Monthly Commentaries

“I think people make way too much of ratings.”
Walter Cronkite

Last month we asked when was the last time you gave an Uber driver less than five stars.  The question segued into an examination of factors that can lead ride-share users and credit agencies to inflate their assessments.

This prompted questions as to what’s in a rating.  For example, a 4.7 out of 5 stars sounds like a great score for your Uber driver; however, it’s actually below average in most cities.

Similarly, what does it mean for a company to be AAA or BBB, and what can and cannot be deduced from these letters?

In its simplest form, a credit rating is an assessment of a borrower’s ability and willingness to meet their debt obligations.  Much like a personal credit score, it’s an indication for lenders on the likelihood of being repaid.

The most cited rating format is that of S&P and Fitch, where the investment-grade spectrum spans from AAA to BBB-, and the high yield universe from BB+ down to D (defaulted).  Although exact methodologies differ across agencies, they are essentially evaluating two key risks: financial and business.

At the heart of the financial risk analysis are accounting ratios; quantitative metrics designed to assess the financial flexibility and health of an entity.  The debt burden is compared to profitability measures and forecasts, sources of funding, cash flow, and the subordination of the specific security.  The business risk element is more subjective and focuses on the strength of the company’s operations and competitive dynamics.  Combining the quantitative with the qualitative, they arrive at a rating.

And based on historical evidence, they seem to work pretty well.  Lower graded securities default more than their higher-rated peers.  The hierarchy of ratings thus provides a reliable indication of relative default probabilities.  For this reason, ratings are often used as a proxy for risk.  But for a true evaluation of riskiness, there is one crucial piece of information missing: price.

In this way, credit ratings are akin to hotel stars.  In comparing a 4-star and a 5-star hotel, an important consideration for most would be price.  Is it worth paying double for a slightly better room?  Similarly, a AAA bond might be overly expensive while a lower-rated security could be overcompensating for the additional risk.

Also, as seasoned travellers can attest, not all 4-star hotels are created equal.    The same goes for debt.  Not all BBB’s are the same, and issuer and security-specific factors, such as liquidity, also need to be taken into consideration.

Having realized that quality and hotel stars aren’t everything, many online booking platforms have included metrics such as value, service, cleanliness, and location into their models.  And while credit ratings offer investors a good starting point, in isolation, they are incomplete.  Most critically, they do not offer any indication of value.  As the legendary investor Howard Marks once wrote: “no asset is so good that it can’t become a bad investment if bought at too high a price and there are few assets so bad that they can’t be a good investment when bought cheap enough.”

The Fund

August’s market moves were dominated by interest rates.  The Canadian 10-year yield dropped by an astounding 32 bps, which meant rate exposure was a tremendous tailwind for returns, as evidenced by the Bond Universe returning 1.88% on the month.  Equity markets opened on a weak footing, but rallied into month-end, resulting in the TSX closing higher by 0.43% and the S&P down 1.58%.  This left credit as the clear underperformer, with Canadian BBB spreads generically higher by 16 bps.

Oddly enough, while corporate bond spreads widened in response to the uncertainty and to compensate for lower all-in yields, credit derivative indices, after initially widening, staged a strong recovery to finish the month nearly unchanged.  Investors on both sides of the border braced themselves for an onslaught of Fall supply.  Thus, despite the late rally in stocks and derivatives at the end of the month, corporate debt buyers were content to sit on the sidelines awaiting the new deals.

There were interesting flows in the US market as funds that invest in high yield, and levered loans saw outflows, while those invested in higher-quality fixed income saw inflows.  The CCC/BB spread ratio hit a 5-year high, suggesting that investors remain concerned about the possibility of a recession and are looking to improve the quality of their holdings.  Thus, while the deterioration in credit was somewhat indiscriminate, higher-quality names did fare a little better than their lower-rated peers

In terms of supply, the sharp drop in interest rates last month drew the attention of banks, financials, and REITs who took advantage of attractive coupons to issue debt.

The month proved to be frustrating as short positions in derivative indices and provincial bonds failed to provide an offset to the widening in corporate spreads, resulting in a loss of 83 bps (F Class down 82 bps).

Credit

August saw portfolio managers frozen by the anticipation of September supply.  On occasion, a barrage of new deals can certainly create bumps along the road. The question is whether there is sufficient demand and cash in the system to smooth the path.

Strong year-to-date returns from bonds, means that solid inflows into fixed-income funds should continue.  Also, with investors moving from lower to higher-quality credit, investment grade funds should see the lion’s share of new capital.  These factors should create a decent amount of demand for the anticipated deals.

On the other side, lower rates mean lower borrowing costs, which makes it attractive to refinance existing debt.  Accordingly, we expect a wide array of issuers to tap the market, in what is typically a busy issuance season.  Thus far, the stream of new deals hasn’t disappointed expectations, but the early indications show that there is sufficient cash on the sidelines to meet the supply.  We continue to closely monitor this balance and remain selective in our purchasing, preferring to maintain flexibility than chase shiny new issues.

The quality improvement trend also occurred within the investment-grade space, as the gap between single-A and BBB paper has grown.  We are paying close attention to this differential, as in such moves, risk is often mispriced, and opportunities created.

With equities only a couple of percentage points below the highs, we are cautious that the perplexing Brexit and China-US trade negotiations could spook global markets once again.  As such, we continue to hold a medium risk posture.

Rates

The escalating trade tension is having an impact on business confidence and investment, with economic data showing signs of weakness. Rising uncertainty about the durability of global growth drove sovereign yields lower, resulting in over $16 trillion of negative-yielding government debt.

The Federal Reserve is expected to cut rates by 25 bps later this month.  Many expect them to cut by another 50 or 75 bps by mid-2020.  Meanwhile, the Bank of Canada has adopted a ‘wait-and-see’ attitude.  They have left the door open to lowering rates, but are not showing any sense of urgency.  We wouldn’t be surprised to see an ease or two by the Bank of Canada over the next six months or so.

The inverted yield curve needs the central banks to deliver the aforementioned cuts.  Should the economic data strengthen (most likely due to a US-China trade deal), the bond market could be due for a vicious move to higher yields.

On the other side of the pond, Germany issued a 30-year sovereign bond in August with a humungous coupon of zero.  The security was offered at €103.61.  This means investors are lending the German government money for 30-years, not receiving any interest, and locking in a loss of 3.5%.  Perhaps they can feel better knowing that they own the best quality (AAA) paper that money can buy.

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“If you’re the police, who will police the police?”
Lisa Simpson to Homer

When was the last time you gave an Uber driver less than five stars?  It seems to have become the de facto rating.  As per one driver’s t-shirt, ‘if you’re alive when you arrive, that’s a five.’

Uber isn’t alone when it comes to overinflated report cards.  A recent study of online marketplaces concluded that not only are judgements heavily skewed to the highest bucket, but they also tend to drift higher over time (Filippas et al., 2019).

The optimistic view is that as empathetic creatures, we don’t want to inflict harm on the reputation of others, particularly in public forums.  And in our desire to leave ‘above average’ appraisals, we fall into a loop of pushing the averages higher and higher.

This rating inflation increases both the cost of receiving a negative critique and the discomfort in giving one.  An effect that is more pronounced when the object of our assessment is a person; it’s easier to leave a negative review for a toaster than for a plumber.  And while this compassion is heartwarming, it undermines the value of the feedback and can render it meaningless.

One solution is to revert to cold-blooded experts.  Why seek the opinion of random diners when you can refer to professional restaurant critics?

Such is the case in the world of fixed-income, where the Michelin stars are given out by the Credit Rating Agencies (CRA).  This oligopoly of firms has been evaluating debt instruments since the early 1900s, from humble beginnings in railroad bonds to the complex structures of modern financial engineering.

But ever since 2008, these bond pundits have been scrutinized, with the integrity of their assessments in question.  Like Uber passengers, they have been accused of (and even fined for) inflating ratings.  But unlike rideshare users, for far less compassionate reasons.

The main contention is the inherent conflict of interest in the compensation model. The CRAs are paid by the very issuers whose securities they are evaluating.   How confident would you be in a review where the critic was paid by the restaurant?  And while it’s harmless for the steakhouse to give their regulars VIP treatment, there is evidence that CRAs also favour the larger, more frequent issuers (He et al., 2010; Botlon et al., 2012).

The conflict of interest is further exacerbated by ‘rating shopping’, with issuers able to select and pay for the most favourable judgements.  In recent years, with the number of agencies receiving SEC regulatory blessing going from three to ten, there are even more to choose from.  This has raised concerns that increased competition for market share is leading to lower standards.

