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Fixed Income Commentary: As at March 31, 2023

Source: Phil Mesman, CFA | Sam Acton, CFA
Publish Date: Apr 14, 2023
Read Time: 7 minutes
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After an extremely volatile year in 2022, fixed income markets are off to a wild start in 2023, with the first quarter seeing three distinct periods:
January – emerging disinflation and hopes for a soft landing pushed both government bond yields and credit spreads lower, which drove a powerful rally to start the year for corporate bonds.
February – stronger economic data and signs of persistent inflation forced the market to price in a higher-for-longer policy rate from the U.S. Federal Reserve (Fed), and long-duration assets gave back their January gains.
March – memories of 2008 were revived as a few U.S. regional banks failed, and regulators forced a Credit Suisse–UBS merger. The initial reaction was a flight to safety, with government bond yields dropping as the Fed cuts got priced in, and credit spreads blew out on fears of a financial crisis. As regulators attempted to stabilize the banking situation, market focus shifted back to the inflation outlook as global central banks continued hiking despite the volatility.
Recent developments in the banking sector
We believe that Silicon Valley Bank (SVB) had a flawed business model, with a concentrated deposit base and an aggressive investment strategy. It took advantage of hold-to-maturity accounting rules to avoid mark-to-market losses. Once deposits started flowing out, the business model was broken and the company was forced to realize losses on its investment portfolio, impairing its capital and triggering a loss of confidence. We expect stronger regulation for regional banks over time, which likely hurts their earning power but ultimately makes the banking sector safer for depositors.
Credit Suisse Group was a unique situation, with several high-profile losses like Archegos Capital Management and Greensill Capital in recent years due to poor risk management and governance, combined with several smaller tax, accounting and money-laundering scandals. As a result, investors lost confidence in the bank over time, and regulators were forced to clean up the weakest link in the global banking system. We believe the merger with UBS was a circuit-breaker moment that provides some stability for the sector going forward. However, we continue to monitor credit default swaps globally for signs of stress at other banks. 
We believe the Canadian banks are in a much stronger position for several reasons: less competition for deposits, more conservative regulatory environment, less reliance on hold-to-maturity accounting, lower leverage ratios and higher liquidity ratios.
Where do we see opportunities in credit markets today?
#1 We see tremendous value in short-duration, high-quality credits trading at a discount to par— specifically three- to five- year BB-BBB bonds, which are yielding 6-8% trading at $0.90-0.95. Within this basket, we are focused on defensive sectors with highly resilient business models and strong cash flow generation. Low bond prices are generally more tax efficient, as a portion of the total return comes from capital gains. These low price bonds can also benefit from the “pull-to-par” effect over time as maturity dates approach.
#2 We are also finding great opportunities in event-driven special situations. For instance, we just had a bond taken out more than 5% above its last trading price in mid-March with a merger announcement amid the market chaos. With an uncertain market backdrop, we like focusing more on idiosyncratic situations that can provide uncorrelated alpha regardless of what rates and spreads do.
#3 We see an outstanding opportunity in Canadian bank limited recourse capital note (LRCN) securities yielding 7.5-8% for BBB risk. We specifically like the higher coupon lines with back-end spreads of more than 400 basis points (bps). This space recently sold off in the aftermath of Credit Suisse (CS) contingent convertible bonds (CoCos) being written down to zero, despite CS shareholders receiving about US$3 billion in value. There are important structural differences between LRCN securities and Swiss CoCos—most importantly the clear specification that bonds rank senior to equity in the hierarchy. We like hedging our long exposure in Canadian-dollar LRCNs with short positions in Euro CoCos.
#4 Another attractive theme we have in the portfolios is low dollar-price bonds where we believe there will be a refinancing prior to maturity. Having a view on the call date can have a dramatic impact on the yield of the bond. Companies often aim to refinance bonds before they become current liabilities, typically one year prior to maturity.
#5 As the macro situation is changing rapidly, we are finding increased levels of dislocations and dispersion within credit markets. We have meaningful hedges in place to help protect against further widening in credit spreads. Our ability to go long/short and use derivatives to hedge the portfolio has added significant value over the past year, and we see it as a critical tool for navigating this complex environment going forward.

Performance table for Picton Mahoney Fortified Income Fund (Cl.F), Picton Mahoney Fortified Income Alternative Fund (Cl.F) and various indices

This material has been published by Picton Mahoney Asset Management (“PMAM”) on April 14, 2023. It is provided as a general source of information, is subject to change without notification and should not be construed as investment advice. This material should not be relied upon for any investment decision and is not a recommendation, solicitation or offering of any security in any jurisdiction. The information contained in this material has been obtained from sources believed reliable, however, the accuracy and/or completeness of the information is not guaranteed by PMAM, nor does PMAM assume any responsibility or liability whatsoever. All investments involve risk and may lose value.

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