“All we need is just a little patience.” Guns N’ Roses
First and foremost, we hope that you and your family are safe, healthy, and coping well during these difficult times.
One of the most frequently used words of this period is ‘unprecedented’. Accordingly, we are going to break precedent from our usual commentary format. Rather than the usual drivel that fills these pages, this month we opted for a summary of the carnage in the corporate bond market, and a review of our portfolio and strategy going forward.
The Ugly.
Corporate Bond Market Summary.
While COVID-19 has taken equity markets on a rollercoaster ride, corporate bonds experienced an unabated sell-off through most of March.
The two major drivers:
Credit risk. With businesses shutting down across the globe, the creditworthiness of corporations has declined, and the risk of delinquencies has increased
Liquidity premium. A scarcity of cash in the financial system has banks, institutions, and asset managers selling high-quality corporate bonds to raise the cash for their immediate needs (regulatory requirements, margin, collateral, fund redemptions etc.)
The net effect was a sharp widening of credit spreads, with short-dated corporate bonds being the hardest hit.
Credit Spreads.
The credit spread is the premium on a corporate bond over government bond yields. This spread is comprised of default risk and a liquidity premium.
The default risk reflects the probability that the corporation will be delinquent on its debt obligations and will vary from company to company
The liquidity premium represents the ease and costs of selling an asset and converting it into cash. For example, disposing of a property can be a lengthy and costly process, as opposed to the relative ease and low transaction costs of selling a stock
The COVID-19 Effect.
The table and graph below offer some illumination into the magnitude and speed of the virus’ impact on credit markets.
Indicative Canadian 5y Credit Spreads.
March 31, 2020
February 19, 2020
Change
Government of Canada 5y Yield
0.60%
1.36%
-0.76%
Bank Sr
+2.50%
+0.85%
1.65%
Bank NVCC
+3.65%
+1.10%
2.55%
Bell Canada
+2.70%
+0.95%
1.75%
Volkswagen Canada Finance
+3.92%
+1.00%
2.92%
RioCan
+3.35%
+1.15%
2.20%
Enbridge
+4.01%
+1.05%
2.96%
We have fielded several questions about how the current experience compares to 2008. The major differences are the underlying causes and the speed of the sell-off.
In 2008, the concern was that the banks would fail and take down the financial system with them. Today, the shock to spreads is due to the global economy unexpectedly and suddenly being put on pause
The credit spread widening of the Great Financial Crisis occurred over several months. During the current crisis, we experienced approximately ¾ of the 2008 move within four weeks
Canadian Investment Grade Corporate Bond Spreads.
While increased default risk has contributed to higher credit spreads, the majority of the move has been driven by the need for liquidity i.e. selling of corporate bonds to raise cash.
The Liquidity Problem.
Everybody either wants or needs cash at a time when it is a scarce commodity.
Businesses and individuals are drawing down on their credit lines
Banks are experiencing funding pressure
Financial institutions and pensions are required to post more margin and collateral against their positions
Asset managers need cash to fund redemptions
To raise the cash to meet their immediate obligations, market participants sell ‘cash proxies’. The most popular assets to sell have been high-quality, shorter-dated investment-grade bonds and commercial paper.
As per the graph and table below, this created a more pronounced spread widening in less than 2-year maturities.
Canadian BBB Spread Curves.
Indicative 3-month Credit Spreads.
March 31, 2020
February 19, 2020
Change
Loblaws
+2.10%
+0.40%
1.70%
Hydro-One
+1.45%
+0.35%
1.10%
National Bank
+3.50%
+0.60%
2.90%
The Bad.
The Fund Performance.
With the Fund concentrated in higher-quality, short-dated bonds, the sell-off in this space led to mark-to-market losses.