The problem is more acute in structured debt and the boom in securitized pools of loans, mortgages, and other borrowings.  These products are highly likely to be ‘rating shopped’, and as their market has grown, so have the revenues from grading them.  In their fight for a slice of the pie, some agencies are relaxing their models and doling out generous verdicts.  Furthermore, booms bring with them their own risk.  Research has shown that CRAs are more prone to inflating grades during booms, which is also when investors are most willing to accept them at face value (Bolton et al., 2012).

This is not to say there is a grand conspiracy in the world of credit appraisal.  The lion’s share of public companies, sovereigns, and municipals have multiple ratings and aren’t picking which report cards to show their parents.  Also, since 2008, new regulations have increased the transparency and accountability of the evaluation process.  And if these measures aren’t enough, the agencies also need to worry about their reputation, as a loss of confidence could lead to business failure.

But given the systemic flaws are biased towards inflating assessments, it is wise not to take the letters assigned to securities as law.  After all, we require an editorial disclaimer for a review that is paid for by the reviewed.

As always, there is no substitute for careful analysis before deciding to put your money to work.  Either that, or we need rating agencies to rate the rating agencies.  As per Homer Simpon’s response to Lisa’s “If you’re the police, who will police the police?”… “I don’t know, Coast Guard?”

The Fund

July saw the classic summer grind tighter in spreads.  Domestic credit was generically 4 bps narrower, while the US was in 7 bps.  In addition to the usual tail-wind of lower issuance, optimism on a trade agreement and the lure of monetary stimulus provided an additional boost.

Perhaps the most interesting story involved the slow-motion train wreck of SNC-Lavalin, with the stock price dropping roughly 20%.  Relatively speaking, the bonds held up reasonably well, as debt holders feel reassured that the remaining stake in highway 407 is sufficient to cover all obligations.  Nonetheless, the credit spread widened 50bps, and we were thankful to have sold all our holdings before the escalation of the drama.

Featured issuers included banks (Bail-In, NVCC and FRNs) as well as CI Financial and First Capital.  Gibson Energy was upgraded to investment grade by S&P which will broaden their following with investors going forward.

The Fund was well-positioned to capitalize on the seasonal pattern.  In June, we built up a medium exposure and maintained that for the better part of July. Because issuance usually starts up in August, we started reducing exposure towards the end of the month.

The modest performance of spreads coupled with carry lead to the month’s 0.80% return (F Class 0.71%).

Credit

The trick with positioning the portfolio for the summer grind is to prepare for the potential post-holiday onslaught of supply.  We have already started the process of taking chips off the table and will continue to make room for new securities.

The picture for supply is mixed.  Foreign jurisdictions continue to be receptive to our great domestic banks, which minimizes the risk of a deluge from them. However, the decline in yields will attract a slew of non-financial issuers looking to take advantage of cheaper funding.

Market participants see-saw between optimism based on central bank stimulus and fear due to geopolitical overhang.  Since it is impossible to predict which camp will win out, we are preparing for volatility by reducing exposure and increasing hedges through short credit positions.

Rates

The Bank of Canada chose to leave rates unchanged last month, although the door is open for them to cut if forecasted inflation moves lower.

The Fed delivered the widely expected 25bps rate cut; however, investors were not enamoured with Chairman Powell’s characterization of the move.  The rhetoric painted it as a mid-cycle adjustment rather than the start of a prolonged easing cycle.  It was either that or the fact that two of the Fed governors did not vote to ease.

With no end in sight to the trade tension between China and the US, the odds do not favour yields moving higher.

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“Inflation is when you pay fifteen dollars for the ten-dollar haircut
you used to get for five dollars when you had hair.”
Sam Ewing

In 1970, you could strut to your local store and style yourself in the latest bell bottom jeans, belted turtleneck, and platform shoes, all for under $25.  You could then boogie on down to your local Chevy dealer and drive off in a shiny new Corvette for a mere five grand.

While the desire to purchase such iconic items is a matter of personal taste, we can all appreciate the retro pricing.

But these bargains didn’t last long, as the disco decade also kicked off an era of ‘rocking’ inflation.  Much like the hairstyles of the time, it was the beast that couldn’t be tamed.  That is until Paul Volcker became Fed Chairman and hiked rates to 20%.  This move plunged the US economy into a deep recession, resulting in widespread protests including indebted farmers driving their tractors through the streets of Washington.

For decades afterwards, the spectre of inflation stalked the fixed income world.  But since 2008, the fears have shifted from its revival to its extinction.  And with yields in free-fall, it appears the bond markets see inflation going the way of the dinosaurs.

With 30-year Government of Canada bonds yielding 1.7% and inflation hovering around 2%, we can arrive at one of two conclusions.  Either people are willing to accept negative real returns from government debt, or they expect consumer prices to remain benign for decades to come.

Now, there are some cool cats who purchase sovereign debt for non-economic reasons, such as liquidity management, liability matching, or regulatory restrictions.  These institutions have even supported sub-zero interest rates in some countries, despite how irrational accepting a sure loss seems.  But for most of us squares, losing purchasing power every year is unpalatable.

For an investment to merely maintain purchasing power, the generally accepted benchmark is 2%.  A hurdle which is well supported by historical evidence.  From 1914 to 1970, the Canadian Consumer Price Index (CPI) averaged 2.2%.  Between 1970 and 1990 it spiked to 6.9%, and since then has normalized back to 2.0%.

Based on these averages, the after-tax returns from GICs and traditional fixed income would lead to a loss of purchasing power.  Thus to allocate to these securities, one must expect the trends in consumer prices to deviate significantly from the past.  Is such pessimism warranted or have bond markets overreacted?

While bond traders are pessimistic by nature, there is something, in particular, troubling them these days.  Despite historically low unemployment levels, economic growth, and low interest rates; inflation remains stubbornly contained.  Several factors are being cited as the causes of this ‘lowflation’ conundrum.  Globalization and technology reduce production costs, while e-commerce saves vendors from the expenses of retail infrastructure and creates a more competitive pricing environment.  There are also those that question the validity of the current CPI measures, pointing to increases in healthcare and necessities being well above 2% per annum.

The reasons as to why inflation is tenaciously low will undoubtedly be the subject of scintillating conversation amongst central bankers and economists. Meanwhile, there will be no dearth of financial pundits offering their predictions of where we go from here.  For the rest of us, the key is to be aware that bond markets are concerned with inflation moving lower and have priced government debt accordingly.

Thus, to invest in traditional fixed income, one needs to have a strong conviction that CPI will disappoint even more than the currently pessimistic picture. Historically, full employment, economic growth, growing deficits, zero or negative real interest rates, rising financial asset prices, and low inflation have not coexisted for long periods.  So, either something has to give, or else we need to believe in theories that hinge on Sir John Templeton’s four most dangerous words, ‘this time it’s different.’

The Fund

After a difficult May, credit spreads staged a strong recovery in June.  The promise of rate cuts by the Federal Reserve coupled with optimism over the China/US trade negotiations saw money flowing back into risk assets.  Canadian investment-grade credit spreads were broadly lower by 9 bps, while the US tightened 13 bps.  The star performers were the CDX derivative indices with IG improving 16 bps and HY 70 bps.

New issue activity did pick up, with $16 bn of corporate and ABS deals getting done.  Domestic banks were the main event as they issued NVCC, bail-in, deposit notes, and covered debt.  Telus, Fairfax and Epcor also tapped the market, while Keyera issued a high yield rated hybrid security.  Despite the large amount of issuance, the new supply was easily absorbed.

We significantly reduced our credit hedges/short positions early in the month and added to select holdings in both the primary and secondary market. These moves allowed the fund to benefit from the strong spread performance resulting in a 1.04% gain in June (0.94% F Class).

Credit

Music genres are often defined by their rhythm (who can forget disco’s ‘four-on-the-floor’ beat.).  Credit markets are also subject to a cadence that often corresponds to the level of primary issuance.  With the ‘dog days of summer’ descending upon us, investors become distracted with vacations, BBQs, and time with family.  As such, most issuers take a seasonal pause, and the volume of supply can drop significantly.  Absent any external shocks; the new issue drought often leads to a grinding tighter of spreads as portfolio managers pick away at dwindling dealer inventories.

The ‘skinny’ on primary issuance is that it trails last year’s numbers by 15%, making it difficult for portfolio managers to replace securities they sell or that mature.  As we saw last month, the heavier supply was met with cash from coupons and maturities that needed to be put to work.

While the supply side looks constructive, spreads have come in a long way this year and are near their long-term average.  This tempers the strong technical outlook and leads us to medium risk posturing, with continued caution around the dicier parts of the credit spectrum.  Thus, in the months ahead, we will look to capitalize on the summer doldrums, with one eye on the powder keg of trade negotiations, Brexit and central bank meetings.

