Ninepoint Fixed Income Strategy

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

The U.S. and Canadian economies continue to evolve as we expect; early leading indicators point to a softening economy while labor markets remain strong, and inflation continues to be a problem. As a result, central banks are increasing interest rates at the fastest pace since the 1980s.

However, the tide is starting to turn. At its October meeting, the Bank of Canada (BoC) surprised markets by hiking “only” 50bps, whereas most were expecting a 75bps hike. Also, U.S. inflation is starting to decelerate more meaningfully, with their October CPI release surprising to the downside. Details were encouraging, with most goods categories declining. Shelter inflation (i.e. house and rent prices) continues to be elevated, but with the housing market slowing down markedly due to elevated mortgage rates, it is only a matter of time before this important subcomponent also contributes to slowing inflation in the U.S.

The message out of the BoC was that the economy is indeed slowing, with some pain to come, and therefore the supply and demand imbalances that are the source of inflation are in the process of resolving themselves. Although they aren’t done raising rates, we are getting closer to the end of the hike cycle (Figure 1).

With the overnight rate now at 3.75%, the weakness is becoming more apparent in the economy. As such, the messaging from the BoC seems reasonable to us - increase rates a bit more through early 2023, perhaps to the mid-4%s, and then pause to see how the economy unfolds. Monetary policy is working, but it takes time for the full effect of rate hikes to be felt in the economy. The full impact of all those rate hikes from 2022 will carry over to 2023. Consequently, most economists and market participants (ourselves included), are expecting a recession in later 2023.

The Canadian yield curve (the U.S. as well) is fully inverted (it has been since August 2022), with yields at the front end (1 month to 1 year) more than 1% higher than longer dated yields. Inverted yield curves are rare, and usually precede recessions. It is simply the bond market’s way of saying that the BoC has overdone it with rate hikes. Once recession hits, unemployment rises, and the BoC loosens monetary policy, taking the overnight rate back down, the slope of the curve returns to a more normal, upward slope.

Given how elevated inflation is, we expect this process will take a bit longer than usual. Central bankers will want to see conclusive evidence that inflation is on a path to returning to their 2% target before they cut rates in the face of recession. This increases the risk that the economic slowdown will prove to be deeper and longer, as opposed to the fast rebound we experienced out of the Covid-recession.

2023 Outlook

Now that central banks are almost done with their punitive hike cycle, we expect bond price volatility to decline. There is no way to sugarcoat this: 2022 has been a terrible year for fixed income investors, the worst year ever, based on the available data from ICE index services (Figure 3 below).

How did this happen? Well, in fixed income, the income a portfolio (or index) generates is the first line of defense against mark-to-market losses (unless a company or country defaults, bonds mature at par). Figure 4 below shows the annual return of the same U.S. Index, decomposed by the contribution of income and price fluctuations. History is peppered with large price drawdowns in bonds, the early 1980s when Paul Volker was fighting inflation, 1994 and 1999 during aggressive hike cycles, the taper tantrum of 2013, etc. However, even during those episodes, the annual total return on the index was always positive or suffered very mild losses (less than 5%).

How? Income.

The grey bars in the chart show the amount of income generated each year by this index. With total income of less than 2% this year and last, it doesn’t take large price fluctuations to completely wipe out the return for the year. And this year was the perfect storm: interest rates went up meaningfully and credit spreads almost widened twofold from their 2021 tights.

But, following the massive repricing of this year, bonds have levels of income we have not seen since the Great Financial Crisis of 2008, setting the stage for bonds to serve investors well once again.

Now consider our fixed income offerings, summarized in the table below:

With yields ranging from 7.3% to 11.4%, our portfolios generate a substantial amount of income annually and are doing so without taking positions in low quality securities (average credit rating of BBB, safely within investment-grade).

As discussed earlier, a bond portfolio’s total return is the sum of the income it generates and the price movement of the securities it holds. Simplistically, those price movements are driven by movements in interest rates and (for corporate bonds) credit spreads. Duration and spread duration measure the price sensitivity of our portfolios to those factors.

For example, the Diversified Bond Fund has a duration of 3.5 years, which means that for a 100bps increase in interest rates (across the whole yield curve), the fund would suffer a one-time price decline of 3.5%. But the fund also yields 7.3%, so over a 1-year horizon, interest rates need to move up by 209bps for the fund to “breakeven”. The same concept is applicable to credit spreads and spread duration (Figure 5 below).

Looking ahead to 2023, given the sizable amount of income generated by our portfolios and their risk characteristics, how could they behave in the upcoming recession (which as a reminder is our base case), in a deep recession (worse case) or if we get that elusive soft landing (best case)?

These scenarios are by no means a forecast or prediction, but instead are meant as a way for investors to understand how different macroeconomic scenarios could impact our portfolios.

1. Under the base case, we enter a recession in 2023, but because of still elevated inflation, central banks hold rates steady. Longer term government bonds rally as the safe heaven asset. Having widened already materially in 2022, credit spreads widen modestly.
2. In an environment where inflation refuses to decelerate, central banks need to keep hiking interest rates, taking the overnight rate to the 5-6% area. Due to the severity of the downturn, long term government bonds rally meaningfully as investors rush to the safety of government bonds. Credit spreads widen to levels last seen during the height of the pandemic.
3. If inflation declines much faster than anticipated next year and the economy proves resilient, then central banks can take their foot off the break faster, cutting rates back to a more neutral level in the first half of the year. Government bonds and credit rally.

Mapping those scenarios to our funds using their individual risk characteristics (across interest rates and credit), we get the following price changes (shown in the Table below).[i] Then, the expected annual gross total return of each portfolio under each scenario is simply the sum of its yield-to-maturity (underlying investments) and the expected price change. Of note, none of those price fluctuations exceed the funds’ yields. In other words, the income generated by each fund over 12-months exceeds the expected price declines under the two negative scenarios. Just like the U.S. bond index from earlier, the income generated allows fixed income funds to absorb negative price movements. This cushion is why we are so optimistic about our portfolios heading into 2023, which may prove to be a challenging year for other asset classes.

This analysis of course assumes we do nothing all year, which, given our history as active managers, is extremely unrealistic. But still, we believe that the current environment has created an opportunity in fixed income that has not been seen in over a decade, and with a recession looming next year, fixed income could very well be the best performing asset class.

Please reach out to discuss further. 

Until next month,

Mark, Etienne & Nick
Ninepoint Partners

ⁱFor simplicity’s sake, we take the average of 2-year and 10-year moves and apply that to the duration of our portfolios.

Appendix: Portfolio Characteristics