These losses are due to marking down the prices of our corporate holdings and are not the result of permanent capital loss due to default
Hedges through short positions in credit derivatives partially offset the rise in default risks within corporate bonds but were ineffective against the increase in liquidity premiums
While we were net sellers of credit exposure through February, we did not anticipate moves of this magnitude and velocity
Despite running much lower than normal exposure, the magnitude and speed of the widening in credit spreads led to a net return of -16.3% for March
1M
3M
6M
YTD
1Y
3Y
5Y
SI
X Class
-16.30%
-15.61%
-13.62%
-15.61%
-10.38%
-0.96%
6.47%
7.23%
F Class
-16.31%
-15.72%
-13.96%
-15.72%
-11.14%
-1.71%
NA
NA
The Good
The silver lining with credit strategies is that while spread widening leads to losses, it does also result in increased portfolio yields and opportunities for recovery and outsized returns in the medium term.
The losses are mark-to-market and as long as the issuers don’t default these losses can be recovered
Given the Fund is concentrated in higher-quality issuers, the risk of portfolio defaults remains low
The dramatic widening of credit spreads has resulted in a substantial increase to the yield on the portfolio
The sharp sell-off has created dislocations and opportunities that we, as active managers of a small fund, can capitalize on
Central Bank and government stimulus are supportive of investment-grade bond markets
Our Portfolio.
Below is a high-level summary of our portfolio as of March 31, 2020. For a more detailed breakdown of exposures and metrics, please refer to the appendix of this document.
Portfolio Yield: 13.5%
99% Investment-grade
Average Term to Maturity: 1.87 years
44% matures within 12 months
92% matures within 3 years
Net 5y Credit Leverage 1.5x
Total Long Credit Exposure 5.6x (not including hedges)
Largest issuer exposures: BMO, TD, and Bell Canada
Largest sector exposure: Banks
Energy exposure
Only exploration and production exposure are two positions in Canadian Natural Resources which mature in 2-months and 4-months, respectively. The remainder is in pipelines and midstream issuers
43% of the energy exposure matures within 4-months
In good standing with prime brokers with a significant excess margin
Liquidity through bonds maturing every month for both deployment and portfolio de-levering
The Opportunity.
Although volatile markets present several enticing opportunities, we feel few offer the attractive risk/reward profile of investment-grade credit.
Wide credit spreads mean high-quality assets offer extremely attractive yields and potential for price appreciation
Central Banks have rolled out programs that already exceed those employed in 2008 in both scope and scale. Many of these measures are aimed at improving liquidity in the markets
The Federal Reserve and European Central Bank have extended Quantitative Easing to include investment-grade corporate bonds, and the Bank of Canada has enacted similar measures for provincial bonds and commercial paper
Large-cap companies that are integral to the economy should benefit from fiscal stimulus and government support
A significant recovery in equities is not a prerequisite for high-quality credit to perform
The Timing.
To paraphrase legendary credit investor Howard Marks’ recent memo:
‘The bottom’ is the day before the recovery. Thus, it’s absolutely impossible to know when the bottom has been reached…ever. Even though there’s no way to say the bottom is at hand, the conditions that make bargains available are materializing.
In the medium-term credit markets typically recover faster than equities. But we anticipate the short-term moves will be slower and more gradual in credit. This gives us a greater opportunity to adjust exposure and participate in more of the upside.
Our Strategy.
Keep It Simple Stupid.
With bonds maturing every month, we look to capitalize on the dislocations in high-quality credit while maintaining financial flexibility should even greater bargains emerge
As markets stabilize, use new issues to enter positions at deep concessions
Focus on high-quality issuers and sectors that will survive and thrive in the long-term. Given the current opportunity set, there is no need to be heroes and venture into lower-quality debt
Final Thought.
In times like these, often the greatest commodity is patience. Patience with self-isolation, your family, long line-ups at stores, and the slow internet.
Thankfully, given the nature of our strategy, the patience we require is not of the Warren Buffet 5-10 year nature, but more like that of a millennial with a one to two-year investment horizon.