Rates

The US bond bulls have rushed to price in 75 bps of cuts by the Federal Reserve for 2019, including a healthy chance of a 50bps cut later this month.  We think they will be bitterly disappointed, as even James Bullard (St Louis Fed), a noted ‘dove,’ thinks only 25bps or 50bps of insurance cuts will be needed.

So far Canadian data has been groovy, beating the pundits’ depressed expectations, allowing Governor Poloz to remain on the sidelines.  The Bank of Canada could probably take a chill pill and hold steady if the Federal Reserve delivers less than 50bps of cuts, however, deeper cuts would likely lead to a much stronger Canadian dollar, which could prompt a cut or two by the BoC.

Expectations for significant cuts by central banks are really high dude, can ya dig it?  The bummer is that even if the Fed delivers a couple of rate cuts, yields could still tilt a little higher.

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“There’s no place like home.”
The Wizard of Oz

Along with sports fans across the country, we have firmly entrenched ourselves aboard the Raptors’ bandwagon.  And Kawhi not?  The newly anointed King of the North and his troops are one win away from being crowned champions.  The energy and enthusiasm are palpable and infectious, with Jurassic Parks popping up from sea to shining sea.

Amidst all the buzz and excitement, it’s natural for local fans and media to be biased in their commentary and analysis: overemphasizing the bad calls and bounces that go against ‘us’ and skewing predictions in favour of the hometown boys.  Even gamblers over-bet on their favourite teams.  Objectivity be damned when it’s your side playing.

This home-bias extends beyond sports and creeps its way into our investment portfolios.  Reports published by Vanguard indicate Canadians hold 60-65% of their equity allocation in domestic companies, even though they represent less than 5% of the global pie.

Does it make sense for investors to be so heavily concentrated in our home and native land?

To be clear, this behaviour is not specific to Canada but is a global phenomenon.  Despite ample evidence on the benefits of an internationally diverse portfolio, people the world over disproportionately invest in their home country.   But given the multitude of simple ways to get foreign exposure and the advantages of doing so, why the tendency to stick within the confines of our borders?

The most rational explanation is that we irrationally expect higher returns from domestic securities.  Studies by French and Porterba (1991) and Kilka and Webser (1997) concluded that investors illogically expect higher and less volatile returns from home markets.  Just like sports fans and gamblers, investors cheer on local companies and expect them to win.

Another reason for concentrating domestically is believing one has an edge.  In some cases, staying close to home can be very profitable.  Consider a real-estate investor with deep local knowledge, access to deals, and the resources and relationships to boost overall returns.  Interestingly, Coval and Moskowitz (1997,1999) found US equity fund managers not only favoured local companies (within 100 miles) but were able to generate better returns from these holdings than from those located further afield.

For specialized and niche players, there can be advantages to focussing and concentrating investments.  We, for example, believe our competitive advantage is greater within our borders than outside of them.  But for the average investor, any informational advantage is typically outweighed by the benefits of diversification.  This is particularly true for Canadians where the market compounds the risk of home-bias with both security and sector concentration.  The ten largest companies account for around a third of the TSX with the financial and energy sectors comprising over half.  Thus, overly patriotic allocations are missing both industry and foreign exposures.

So how do we overcome our home-bias?

As we are also fans of the Toronto Maple Leafs, we find stats can often sober optimism and add some objectivity.  Over the past decade, the S&P returned 269% while the TSX was up only 107%.  Ignoring our elephant neighbour to the south over this period would have been rather detrimental.  Furthermore, there is a plethora of quantitative research indicating superior risk-adjusted returns from global portfolios over allocating solely to a single country.

But numbers and facts are usually not enough to break biases.  To overcome a behavioural tendency, it also helps to understand its root cause.  In this case, it appears that ‘familiarity breeds investment.’ In an extreme example, respondents to a Gallup survey (Driscoll et al., 1995) viewed their employer’s stock as safer than a diversified equity fund.  There is a certain comfort that comes with the familiar. Consider how we are more amenable to strangers if we’ve seen their picture before or if they look like someone we know.  We need to remind ourselves that the slimmest of personal knowledge can make us feel that the risks are lower than they might be.

The bottom line is that our portfolios are often much more than the abstract return streams of economic models.  There are a whole host of factors at play, some rational, some emotional, and others based on external drivers. We are often more enamoured by the stories behind investments, which can be more compelling and interesting than boring risk-return projections and models. But given our jobs, homes, and so much else is correlated to domestic asset prices, it probably makes sense to examine how much extra home-bias your investments are adding.

Playing at home doesn’t confer a return advantage and may increase risk. But we are hopeful home-court will give the Raptors a decisive edge tonight.  While we can’t advocate a ‘We the North’ portfolio, when it comes to the Raptors, we fully support going all in.  Let’s Go Raptors!

The Fund

With trade tensions and geopolitical risks in the spotlight, May was a difficult month for risk assets.  A souring in US-China negotiations led to a sell-off in equities.  And with no further talks scheduled with the Chinese, US negotiators had time on their hands to pick another fight, this time with the ‘bad hombres’ to the south.  The White House opted to link immigration with trade and threatened tariffs on Mexican made products.  The surprising move caught investors off guard, who unsurprisingly hit the ‘sell’ button.  Energy and auto-related securities were hit particularly hard.  Over the month, the TSX was down 3.1% while the S&P plummeted 6.4%.

Credit markets jumped on the risk-off bandwagon with US investment-grade spreads higher by 17 bps and high yield climbing a whopping 74 bps.  Like our beloved Raptors, the Canadian market proved more resilient.  Domestic credit was relatively unchanged until the last few trading days in May, when the ‘Mexican Job’ finally pressured spreads 6 bps higher.

The muted move in domestic spreads was due to the large amount of cash building in fixed-income funds.  The build-up of dry powder is the result of lower than expected issuance (down around 25% year over year), and inflows from large maturities and coupon payments through May and early June.  As a result, the market remained open all month and notably saw the pricing of two high yield issues as both Cominar REIT and Kruger Packaging priced new deals.  Even TD’s $1.75B bail-in deal couldn’t really dent demand.

With trade concerns leading to fears of impaired and slowing growth, we elected to reduce corporate exposure and increase hedges through short credit positions.  Thus, despite the negative tone, we managed to preserve capital and post a modest gain of 0.15% (F Class 0.10%) for the month.

Credit

The Canadian banks seem to be diminishing their home bias as they continue to tap foreign jurisdictions to raise debt.  Since financials represent roughly 50% of the corporate debt securities, their activity or lack thereof does leave a mark.  Going forward we do expect them to return home (at least to a greater extent than they have done so far this year), but we also anticipate less supply from non-financial companies.

The recent decline in sovereign yields and curve inversion is a strong motivation for managers to increase their allocation to the corporate sector to meet return targets.  Thus, all else being equal, the supply and demand dynamics appear positive for domestic credit spreads.

As for the broad credit market, debt-funded mega-mergers are still possible, but we continue to think that large high-quality companies are making decisions with a careful eye on their balance sheet.  With concerns of a slowdown mounting, there is additional impetus to decrease financial risk through debt reduction to balance off increased operational risks.

With rising geopolitical and macro risks leading to wild gyrations, we expect to see an increased bifurcation in spreads based on quality and idiosyncratic business factors (i.e. an auto company may find its assets in Mexico impaired because of tariffs, but a mobile tower company would feel far less impact).  We remain cautious with over-levered companies (high yield and levered loans) who have fewer leverage reduction options.

Rates

It increasingly appears that the Federal Reserve is going to lower rates sometime this year.  The ‘easy-to-win’ trade war with China is hurting the US economy.  While we thought the potential inflationary impact of tariffs could dampen their instincts to ease, it appears that fears of rising unemployment are of greater concern.  Prices of sovereign bonds suggest that participants are expecting 75 bps of cuts over the next 12 months.

Canadian economic numbers have bounced higher from the terrible data several months ago.  This rebound will make it more difficult for the Bank of Canada to lower rates, although yields have a 70% chance of a cut priced in before year-end.

As things are unfolding so far, it seems that the Federal Reserve will lower rates more aggressively than the Bank of Canada.  This should be good news for snowbirds as the Canadian dollar should strengthen making the trip south a little cheaper.

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“Heads I win, tails you lose.”
Norville “Shaggy” Rogers

Becoming better investors involves learning from mistakes, our own and those of others.  While some lessons need to be learnt the hard way, the preferred method is to draw wisdom from the missteps of others.  It is, after all, the cheaper option.

This month, our ‘others’ are the darlings of so many academic studies: university students and young finance professionals.    This particular lot was staked $25 to play a game with odds that would make a casino owner salivate.  They had half an hour to bet on flips of a coin that they knew was rigged to land heads 60% of the time.

