We believe it is the right time for investors who are underweight in a core bond position to increase their allocation and take advantage of this opportunity with RP Strategic Income Plus Fund (“RP STIP”).
Following the softening in policy stance from the Bank of Canada, domestic bond yields have moved lower in recent weeks, and we see signs of potential stabilization at home. South of the border, the US market raised its overnight rate by 75pbs on November 2nd and has now priced in another 125bps of rate hikes by early 2023, increasing the expected terminal rate to over 5.25%.
We believe interest rates are now sufficiently restrictive to slow the economy and the income opportunity is very compelling while providing significant safety for investors today.
It is impossible to conclude that we are at the proverbial “bottom” as short-term risks and inflation continue to remain elevated, but we believe the potential upside far outweighs the downside at this point, and investors who do not get back in now may regret doing so.
That said, we do not think investors should be extending duration risk blindly using a passive allocation. Instead, we believe that investors can use a highly active approach to capture these extraordinarily attractive all-in yields without taking undue risks.
Positioning RP STIP for an Optimal Offense Moving Forward
The recent dislocations in credit spreads across the investment grade universe, and the continued volatility in rates has allowed us to put our offense back onto the field. But this doesn’t mean we are blindly buying the highest-yielding bonds. Instead, we are aiming to optimize our portfolios and capture higher yields per unit of risk while taking advantage of what we view as the subtle mispricings in the market.
The table below illustrates what this looks like versus the broader bond universe:
RP STIP currently provides a higher yield relative to the interest rate risk (duration) it assumes, compared to the Canadian and Global Investment Grade Universes. In other words, we are taking advantage of all-in yields available today without sacrificing much in the way of credit quality or taking undue interest rate risk.
We believe that this sets up the fund to provide a more asymmetric return profile, irrespective of where we might be in the tightening cycle. Moreover, these attributes are seen as contributing to increased investor confidence to come back into the bond market and capture what we believe is a noticeable upside of bond yields reverting to lower averages in the coming 12 months if inflation slows or central bank policy starts to come off its aggressively hawkish stance.
Forward Outcomes are Skewed to the Upside
Our long-short credit strategies can hedge and mitigate sharp moves from broad changes in rates and credit spreads, which has been the downfall of most traditional bond strategies during this period. Simultaneously, our highly active nature allows us
to be tactical and gain returns from the opportunities we see in credit markets. We believe that these strategies can deliver diversification and positive returns to investors in this challenging environment. Please do not hesitate to get in touch
with our team if you want to discuss how long-short credit strategies could benefit your portfolio.
In our base case analysis, we view investment grade bond yields as largely being range-bound for the next 2-3 quarters and representing excellent value at current levels. Let’s look at a few simple scenarios to illustrate why this is the case:
- Rates Stabilize
The yield to maturity of a fixed income portfolio could provide a return more attractive than GICs/cash deposits while allowing for additional return opportunities from credit selection.
- Rates Fall If yields move lower as the chance of recession risk increases or it materializes and causes an easing in hawkish language from central banks, a fund could rally notably. In such a scenario, the combination of coupons and lower market yields could lead to capital gains and approach double-digit returns over the next 12 months, depending, of course, on the path of credit spreads.
- Rates Rise
A further rise in rates would be less ideal, but our belief is that current yields are high enough to provide a substantial cushion for investors. For example, a current 2-year investment grade portfolio that yields 6% per year, or 0.5% per month, would need to see a combination of bond yields and credit spreads rise by over 3% before it endures a loss over the next 12 months. We think that scenario is unlikely at this point in the cycle.
This Same Flexibility Can Enable Us to Protect Capital
Our highly active investment team has the tools necessary to effectively implement high conviction views agnostic of any benchmark.
Year-to-date, we have taken a commonsense approach to reduce risk and conservatively positioned ourselves to protect capital.
First, we reduced our interest rate exposure across the portfolio and accepted a lower yield and fewer return opportunities. This turned out to be very prudent and allowed us to protect against higher bond yields that caused lower bond prices.
Second, we conservatively managed credit risk within the portfolio and elected to grind out incremental returns through active credit selection and relative value opportunities. This allowed us to be less correlated to broad credit markets and helped protect capital when credit spreads widened.
The ability to manage rate risk and credit risk separately allowed us to outperform broad Canadian bonds by +6.1% and global investment grade bonds by +10.9% YTD (net of fees).
We believe investors who have been sitting on the sidelines or are underweight a core bond position could benefit significantly from increasing their allocation at this point in the tightening cycle.
RP STIP is a highly active strategy that invests in developed market investment grade credit, and we believe it can take advantage of the recent market volatility to capture attractive all-in yields and provide compelling returns moving forward.