An individual who, alone or together with a spouse, owns financial assets worth more than $1,000,000 before taxes but net of related liabilities or An individual, who alone or together with a spouse, has net assets of at least $5,000,000
An individual whose net income before taxes exceeded $200,000 in both of the last two years and who expects to maintain at least the same level of income this year or An individual whose net income before taxes, combined with that of a spouse, exceeded $300,000 in both of the last two years and who expects to maintain at least the same level of income this year
An individual who currently is, or once was, a registered adviser or dealer, other than a limited market dealer
Financial institutions
Governments and governmental agencies
Insurance companies
Pension funds
Registered charities
Certain mutual funds, pooled funds and managed accounts
Companies with net assets of at least $5,000,000
Persons or companies recognized by the OSC as an accredited investor
The Ugly, The Bad, And The Good | March 2020
First and foremost, we hope that you and your family are safe, healthy, and coping well during these difficult times.
One of the most frequently used words of this period is ‘unprecedented’. Accordingly, we are going to break precedent from our usual commentary format. Rather than the usual drivel that fills these pages, this month we opted for a summary of the carnage in the corporate bond market, and a review of our portfolio and strategy going forward.
The Ugly.
Corporate Bond Market Summary.
While COVID-19 has taken equity markets on a rollercoaster ride, corporate bonds experienced an unabated sell-off through most of March.
The two major drivers:
The net effect was a sharp widening of credit spreads, with short-dated corporate bonds being the hardest hit.
Credit Spreads.
The credit spread is the premium on a corporate bond over government bond yields. This spread is comprised of default risk and a liquidity premium.
The COVID-19 Effect.
The table and graph below offer some illumination into the magnitude and speed of the virus’ impact on credit markets.
Indicative Canadian 5y Credit Spreads.
We have fielded several questions about how the current experience compares to 2008. The major differences are the underlying causes and the speed of the sell-off.
Canadian Investment Grade Corporate Bond Spreads.
While increased default risk has contributed to higher credit spreads, the majority of the move has been driven by the need for liquidity i.e. selling of corporate bonds to raise cash.
The Liquidity Problem.
Everybody either wants or needs cash at a time when it is a scarce commodity.
To raise the cash to meet their immediate obligations, market participants sell ‘cash proxies’. The most popular assets to sell have been high-quality, shorter-dated investment-grade bonds and commercial paper.
As per the graph and table below, this created a more pronounced spread widening in less than 2-year maturities.
Canadian BBB Spread Curves.
Indicative 3-month Credit Spreads.
The Bad.
The Fund Performance.
With the Fund concentrated in higher-quality, short-dated bonds, the sell-off in this space led to mark-to-market losses.
The Good
The silver lining with credit strategies is that while spread widening leads to losses, it does also result in increased portfolio yields and opportunities for recovery and outsized returns in the medium term.
Our Portfolio.
Below is a high-level summary of our portfolio as of March 31, 2020. For a more detailed breakdown of exposures and metrics, please refer to the appendix of this document.
The Opportunity.
Although volatile markets present several enticing opportunities, we feel few offer the attractive risk/reward profile of investment-grade credit.
The Timing.
To paraphrase legendary credit investor Howard Marks’ recent memo:
‘The bottom’ is the day before the recovery. Thus, it’s absolutely impossible to know when the bottom has been reached…ever. Even though there’s no way to say the bottom is at hand, the conditions that make bargains available are materializing.
In the medium-term credit markets typically recover faster than equities. But we anticipate the short-term moves will be slower and more gradual in credit. This gives us a greater opportunity to adjust exposure and participate in more of the upside.
Our Strategy.
Keep It Simple Stupid.
Final Thought.
In times like these, often the greatest commodity is patience. Patience with self-isolation, your family, long line-ups at stores, and the slow internet.
Thankfully, given the nature of our strategy, the patience we require is not of the Warren Buffet 5-10 year nature, but more like that of a millennial with a one to two-year investment horizon.
Download
Appendix
For portfolio metrics please see below.
Fund & Performance Summary