Easy money.  Right?

The optimal strategy has the potential to turn the $25 into over $3 million.  And while perhaps not intuitive, it is rather simple: bet 20% of your stack on heads each time (as per the Kelly Criterion, for you fellow nerds out there).  Three million isn’t too shabby for half an hour of repeatedly betting heads.

To spare themselves from financial ruin, the researchers, Victor Haghani of Elm Partners and Richard Dewey of Pimco, capped the maximum payout at $250.  If the participants consistently wagered 10-20% of their money on heads, it was expected that 95% would reach this upper limit.

The results were not flattering. Only 21% of people walked away with $250, while a shocking 28% went totally bust.  Amongst the various conclusions we could draw, one is that most of us are idiots. Fortunately, the researchers, being far less shallow than we at Algonquin are, devoted some thought in trying to understand the poor results.

Overall, the approaches to the game were ad hoc and overcomplicated, with some doubling down after losses (martingale), and others betting too little, too much, or too erratically.  Remarkably, the majority of participants even placed wagers on tails.

Thus, the first lesson from this experiment is that you need to understand the appropriate strategy to follow. This can be accomplished through research and working with the right people.

But even knowing the right path isn’t necessarily enough.  Some of these well-educated lab rats knew the optimal strategy but were still unable to capitalize on the opportunity.   From them, we get the second lesson, that execution and ‘stick-to-itness’ matters.  It’s easy to know you should exercise more and be committed to it.  It’s a different story getting your butt to the gym.

In their meta-analysis, psychologists Gollwitzer and Sheer concluded that motivation and intention alone aren’t enough. We also need help regulating our behaviour towards achieving our goals.  In this regard, one measure they found moderately to largely effective was ‘implementation intentions.’

These are ‘if/then’ statements of the form ‘if situation X arises, I will respond with Y,’ where Y is some goal-oriented behaviour.  Thus turning ‘I intend to exercise more’ into ‘if it’s Tuesday and my work is finished, then I’m going to the gym.’

Like Britney Spears, investors are notoriously bad at self-regulating. Too often their reactions to market swings run counter to their ultimate objectives.  Cognitive sciences have shown these counterproductive misbehaviours to be instinctive and evolutionary.  Given that much of our hard wiring is working against us, an implementation plan could be very useful.

As fans of simple and effective solutions, one easy method is to pursue the path of sloth-like laziness.  There is plenty of evidence showing that less frequent (even just annual) portfolio reviews can curb misbehaviour and help achieve long-term goals.  And to assist the process, investors can add the implementation intention, ‘if markets are volatile, then I will ignore the noise and wait for my next investment review date.’ After all, sometimes less is more and the best (and often hardest) thing to do is nothing at all.

The Fund

April was an eventful month with North American equity indices hitting all-time highs.  The euphoria crept into credit spreads as the domestic index narrowed 10 bps while the US tightened 8 bps.

The telecom sector garnered most of the attention as the results of the spectrum auction were announced early in the month.  Rogers made the biggest splash picking up $1.7bn worth of spectrum.  Other notable buyers were Telus, Shaw, and Quebecor, while Bell surprisingly bought none.

There is normally some post auction trepidation as people brace themselves for a slew of bond deals to raise funds to pay the bills.  To use a dangerous cliché, this time it’s different. Rogers successfully raised $1.25bn in the US, leaving them only $1bn to raise at home.  Given the last time they issued in Canada was in 2014, the domestic deal also performed well.

S&P also released a timely note stating that Rogers, Telus and Bell could incorporate higher leverage and maintain their high-BBB ratings.  Separately, Moody’s upgraded Shaw one notch to reflect the improvement in its business profile.  Sentiment in the sector was further aided by good results from AT&T, which saw its spreads narrow 30bps.

In other security-specific news, Allied Properties was upgraded to a positive outlook, and WestJet was downgraded to junk.

The Fund benefited from the overall rally in credit and was able to generate excess returns through overweight positions in telecoms and other outperforming securities.  The net result of the spread performance along with the yield earned was a gain of 1.54% for the month.

Credit

After a rather dismal 2018, credit and equity markets have rebounded this year.  Although equities reached a new apex last month, credit is merely back to where it was in early November, before the tantrum escalated.  Perhaps this is because fixed-income managers have pessimistic tendencies.

Of the performance we have seen, a significant contributor is the lack of new issuance which is running roughly 20% lower than last year.  The main culprits behind the decline in supply are financials, who have found foreign jurisdictions to be very receptive.  The banks need to issue some $150bn by November 2021, so the drought will end, perhaps soon after earnings which are due in late May.

Issuance is expected to pick up south of the border. However, dry conditions are expected to persist here.  Although droughts are not good for crops, they do lend support to spreads.  ‘Patient’ central banks are also having a positive influence on risk assets.

In the very near term, all eyes are on the US/China trade negotiations. Other things to watch closely include the unrest in Venezuela, the tightening of sanctions on Iran, and corporate earnings.

Upon weighing the pros and cons against current valuations, a modest risk exposure seems sensible.  Such a posture allows us the flexibility to dynamically adjust our portfolio.

Rates

The Bank of Canada followed other central banks in abandoning their hiking bias. Although his peers are questioning whether current monetary policy is stimulative or not, Governor Poloz has not yet joined this debate.  Nonetheless, bond traders are betting that both the Bank of Canada and the Federal Reserve will cut rates later this year.

The wild card is an escalation of tariffs.  Comments and papers by both central banks suggest they will hike rates in a higher tariff world.  Despite knowing the odds are biased towards hiking rates if this situation evolves, it will be interesting to see whether investors continue to bet on ‘tails.’

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“Dogs got personality. Personality goes a long way.”
Pulp Fiction

In our business and professional lives, one of the most important choices we make is who we hire and work with.  For investors and allocators, this is usually the final step of their investment process.  After determining the financial objectives and portfolio allocation, comes the selection of the assets and managers.

Given the plethora of options to choose from, this can be a daunting task.  To assist in separating the wheat from the chaff, allocators have devised rigorous due diligence processes with checklists full of ‘P’s’: Performance, Process, Products, Partnerships, Philosophy, Price, Portfolio, People, and a Peck of Pickled Peppers.

Of all these factors, the one that is most personal and subjective is the ‘People’.  After all, what criteria do we use to judge the management team?  To examine this, we are adding another couple of ‘Ps’ to the pile, and ask if any ‘Personality’ traits or ‘exPeriences’ impact performance.

The Hollywood portrait of the successful investment professional is that of a ruthless, arrogant, and unempathetic character (think Gordon Gekko).  There is also the notion that these psychopathic, Machiavellian character traits can lead to success in high-powered and competitive arenas.  A research study of hedge fund managers discovered that those with greater psychopathic tendencies produced lower absolute returns, and those with narcissistic qualities delivered inferior risk-adjusted returns (2018, ten Brinke et al.).

Further debunking the media’s stereotype is a study of sensation and thrill-seeking in hedge fund managers, as measured by the cars they own (2016, Brown et al.).  They concluded that drivers of ‘powerful sports cars take on more investment risk but do not deliver higher returns.’  Although they should easily beat their minivan safety-first peers in a street race, they lag in Sharpe and information ratios.

Garage inspections and Myers-Briggs tests are rather extreme measures.  Although interesting and novel, the research in this field is not deep enough to draw any concrete conclusions.  Thus far, the mapping of character disposition has been concentrated on the risk tolerances of inexperienced investors.  But one thing that most allocators agree on is evaluating the experience of the ‘People.’

Grey hairs, wrinkles, and battle scars provide investors with a sense of comfort.  But the hard data does not suggest a correlation between time served and results.  If anything, we’ve come across several papers pointing to out-performance early in one’s career.  The thesis being they are hungrier and more willing to take the risk to out-perform rather than protect a legacy.

With industry experience offering little guidance, perhaps investors should focus on other aspects of a manager’s personal history.  In an analysis of mutual fund performance, researchers found that managers from families in the bottom quintile of wealth outperformed those in the top quintile by over 1% a year on a risk-adjusted basis (2016, Chuprinin & Sosyura).

The popular explanation is Darwinian natural selection, with individuals from poorer backgrounds facing greater barriers of entry.  Consistent with this thesis, Chuprinin and Sosyura also found that the silver spoon crowd are more likely to be promoted while their less fortunate peers must outperform to rise to the top.

Digging deeper into a manager’s life story comes the awkward topic of losing a parent.  While there is no research specific to the investment industry, analysis on world leaders, Nobel prize winners, and prominent historical figures shows a high percentage lost a parent at a young age.  Overcoming adversity and early independence seem to be a strong motivation to excel.

