks associated worth investing in a Fund depend on the securities and assets in which the Funds invests, based upon the Fund's particular objectives. There is no assurance that any Fund will achieve its investment objective, and its net asset value, yield and investment return will fluctuate from time to time with market conditions. There is no guarantee that the full amount of your original investment in a Fund will be returned to you. The Funds are not insured by the Canada Deposit Insurance Corporation or any other government deposit insurer. Please read a Fund's prospectus or offering memorandum before investing.

Ninepoint Credit Income Opportunities Fund is offered on a private placement basis pursuant to an offering memorandum and are only available to investors who meet certain eligibility or minimum purchase amount requirements under applicable securities legislation. The offering memorandum contains important information about the Funds, including their investment objective and strategies, purchase options, applicable management fees, performance fees, other charges and expenses, and should be read carefully before investing in the Funds. Performance data represents past performance of the Fund and is not indicative of future performance. Data based on performance history of less than five years may not give prospective investors enough information to base investment decisions on. Please contact your own personal advisor on your particular circumstance. This communication does not constitute an offer to sell or solicitation to purchase securities of the Fund. 

Ninepoint Partners LP is the investment manager to the Ninepoint Funds (collectively, the “Funds”). Commissions, trailing commissions, management fees, performance fees (if any), other charges and expenses all may be associated with mutual fund investments. Please read the prospectus carefully before investing. The indicated rate of return for series F units of the Fund for the period ended July 31, 2022 is based on the historical annual compounded total return including changes in unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The information contained herein does not constitute an offer or solicitation by anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their financial advisor to determine whether securities of the Fund may be lawfully sold in their jurisdiction.

The opinions, estimates and projections (“information”) contained within this report are solely those of Ninepoint Partners LP and are subject to change without notice. Ninepoint Partners makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, Ninepoint Partners assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. Ninepoint Partners is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Ninepoint Partners LP. Any reference to a particular company is for illustrative purposes only and should not to be considered as investment advice or a recommendation to buy or sell nor should it be considered as an indication of how the portfolio of any investment fund managed by Ninepoint Partners LP is or will be invested. Ninepoint Partners LP and/or its affiliates may collectively beneficially own/control 1% or more of any class of the equity securities of the issuers mentioned in this report. Ninepoint Partners LP and/or its affiliates may hold short position in any class of the equity securities of the issuers mentioned in this report. During the preceding 12 months, Ninepoint Partners LP and/or its affiliates may have received remuneration other than normal course investment advisory or trade execution services from the issuers mentioned in this report.

Ninepoint Partners LP: Toll Free: 1.866.299.9906. DEALER SERVICES: CIBC Mellon GSSC Record Keeping Services: Toll Free: 1.877.358.0540

Historical Commentary