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COVID-19

Our Response

 

Updated as of September 21, 2020 

We continue to aim to strike an appropriate balance between our commitment to the health and safety of all our employees, and our obligation as a firm and individuals to continue providing essential services to our clients. To that end, and in line with Federal, Provincial, and Municipal recommendations for businesses, we have implemented a Return To Work Plan that, with appropriate and reasonable safeguards to protect them, will see employees work on site and from home on a rotational basis. We have enacted standard health and safety measures such as: avoiding non-essential travel outside of Canada, maintaining physical distancing between workstations, frequent hand washing, and wearing  a  mask whenever physical distancing is not possible. In addition to these standard health and safety measures, we have enhanced the air filtrations system in our offices by adding air purifiers and high grade filters to our HVAC system to boost the air quality throughout the building. RPIA will endeavour to update these efforts as the pandemic evolves and new expert advice becomes available.

Market Conditions & Opportunities Ahead

COVID-19 has and will continue to reshape the global economic landscape. Six months on from the liquidity crisis of March 2020, investors are faced with a difficult challenge. Equity markets have rebounded strongly and valuations sit at elevated levels by historical standards. In contrast, fixed income securities provide a very low yield, with little margin of safety if interest rates rise. A 60/40 blend of equities and bonds may not deliver the return individuals and institutions are looking for.

We believe investors should be looking to credit strategies as a way of addressing this challenge. Credit is often referred to as “equity light” – a way of generating a reasonable return without the downside risk of equity investments. The performance of credit investments has been strong since March 2020. Looking forward, we continue to be excited by the opportunity to invest in corporate bonds at attractive levels. Uncertainty in the market generally leads to volatility, which we believe represents an opportunity for actively managed credit strategies.

Please contact a member of the Client Portfolio Management team if you would like to discuss our market views or strategies in more detail.

Market Insights

Seeking Opportunity in Rising Yields

May, 2022

Since the beginning of 2021, bond holdings have posted double-digit losses and weighed down portfolio performance.1 However, as is often the case in markets, with pain comes opportunity. Despite the potential for continued short-term volatility, we believe the time to  increase bond allocations for intermediate and long-term investors is now.

Anticipated Rate Increases are Largely Priced into Higher Yields

Suggesting that fixed income looks attractive is wildly unpopular today, but it should be recognized that the market has already priced in an additional 2.25% increase in rates from the US Federal  Reserve, even after their most recent 50bps hike last week – that is equivalent to 9 quarter-point  hikes from now until May 2023.2 Under this assumption, the “terminal rate” (the rate at which  markets believe the Federal Funds Rate will peak in this hiking cycle) will approach 3.25% in the US.

It is a similar story in Canada. The overnight rate sits at 1.0% after the latest 50bps rate hike in April, while the yield on the 2-year government bond sits at approximately 2.7%.3 This means that an  investor can effectively buy bonds and “lock in” a good amount of the anticipated increases in rates  today, even though they may not fully come to fruition.

In fact, the market’s ongoing attempt to gauge the future path of interest rates has been “feast or famine.” We went from a limited number of quarter-point hikes expected at the turn of the year to  perhaps the most aggressive rate-hiking cycle in recent history. While the true path will be data-dependent,  it may be reasonable to assume that the potential upper range of hikes is priced in.  More importantly, the concept of margin of safety is reinstated at these yield levels, meaning the  greater income stream being offered can provide a cushion to total returns even if the adverse  dynamics of the current bond environment were to persist.

Active Management: Building a Base of Attractive Bonds

The Federal Reserve’s asset holdings are primarily made up of Treasuries and mortgage bonds backed by government agencies. These assets were more than doubled during the pandemic from $4.2 trillion to $8.9 trillion until March 2022, when the Fed officially stopped adding to its balance sheet.4

Just as Quantitative Easing drove interest rates down, Quantitative Tightening can be expected to put pressure on them to rise. The expectation for an increasing trajectory of interest-rate hikes alongside a contracting Fed balance sheet has been the key reason treasury yields soared in the first quarter of 2022.

If markets have underappreciated the potential impact of quantitative tightening, it could be the driver of more short-term volatility in bond markets. But again, given the anticipated terminal rate, we think there is enough cushion for investors to begin picking up bonds now, with a chance for capital gains if these measures turn out less aggressive than anticipated in the next 12 months.

Corporate Bonds Trading at Attractive Levels 

In addition to higher risk-free rates, investors can further increase their yield pick-up by taking a  modest amount of credit exposure. The investment grade bond market offers a nearly 4.4% all-in yield today, a level that has eclipsed the 20-year average yield and is approaching pandemic levels. 

IG Corporate Yields Have Eclipsed the 20-Yr Average showing US IG Corporate Yield versus the 20yr average

But this doesn’t mean that investors should blindly lock in the highest yield possible – as many of the highest yielding bonds can also come with uncompensated interest rate risk and/or credit risk.

Against this backdrop of wider spreads and the sharp sell-off in rates, the level of yield support has notably improved across a variety of fixed income markets. We believe yields at these levels can provide critical upside if the Fed decides to re-evaluate and slow down over the next 12-months or inflation begins to crest and surprise us on the way down.

Buy the Dip Mentality for Bonds  

Investors hold bonds because no other asset class has consistently done what they historically have – preserve capital if held to maturity (defaults are very rare for investment grade bonds) and generate modest returns.