This is not to say that investors should be looking for poor orphans driving family cars.  For every study of this nature, there is another proving the opposite.  But amongst all the numbers and analysis, perhaps pausing to assess a manager’s character and history is worthwhile.  For the curious who are wondering, the Algonquin car collection consists of a Honda, an Audi, a Toyota, a Mini Cooper, and a TTC Metro Pass.

The Fund

After the volatility of the past few months, March provided a bit of respite with spreads trading in a narrower range with mixed moves across the maturity spectrum.  As the interest rate curve inverted, credit spreads adjusted to keep corporate yields positively sloped.  As a result, short-dated credit spreads declined marginally, while longer maturities slightly widened.

With lower all-in borrowing costs enticing corporate treasurers, the new issue market finally opened up.  Banks, auto finance, Telus, Investors Group, and Canadian Pacific were among the featured names.  Inter-Pipeline brought their inaugural hybrid deal, joining the ranks of Enbridge and TransCanada who also use this innovative structure.

After two very strong months in credit, we hedged a portion of the portfolio exposure with short derivative positions, as we assessed the longevity of the rally. While corporate bonds spreads were a touch wider in March, the derivative index was tighter by 4 bps.  This divergence was modestly unfavourable for the fund.

The moves in credit spreads had a de minimis impact on the Fund and the losses from hedges were more than offset by the yield on the portfolio and profits from active trading.  The net result was a return of 0.36% for the month.

Credit

Market sentiment is currently positive, but the inverted yield curve serves as a reminder that all might not be well.  Although recent economic data has softened, there have been enough upside surprises in North American and Chinese employment and Purchasing Manager Indices to support the pundits who claim the weakness is transitory. Germany’s numbers continue to be horrible, but one can’t be certain how much impact Brexit and weakness in China is having.

With the new issue market finally open, there should be a steady stream of deals until the summer doldrums.  With fears of higher interest rates vanishing, flows into bond funds have been strong. US investment grade funds have seen weekly inflows since early January.  Not to be outdone, high yield funds attracted $14.3B of new money which is the second-best quarterly inflow ever.  The flow of funds is a strong tailwind for credit markets.

Should the US and China reach a trade agreement and the UK agree on a deal with the EU (we’ve given up trying to predict the outcome), there could be a surprising recovery in growth.

As a result, we have slightly increased exposure, but remain mindful that sentiment can easily turn negative very quickly.

Rates

Canadian and US yield curves have inverted as people anticipate the next central bank move will be to lower interest rates.  The Federal Reserve has made it quite clear they are going to be patient.  With the US overnight rate above inflation, Chairman Powell and Co. have the luxury of waiting to see whether the economy is in a soft patch or heading into a slump.

The Bank of Canada is also on hold, but Governor Poloz is leaning ever-so-slightly in favour of the next move being a hike, largely because the overnight rate is still lower than inflation.  Furthermore, the Bank still thinks that if the broader trade issues are resolved, there should be a bump in business investment and exports.  That said, bond traders, being a pessimistic lot, are more focused on the slump in residential real estate and the high level of consumer indebtedness, so continue to price in healthy odds of a cut this year.

We believe the bar is high for either central bank to ease or hike.  Bond yields could swing violently depending on how the next few months of economic data unfold, and on whether trade tensions mount or subside.  As a result, we are keeping our interest rate exposure to a minimum.

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“People are predicting the end of the world like there’s no tomorrow.”
Mr. Greg Jeffs

Since the beginning of civilization, people have been predicting its end.  Everyone from religious figures to psychics and scientists have warned of nuclear holocausts, asteroids, zombie invasions, and other apocalyptic events leading to the extinction of the human race.  In a 2012 poll conducted across 20 countries, 14% of respondents expected the world to end in their lifetimes.

This morbid fascination with the ‘end of days’ extends to the financial markets, where bouts of volatility are met with pundits calling for the next crash or collapse.  The latest market ups and downs (or more accurately downs and ups) have seen fingers pointed at the ticking time bomb in credit as the potential cause of the next disaster.

So, is there a corporate debt bubble that is ready to pop?

As is the case with many doomsday prophecies, there is a little basis in truth.  Credit markets have grown substantially over the past decade.  Low-interest rates created a thirst for yield, which allowed many new issuers to access the market.  Furthermore, until recently, the US tax code led many companies to issue debt to minimize tax while rewarding shareholders with dividends and stock buybacks.  The result is that the level of corporate bonds and loans outstanding has never been larger.  At first blush, this seems terrifying, but should it be?

While the level of corporate debt as a percentage of GDP has never been higher, the same is also true of assets.  It’s natural that growing corporations finance their investments with a combination of debt and equity.  To do otherwise, would be an inefficient use of shareholder capital.  Although it is difficult to determine the degree to which the corporate debt pile should have naturally grown, we think it is reasonable to believe some excess exists.

The real question thus becomes, what happens in a recession or economic slowdown?

While borrowers of all stripes have been to the trough, not all debtors are created equal.  Thus, it is important to separate any analysis between the low and high-quality issuers.

Let us take a look at investment grade borrowers first.  These corporations tend to employ lower amounts of leverage and are cash flow positive, in many cases, even when the economy is contracting.  The bond market generally remains open to them when it comes time to refinancing maturities, albeit with investors demanding higher compensation.  Should the bond market not be receptive, these companies tend to have undrawn bank lines that can be used as a bridge until sunnier days emerge.  Senior executives also have a variety of other levers at their disposal including cost-cutting, dividend reduction, and asset sales to shore up their balance sheets.

Lower quality borrowers who depend on the high yield or levered loan market are a different kettle of fish.  These companies are typically highly levered and/or cash flow poor.  Often, they are reliant on a strong economy to execute their business plan.  Also, given the risky nature of their debt, there is a smaller pool of lenders willing to extend them capital.  Should a recession hit, these businesses have few options within their control to improve cash flow.  If their limited pool of creditors disappears when they need to roll over maturing debt, they could find themselves battling to survive.  In this scenario, defaults can occur quickly.

The doom merchants would have us believe that such a wave of defaults would trigger a tsunami and plunge the economy into a sequel of the Global Financial Crisis.  Given that there hasn’t been a recession since 2008, ‘recency bias’ skews us towards viewing that as the base case of what should occur.  While it is impossible to rule out such a scenario completely, we think the odds are remote.

2008 was about the real possibility of a complete collapse of the banking system.  Since then, governments, and those who finance banks have brought about much change in the way financial institutions conduct business.  One of the reasons for the tremendous growth in the corporate bond and levered loan space has been that banks are more selective with their lending.

Although vulnerabilities in credit could contribute to or exacerbate future recession dynamics, we don’t see the magnitude of the risk being equal to that of the household and financial leverage that led to the crisis of 2008.  Also, amongst all the doom and gloom, there have been a few positive developments that could cushion any blows sustained by corporate debt.

With sovereign yields not expected to rise significantly, the demand for fixed income should be stable.  And on the supply side, issuance is expected to fall this year as companies no longer issue debt to pay dividends or finance buybacks.

Another, more recent, positive development has been the alignment of interests between bond and equity investors, two camps that are usually at loggerheads.  Corporations that are taking bondholder friendly steps to reduce leverage, including taking drastic measures such as selling assets or cutting dividends, are being rewarded with a surge in their stock price.  Furthermore, while the earlier stages of the cycle saw substantial debt-financed M&A, the latest deals have leant towards share financing, with the costs/risks skewed to shareholders rather than the fixed income investor.  If these trends continue, we could see more corporations joining the debt diet.

Until the next recession occurs, there will be no shortage of doomsayers vying to predict the event and its causes.  And just like a ‘stopped clock is right twice a day,’ they too will eventually be correct.   But it is important to remember that economic slowdowns occurred many times before 2008 for a variety of different reasons, and it is far likelier the next one will occur due to events that few foresee today. And whilst some financial forecasters and conspiracy theorists make repeated apocalyptic prophecies, the reality is, that the world will only end once.

The Fund

February saw a continuation of the rally that started in early January, although at a less frenzied pace.  Canadian investment grade spreads were generically lower by 7 bps on the month.  With the banks in a blackout period, new issues were a scarce commodity.  Artis REIT, Brookfield Properties, Canadian National Railways, Enbridge Pipelines, Wells Fargo and Manulife Bank were the featured issuers in an otherwise quiet month.

There were a few signs that supply was not being easily absorbed and with spreads having narrowed substantially since the beginning of the year, our enthusiasm has waned slightly.  We took the opportunity to take some profits, reduce a few holdings, and modestly increase hedges through short credit positions.

The impact of tighter spreads, active trading and the yield earned contributed to a 1.15% gain for the February.

Credit

March is expected to be (and thus far has been) busier with respect to new issuance, especially from banks and financials.  Supply from the telecoms should also gear up to fund the spectrum auction later this month. The pick up in issuance will be a real test of demand.  In the fall, fears of rising rates led to redemptions in fixed income funds.  With those concerns behind us, the question is whether the hunt for yield will be strong enough to digest the heavier supply without materially impacting spreads.

On the macro picture, simmering trade tensions and the uncertainty around Brexit still overhang the market.  Also given the pace and magnitude of the recent rally, a mild retracement is possible.  As such a defensive position, concentrated in short maturity, high-quality names is still warranted.

Rates

The best-laid schemes of mice and men and central bankers have gone awry.  Evidence that the domestic economy is much weaker than expected has forced the Bank of Canada to shift to a neutral position joining the Federal Reserve who capitulated in December.

With the next rate move a toss-up, the year might not be as boring for bond traders as we initially thought.

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“All the world’s a stage,
And all the men and women merely players”
William Shakespeare

From his days as a businessman and TV personality to his tenure in the White House, the President has never shied away from the spotlight.  With his and China’s cold trade war representing the greatest source of risk and uncertainty for investors, the question is, how will he fare in the market’s limelight?

Although Trump likes to brand everything from towers to steaks, there is something he would rather not have his name attached to; a recession.

But if a deal can’t be reached and ‘Tariff Man’ follows through on his threats of 25% duties on everything made in China, this could be the unwelcomed outcome.  So as the President tackles the perceived problem of a trade deficit and saving America from foreign exploitation, the rest of us are left watching and wondering.

Given the euphoria currently gripping the markets, it’s hard to believe that only weeks ago, the stage was being set for a recession.  The first cracks started appearing in European and Chinese growth, and Canadian GDP slipped from 2.9% to 2.0%.  This global slowdown was attributed to a drop in confidence exacerbated (or even caused) by the trade tensions.  This lack of confidence led to a decline in both business investment and equities.

These developments dragged another set of actors into the spotlight; the central bankers.  The precipitous drop in stocks was enough to push the Federal Reserve to let the curtain fall on their rather mechanical tightening program.  US yields declined as expectations for two or three hikes in 2019 faded to none at all.  With the ‘patient’ Fed providing some relief, Trump’s negotiations with China have retaken centre stage.

And we find ourselves at the point where ‘two roads diverge, and we can’t travel both.’  The question is whether or not we take the one less travelled.

The outcome the investment community desires is the well-worn path; a deal that sees all tariffs removed.  Such a move would essentially restore the free-trade trend that the world has embraced for decades.  With confidence being a fickle beast, this could result in a rapid recovery in business investment and markets. The burst of activity would underpin an improvement in GDP, employment, and likely wages. Under this scenario, we expect the Federal Reserve and the Bank of Canada would restart their dormant hiking programs, and sovereign yields would gradually rise.

The alternate storyline, escalating the global trade war, is a path not followed since the ‘dirty thirties.’  The US slapping 25% tariffs on everything Chinese would certainly leave a mark.  The tariffs currently in place are estimated to have a 0.25% drag on global growth.  A massive escalation of duties would almost certainly drop the US and most of the world into a recession.  Equities would likely see a sharp move lower, and the knee-jerk reaction would be for yields to drop in anticipation of looser monetary policy.

But perhaps there won’t be heroes in this play.  Although investors have grown accustomed to central bankers bailing them out, we are not so sure they will ride to the rescue this time.  In an all-out trade war, GDP and employment would very likely drop while inflation rises. Central bankers would find themselves in ‘another fine mess,’ as monetary policy cannot simultaneously offset recessionary and inflationary forces. If they lower rates to stimulate growth, they risk adding to inflationary pressure, however, raising rates may make the slowdown even worse.

In the early ’70s, the Federal Reserve faced a similar conundrum when the oil price shock resulted in both higher inflation and an economic slowdown. The Fed eased to support growth, which resulted in a period of very high inflation, ultimately damaging GDP and employment for a generation.  While investors often forget the lessons of history, central bankers rarely do.

The hope is that this entire plot twist can be avoided and that the story has a happy ending, which brings us back to the negotiating table.  As we learnt from the ‘Art of the Deal,’ ‘always go into the deal anticipating the worst. If you plan for the worst–if you can live with the worst–the good will always take care of itself.’  The question for the President is can he live with the worst, taking the US ‘economic miracle’ into a recession and risk being ousted in 2020.  Although his desire might be to settle the score with China, we certainly hope re-election fears trump Trump.

The Fund

With issuers unable to tap the market in December, portfolio managers feared that a ‘great, great wall’ of supply was building and that desperate CFOs and treasurers would immediately grab any chance to raise money.  Much like Trump’s border wall, it failed to materialize.  The first few deals came with significant concessions and found eager buyers.

Autos (Ford and BMW) kicked off the issuance calendar and were followed by CIBC and BNS.  The sentiment was strong enough to allow some ‘trickier’ names such as Capital Power, Algonquin Power, and Morguard to sell debt.

Sensing that the herd was moving, managers started putting money to work.  The new-found enthusiasm for credit amidst a positive backdrop saw Canadian investment-grade spreads decline 16 bps.  But as is the habit of Americans to do everything bigger, spreads south of the border rallied a healthy 25 bps.

We entered the month with the accumulated hedges of the past months in place but quickly started paring these back as it became clearer that positive momentum was building.  This allowed us to benefit from credit tightening without clamouring for product in a heated market.  With the Fund well positioned for the rally, we ended the month with a net return of 2.03%.

Credit

Outside trade negotiations, the supply and demand side of the story revolves around maturities, coupon payments and financing activity.  The banks are in blackout for the latter half of February, so issuances should underwhelm again.  As such, the path of least resistance is for tighter spreads, albeit at a more moderate pace.

We sense that people are more comfortable with the general level of spreads so that attention should shift to idiosyncratic stories.  In particular, companies that are focussed on delivering and improving their balance sheet are being rewarded by the equity market, while those that continue to issue debt to fuel buybacks and dividends are being punished.  This aligns ‘C-suite’ executives with bondholder interests, as companies are incented to reduce leverage.

Despite the positive tone, a cautious approach is still warranted.  The levered loan space remains a nagging concern.  Borrowers continue to find favourable terms in this space, however, should bankruptcies increase or lending criteria tighten, some companies will be forced to find other sources of financing or default.  As a result, prices of high yield and lower-rated securities would fall.

As their name would suggest, investment grade issuers tend to generate enough internal cash flows to service their debt obligations or have levers to pull (asset sales, dividend cuts, equity raises, multiple sources of funding). Accordingly, we are not as concerned from a fundamental standpoint, but do acknowledge that there may be a knock-on pricing effect.

So while the near-term outlook is optimistic, it is cautiously so with the usual hint of healthy skepticism.

Rates

The recent volatility caught the attention of central bankers everywhere.  Despite the strong US economy, the Federal Reserve has noted that inflation remains muted.  As such, they have decided that since the overnight rate is near the bottom of the neutral band, that they can be patient with further hikes.  Furthermore, the pace of balance sheet shrinkage is open to alteration depending on the situation.

The Bank of Canada also adopted a ‘wait and see’ attitude, although they still hold the view that further removal of accommodation is required.

Given the rather sanguine central bank stance, sovereign yields drifted lower to hover close to the overnight rates.  At this point, it certainly does appear that it will be a very boring year for government bond traders.

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“Only time will tell if it was time well-spent.”
Jimmy Buffett

With calendars flipping from December to January, we rang in the new year and bid adieu to 2018. For most portfolio managers and investors, this was not a sad farewell. Equities endured their worst performance in a decade, and there was little respite elsewhere, as most asset classes posted negative returns.

Amidst the volatility and pain of losses, sentiment shifted from the glass being half full to half empty to fears of it shattering completely. The shift has led to some rather gloomy predictions and outlooks for 2019.

While we aren’t fans of crystal balling, we do focus considerable energy on understanding the current environment. To paraphrase Howard Marks, ‘you might not know where you’re going, but you sure as hell better know where you are.’

So, for our new year’s commentary, we look at what happened, where we are, and what factors could influence where we’re going.

In their simplest form, markets reflect our expectations of the future. And in the latter half of the year, investors braced themselves for weaker economic data and lower corporate earnings. Concerns over a slowdown and less accommodating monetary stimulus were exacerbated by the escalation of the US/China trade battle and other political dramas. Accordingly, investors demanded substantially greater premiums for taking on risk, and prices dropped.