The proverbial “buy the dip” methodology has worked wonders for equity investors over the past decade. We think investors can use a similar strategy with bonds at these levels to help insulate their portfolios prudently and keep them aligned with their risk profiles better than other income-oriented asset classes.5 As an aside, bonds are also beginning to look attractive relative to beloved equities.

Fixed Income is Beginning to Look Attractive Relative to Equities showing equity risk premium vs the long-term average

Active Management: Building a Base of Attractive Bonds

We believe you need to pick away in stages to take advantage of the opportunity right now. We recognize that each new data point and headline could spawn further volatility, but we are advocating  for a gradual re-entry without trying to pick the proverbial “bottom of the market.”

For example, we want to buy bonds today that will give us a predictable downside scenario over the next 2-3 years, but that has upside capital gains optionality if spreads tighten from here due to an  improving economy or avoiding a recession, idiosyncratic fundamental improvements, and/or other  technical market catalysts that offer relative value.

To illustrate, the table below shows how our strategies are taking advantage of yield opportunities in the market without taking on nearly as much interest rate risk as Canadian and US Corporate Bond  indices.

RPIA Strategies Can Provide Reasonable Yield Without Taking on Undue Interest Rate Risk showing RP AGB, RP DOF, Canada Corporate Bond Index, and US Corporate Bond Index (CAD hedged) for YTM, Interest Rate Sensitivity (yrs), and Yield to Duration ratio

Year-to-date, the market volatility has allowed us to increase all-in yields while limiting interest rate exposure and reducing credit risk metrics. For example, RP Alternative Global Bond Fund’s yield has  increased +151bps while its rate sensitivity has only increased +45bps, all while its credit leverage  has been reduced by -25%. This helps highlight how we pursue attractive risk-adjusted yields and not  focus solely on absolute yields, which can come with uncompensated amounts of risk.

Figure 4 - YTD Change in Yield, Interest Rate Sensitivity, and Leverage showing RP DOF and RP AGB for Net Credit Leverage (% change), Interest rate sensitivity (bps), and YTM (bps)

This is an exciting time for us as bond investors. The coming months should give us the opportunity to turn the page from solely a capital preservation focus to a more balanced stance as we search for compelling return opportunities for our investors.

 

 

 

 

1 As of May 6th, 2022, the Bloomberg Barclays Global Aggregate Bond Index has suffered a drawdown of -16.7% since January 2021.

2 Source: CME FedWatch Tool, CME Group Inc. (www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html). Data retrieved May 6th, 2022.

3 Source: Bank of Canada. Data retrieved May 6th, 2022. 

4 Source: Federal Reserve. Data as of May 4th, 2022. US Total Assets Held By All Federal Reserve Banks.

5 For example, cash might protect your capital, but you’ll lose purchasing power over time, thanks to inflation. Treasury Inflation-Protected Securities (TIPS) and floating-rate loans can have negative yields if deflation comes to pass over the coming year. Granted, commodities, cryptocurrency, and gold can diversify your equity holdings. Still, all of these bring new risks to the table and do not come with any guarantees or maturities backed by a business or its cash flows.


Important Information

The information herein is presented by RP Investment Advisors LP (“RPIA”) and is for informational purposes only. It does not provide financial, legal, accounting, tax, investment, or other advice and should not be acted or relied upon in that regard without seeking the appropriate professional advice. The information is drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does RPIA assume any responsibility or liability whatsoever. The information provided may be subject to change and RPIA does not undertake any obligation to communicate revisions or updates to the information presented. Unless otherwise stated, the source for all information is RPIA. The information presented does not form the basis of any offer or solicitation for the purchase or sale of securities. Products and services of RPIA are only available in jurisdictions where they may be lawfully offered and to investors who qualify under applicable regulation. “Forward-Looking” statements are based on assumptions made by RPIA regarding its opinion and investment strategies in certain market conditions and are subject to a number of mitigating factors. Economic and market conditions may change, which may materially impact actual future events and as a result RPIA’s views, the success of RPIA’s intended strategies as well as its actual course of conduct.

RP Debt Opportunities is offered pursuant to available prospectus exemptions to eligible Canadian investors through units of RP Debt Opportunities Fund Trust respectively. Investor level fund performance may differ from the strategy level performance presented. RP Alternative Global Bond Fund is a mutual fund offered pursuant to a simplified prospectus in all applicable Canadian jurisdictions and are subject to applicable securities law and regulations.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Indicated rates of return include changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Returns for time periods of more than one year are historical annual compounded total returns while returns for time periods of one year or less are cumulative figures and are not annualized. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The compound growth chart is used only to illustrate the effects of a compound growth rate and is not intended to reflect future values or returns of the Fund. Performance presented for RP Alternative Global Bond Fund is for Class F of the fund. Class F units does not include embedded sales commissions, which results in higher performance relative to Class A units of the fund. Performance data for RP Alternative Global Bond Fund is calculated in accordance with NI 81-102.

The index performance comparisons presented are intended to illustrate the historical performance of the indicated strategies compared with that of the specified market index over the indicated period. The comparison is for illustrative purposes only and does not imply future performance. There are various differences between an index and an investment strategy or fund that could affect the performance and risk characteristics of each. Market indices are not directly investable and index performance does not account for fees, expense and taxes that might be applicable to an investment strategy or fund.

 

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