The question is whether the adjustment is too much or too little, or like the baby bear’s porridge, just right. This is what the markets appear to be grappling with right now. Having priced in weakness on the prospects of lousy headlines to come, investors have moved into the ‘show me’ phase. So, what are we waiting to be shown?

The dominant story is Trump vs. China. The good news is that both sides are engaged in negotiations, the bad news is that if a deal isn’t reached by March 1st, Trump is threatening to both raise and broaden tariffs on virtually everything made in China.

The ‘deal or no deal’ outcome will also have knock-on effects on another topical topic, rates. Under the ‘no deal scenario,’ higher and more expansive tariffs raise the spectre of ‘stagflation.’ A world of high inflation coupled with low growth. Given the Federal Reserve’s dual mandate (inflation and employment), such a scenario would make it very difficult to predict whether they would raise or lower the overnight rate. But there is little doubt that stocks and bonds would suffer from the uncertainty. On the other hand, if a deal is reached the markets would cheer, and sentiment would improve.

The other political drama unfolding is Brexit, with the UK scheduled to leave the EU on March 29th. It is difficult to see how this story will end. Perhaps Theresa May’s deal gets parliamentary approval, but it seems far likelier to fail. If Parliament chooses not to accept her proposal, there will be a frenzy of activity as people advocate for a variety of possibilities ranging from another referendum to a hard exit. Although folks on this side of the ‘pond’ have not been bothered by the shenanigans so far, they might change their minds if chaos engulfs Westminster and the odds of a hard Brexit rise.

The next issue being followed is closer to home. Despite significant advances in alternative energy, oil still matters. Declining prices spooked markets and helped prevent the Bank of Canada from delivering another rate hike. As such, strength in Canadian oil would spice up the bond market, which is not expecting another move by the central bank this year. Higher prices in Western Canada Select will test this conviction. A bonus for world travellers is that higher oil prices should strengthen the floundering ‘loonie.’

While the aforementioned items will make headlines, it is also worth paying attention to the less riveting economic numbers. Investors are preparing themselves for very poor growth and possibly a recession in the near future. That makes corporate earnings (especially any forward guidance), employment trends, and inflation numbers very important. In particular, the bears need to see poor corporate results, very low or possibly negative job growth, and core inflation dropping well below 2%.

In terms of recession indicators, another valuable tool is the shape of the interest rate curve. Before the last three recessions, the yield curve inverted, with shorter-term rates higher than longer ones. The tricky question is which part of the curve to watch. We feel the spread between 3-month T-Bills vs. 2-year government debt is the most important. This spread is currently +22 bps. Seeing this go negative would be an ominous sign.

Although following the flow of information and data seems an easy task, untangling the facts and developments is difficult given the myriad and often conflicting items that need to be parsed in order to develop a clearer picture. A task that is further complicated given that we humans are not the rational agents of economic models, and there are psychological ‘forces’ amplifying the pendulum’s swing. Based on the current tone, we expect bad news to be overweighted and good news underemphasized or brushed off as ‘fake news.’

So, while the markets have priced in a bleak future, data lags, ‘people be crazy’, and in the end, only time tells.

The Fund

As per the ugly picture above, the generic Canadian five-year BBB spread widened 70 bps from the euphoric levels reached in January 2018. The most violent move transpired over the last six weeks of the year (15 bps in December). Canadians were not alone in their misery, as US credit experienced similar moves.

Underperforming sectors included most things energy-related, as well as Maples (foreign debt issued into Canada), REITs and subordinated financial debt. Preferred shares were particularly hit hard on ETF and retail selling in a very thin market. Although our exposure to preferred shares is small (<1% of the portfolio), the large move inflicted moderate pain.

December typically sees a significant reduction in liquidity as the holiday season kicks in. The reduction was far more pronounced this time as fixed income funds struggled to keep up with redemption requests. Furthermore, extra pressure was exerted as portfolio rebalancing saw bonds being sold to purchase equities. New issue activity was exceptionally light as negative sentiment kept everyone on the sidelines.

Our holdings are concentrated in short maturity securities and included some tactical short positions as hedges. Nonetheless, we were roughed up a touch and ended the month (0.81%) as the hedges were simply not enough relative to the widening move.

Credit

The carnage of the past few months has left corporate debt much cheaper. In the short term though, the challenge will be to navigate the new issuance market. After the illiquidity and risk-off move of Q4 2018, issuers sat on their hands and deals are backed up.

New supply will need to come at meaningful concessions on top of already much wider secondary spread levels. This presents the opportunity to enter positions at attractive prices but also has the potential of repricing existing debt wider in response to the new issue levels. Our approach is to actively manage positions in sectors and issuers where we anticipate heavier volumes of supply. And over the coming weeks and months, we will be watching primary issues very carefully. In particular, we will gauge the magnitude of supply versus forecasts, the concessions required to place deals, the performance of secondary markets, and the amount of cash on the sidelines available to go to work.

There is no rush to significantly increase exposure given the ‘wall of worry’ to be climbed, however, we do expect activity to pick up and are prepared to exploit any opportunities that arise.

Rates

Canadian and US sovereign yields marched steadily lower as traders reduced the odds of central bank hikes in 2019. At this point, expectations of continued hikes by The Bank of Canada and the Federal Reserve are very low.

Bond traders are ‘twitchy’ by nature and will be quick to move yields in response to the unfolding economic data, which will test the conviction of anyone making long term duration calls.

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“In the short run, the market is a voting machine,
but in the long run it is a weighing machine.”
Benjamin Graham

Although November marks the Day of Remembrance, for most credit managers it was a month they’d rather forget. To borrow an analogy from investment guru Ben Graham, Mr. Credit Market’s mood went from sour in October to rather ugly in November. Spreads on domestic BBB corporates (i.e. Rogers, Loblaws, Enbridge) were 25-35 bps higher over the month, preferred shares dropped 6%, and even the great Canadian banks saw their spreads move out over 10 bps.

Mr. Credit’s mood swings caused jitters, made some headlines and led to the Fund enduring its worst period of performance since inception. With that in mind, we decided to begin this month’s commentary with a broader look at the credit markets and our strategic approach to managing the portfolio going forward.

When most people hear about weakness in credit, their mind flashes back to 2008. The sheer magnitude and impact of the Global Financial Crisis left an indelible mark in our memories. And with no shortage of self-proclaimed pundits selling the ‘debt bubble end of the world’ story, fears of a repeat performance have been creeping into people’s minds.

While there are grains of truth to the ‘sky is falling’ claims, it is important to understand the assumptions and uncertainties of these predictions. The odds of a 2008 repeat are low, and a recession is not a foregone conclusion. Having said that, the expectation is for growth to decelerate, and a move from 4% GDP in the US to 2% will feel recessionary rough. Such a slowdown would lead to rating downgrades of investment grade issuers and defaults by riskier (i.e. high yield) borrowers. It would also test the structure and liquidity of credit markets. We think the greatest areas of concern lie in leveraged loans and the debt of lower quality high yield borrowers, who need the economic tide to continue to rise. To poorly paraphrase Warren Buffet, ‘you never know who is borrowing naked, until the economy weakens.’

On top of a slowdown, we have a backdrop of rising rates, the withdrawal of monetary stimulus, and an expansion that is long in the tooth. As these developments unfold, markets will continue to re-price assets and recalibrate return expectations. While the eventual magnitude and impact are unclear, what we can be certain of is an increase in volatility across asset classes.

For the past few years, volatility has been tempered with Mr. Market’s mood swings moderated by central bank ‘anti-depressants.’ But with the meds being taken away, he is left to navigate the changing world on his own. Throwing in wildcards such as Donald the ‘Tariff Man’ Trump, the China Syndrome, a Shakespearean Brexit tragedy, and the Italian opera, doesn’t help the withdrawal symptoms.

While his mood swings can be nerve-wracking and test our patience, turbulent times create interesting opportunities. We look to capitalize on the strengths of our strategy and offer an interesting investment option amidst the uncertainty. As for overall positioning, we will remain focused on shorter-dated, high-quality securities where we feel the risk of default is de minimus. At present, the average maturity of our corporate positions is 1.7 years, the interest rate duration is 0.39, and the levered yield on the portfolio is around 6% (after funding costs).

By holding shorter-dated, liquid, investment grade names, we retain the flexibility to respond to both positive and negative shocks. Another advantage is that mark-to-market losses, while painful in the short term, are much easier to stomach when the recovery to par is within sight.

As always, we will remain dynamic in managing and hedging the portfolio’s exposure. In the longer term, we will be looking for the babies that get thrown out with the bathwater in the form of opportunities to buy good assets at fire sale prices. Thus, boosting prospective yields by taking incremental amounts of risk while maintaining a substantial margin of safety.

We do expect the ride to be bumpy but given the limited time to maturity and quality of securities in our portfolio, the key for us is to dig in and allow the bonds to do their job; to repay coupon and principal. As always with investing, the greatest advantage is often to play the long game, particularly when the rest of the world is reacting to volatility and caught-up in short-term thinking. As Warren Buffet says, “games are won by players who focus on the field, not by those whose eyes are glued to the scorecard.”

Credit

It appears that fixed income managers still need to raise cash, resulting in net selling pressure. Given the dramatic reduction in new issues in what is normally a very active period, the need to sell might be waning, but we have yet to see concrete signs of this is occurring.

Normally, December sees a significant reduction in trading volumes during the second half of the month and is usually blessed with spreads grinding tighter as new issue supply dwindles and dealer inventories shrink. Perhaps this will be the case this year. However, since the latter half of December is a poor time to trade, flows (even small ones) can have a disproportionate impact on prices. We will be watching carefully. After all, like the Bank of Canada, we are data dependent.

From a portfolio positioning standpoint, we will maintain a cautious stance until a catalyst emerges for a reversal. Certainly, substantive progress on China/US relations would be a good start. It is always difficult to time the markets, and given the tone, the widening in credit spreads could persist. But valuations are starting to look more attractive and indiscriminate selling results in mispricings and investment opportunities. Accordingly, we will continue to concentrate on shorter-dated paper and remain patient for opportunities to establish positions from both the long and short side.

Rates

Both the Bank of Canada and Federal Reserve have been raising interest rates for several months. As a result, rates are nearing the neutral interest rate range. Unfortunately, nobody, including central banks, knows precisely what that rate is. Instead, as is the case with hand grenades and horseshoes, ‘close enough’ is the order of the day. But even ‘close enough’ is difficult given the volatility in other asset classes and the vast unknowns introduced by geopolitical events.

Sovereign bond traders are struggling to figure out when and where the central banks pause. As an example, only six weeks ago, they expected three hikes by the Bank of Canada in 2019. Now they expect only one. If the US and China suddenly reach a trade agreement and end all tariffs, the betting odds can quickly shift back to three.

As discussed throughout the commentary, volatility is the new normal!

Regards,

The Algonquin Team

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“If you think your teacher is tough, wait until you get a boss. He doesn’t have tenure.”
Bill Gates

On the list of things not to lose, our jobs typically rank pretty high. That’s why, as our mothers encouraged us to, we come to work ready to do our best. But sometimes doing the ‘best’ job can put that very job at risk.

Politicians forgo pursuing a policy they deeply believe in because of re-election fears. Corporate executives bite their tongue as not to express an unpopular opinion in the boardroom. Doctors overprescribe and overtreat to appease patients and avoid backlash.

The bottom line is that we all have a boss, directly (org chart) or indirectly (voters, clients), and therefore, all run the risk of being fired. And in the world of investment management, where results are so easily quantifiable and trackable, portfolio managers certainly feel the heat. This pressure can exert undue influence on investment decisions and is a risk that is often neglected by investors.

Of the 200 institutional investors interviewed by the Centre for Applied Research, the majority cited career risk as the largest determinant in their decision-making process. With around half of them feeling their jobs would be in jeopardy after 18-24 months of underperformance. Thus in asset management, career risk comes from underperforming your benchmark or peers in the short-term.

And herein lies the portfolio manager’s dilemma. To generate excess returns, you have to be different. But the more you deviate from your peers, the more likely you’ll have periods of underperformance. Thus running the risk of having a potentially superior portfolio but no investors.

In his quantification of career risk, Joachim Klement (2014) concluded that with quarterly evaluation periods, even highly skilled managers risk being unduly terminated. And the best way for them to protect their jobs is to minimize deviation from benchmarks. Thus industry professionals are incentivized away from outperformance and towards herding, closet indexing, and short-termism.

But surely, this isn’t what clients want. Or is it? Modern corporate culture purports to encourage failure in the pursuit of greatness. But how often does the leader of an ambitious yet ultimately unsuccessful project get promoted? Similarly, the objective for investors and boards might be long-term outperformance, but their behaviour is usually more short-sighted. And while retail investors typically get a bad rep for chasing returns, institutional allocators don’t appear to be much better.

Goyal and Wahal (2008) examined 9,000 hiring and firing decisions made by pension funds. They concluded that these decisions were based on who out or underperformed during the previous three years. Only for the pension funds to see the fired managers generate greater returns than the hired ones over the next three years.

Similarly, Goetzman and Oster (2012) discovered that university endowments, much like the students of their institutions, are subject to peer pressure. They noticed allocations being adjusted to more closely reflect peer groups, particularly by those that had been underperforming.

So, from the top down, investors, allocators and money managers fear leaving the herd and failing unconventionally. Portfolio managers are scared that markets can stay irrational longer than they can keep their clients. And investors worry about missing out by exiting a good fund too quickly or sticking with a bad one for too long. These fears create a spiral of irrational expectations from the bosses being met with irrational behaviour from the employees.

But as with most relationships, the one of boss and employee can be mended with communication, understanding, and trust.

Transparent communication ensures everyone is on the same page and offers the client a more holistic understanding of the strategy and its risks. With this deeper understanding, the investor can move away from evaluating the fund solely based on short-term performance.

And with this greater communication and understanding comes trust. The clients can trust that the manager has their best interest at heart. And the manager can trust that the client won’t run for the hills at the first signs of underperformance. And they both can trust that their interests are aligned in the common pursuit of ‘long-term greed.’

The Fund

In technical terms, September was a mixed bag for credit markets. Canadian spreads were essentially flat with modest moves on either side of unchanged depending on issuers, ratings, and maturities. Meanwhile, US credit had a particularly strong month with spreads broadly tighter by 8 bps.

NAFTA concerns weighed on the domestic market, and new issue supply picked up relative to August as approximately $10 bn hit the primary market. New supply was weighted towards financials with the most notable (and highly anticipated) transaction being the first domestic bank “bail-in” bond. This new structure will replace legacy senior unsecured funding and applies to domestic systemically important banks (D-SIBs). RBC was the first out of the gate to issue bail-in debt bringing $2 bn to market at a spread of about 16 bps over legacy deposit notes (around the midpoint of expectations). RBC followed this up with USD 1.8 bn issued south of the border.

Other notable transactions were foreign issuers, Sysco (wholesale food distribution) and Aroundtown (German REIT), tapping the Canadian market. CIBC also launched Canada’s first Women in Leadership bond, with the proceeds of the transaction going to support companies committed to promoting gender-diversity at the executive and board level.

While the performance in domestic credit gave little to be excited about, the mixed moves did provide some trading opportunities. In particular, the fund benefited from exposure to legacy deposit notes en route to a 0.47% month. Given that Canadian bond and equity funds were down around 1% in September, we hope our bosses are happy.

Credit

As we head into the last quarter of the calendar year, the outlook for domestic credit is more positive than has been for several months. New issue supply should be manageable, and there is a significant amount of cash coming from bond maturities and coupon payments (particularly in December) to help provide extra demand. Furthermore, the resolution of NAFTA (now USMCA) will help calm some of the nerves that had been nagging the market.

Furthermore, the general environment supports risk taking.The US-China trade war is in full swing with few shots left to be fired until early next year, leaving the Brexit negotiation (or fumbling) and Italian budget process as the potential spoilers. The latter two issues are probably not significant near-term factors. Given the dissipating headwinds and slight tailwinds for corporate credit, we have taken the opportunity to selectively add exposure.

Rates

Rates continued their steady ascent as deflation continues to ebb. In recent years, the final quarter has not tended to be friendly to bondholders. It appears that trend may continue this year. The USMCA deal should seal another 25 bps rate hike by the Bank of Canada on October 24th, and increase the odds of further move in January 2019. The Federal Reserve is poised to hike in December as it continues the steady march towards neutrality.

We think that Federal Reserve Chairman Jerome Powell is going to make the US Treasury market a little more interesting by doing away with the ‘dot plot’ in the coming months. The ‘dot plot’ is essentially a poll of where Federal Reserve Governors expect the overnight rate to be over the next two years. The Federal Reserve started this process as a form of forward guidance to prevent bond traders from freaking out that quantitative easing had ended and that monetary accommodation was being withdrawn. Bank of Canada Governor Stephen Poloz did away with forward guidance early in his tenure because he said that it dampened ‘signals’ from the bond market. In other words, the Bank of Canada is very interested in understanding investor expectations on how growth and inflation are evolving. Forward guidance by central banks diminished this signal.

With the US overnight rate approaching ‘neutral,’ we think the Federal Reserve will drop forward guidance as it too will need a clear picture as to what market participants are thinking.

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