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From the Bond Desk: Breaking Down Bonds

Source: Phil Mesman, CFA | Sam Acton, CFA
Publish Date: Jun 3, 2022
Read Time: 8 minutes
an image of desktops, laptops, notebooks, graphs, and tables with working hands for Picton Mahoney's From The Bond Desk Insights article June 2022

As we all know, it’s been a tough year for bonds and the market is still struggling to find its bearings as the U.S. Federal Reserve, economic indicators, and financial conditions create uncertainty for investors. So many questions! But perhaps the most important question of all is what should investors do with fixed income allocations right now amidst the uncertainties.

First things first - we’d recommend investors to Debrief, Zero-Base, and Rebalance.
Debrief: Stepping back to review what transpired is a critical part of our process. It involves assessing your investment performance, identifying where there is correlation overlap, and evaluating both your single name and allocation choices.
Zero-Base: Creating your ideal portfolio from scratch, what would you buy if you have $100 to invest in bonds today?
Rebalance: Pulling it together, with an understanding of your positioning, correlations amongst them and your desired portfolio, now double back and rebalance. “You don’t need to earn it back the same way you lost it” is a common principle that Phil Mesman talks about.
With those in mind, here are two high level principles that investors should be aware of:
  • Diversification: We like the idea of combining a few strategies that do different things. Simply put, strategies that are uncorrelated and have different return drivers. Be careful with duplicating allocations.
  • Process is essential: Get under and understand the process of your managers . Be forensic, how are they going to make you money? How have they done in prior sell-offs and recoveries? Process is the composition.

Thoughts on Fixed Income Allocations:
  • Government Bonds/Duration: Investors have been programmed for decades to expect low and declining yields. We’d encourage a paradigm shift in thinking about that—lower yields are less likely going forward given a normalization of central bank policy globally. Stepping back, one generally buys government bonds for income, capital preservation, and downside protection against one’s equity book. However this traditional correlation benefit should not be presumed going forward as the global central bank tightens and monetary policies normalize, which can make this allocation even more unattractive when looking at yield versus volatility 

  • Cash replacements: The idea of parking part of your income allocation in money markets / GICs / high interest savings is appealing. It provides income and capital preservation goals without taking on duration uncertainty. Yields are generally higher and it can also afford dry-powder that you can put to work as clarity emerges.

  • Corporate Bonds: We are now seeing some very compelling opportunities in short duration BB and BBB credit after the rise in yields and the widening in spreads. While there may be room for spreads to widen further given the risks we discussed, we are becoming much more excited by the risk/reward profile in certain parts of the credit market. However, divergence is emerging and companies that miss earnings are being penalized to a greater extent, leading to larger dispersions in the credit space. Therefore, allocator due diligence is very critical here—understand your managers’ process for navigating this divergence. In pragmatic conceptual ranking, we prefer long/short over long-only and active over passive in these market conditions.
Value Proposition in our Income Strategies: Our alternative income strategies can provide diversification benefits by increasing total return potential while providing downside hedging and potential shortside alpha.
Downside mitigation: Year-to-date, our income funds have held up well against the broad fixed income market (represented by the indices being compared) as shown in the chart below. Defensive positioning, single-name shorting, and portfolio hedging all contributed to the strong outperformance.

Year to date performance chart for Picton Mahoney Fortified Income Alternative Fund (Cl.F), Picton Mahoney Fortified Income Fund (Cl.F), and  various indices

Increased Total Return Potential: Taking advantage of the sell-off, we’ve started to put money to work and have increased the portfolio yield across the strategies, boosting our investors’ total return potential going forward. That said, with all the uncertainties, we remain cautiously positioned with hedges in place.

Corporate Bond Yield graph from Bloomberg L.P.

Picton Mahoney Fortified Income Alternative Fund (Cl.F) and Picton Mahoney Fortified Income Fund (Cl.F) yield and duration table from Dec.31 2021 to May 31, 2022

Long/Short Flexibility: Our resilient process and the ability to go long and short allow investors to get in the market while taking the edge off. From an asset allocator’s perspective, it makes sense to hold cash or money market alternatives in these uncertain times (as we said). But the issue with that is the opportunity cost of giving up total return potential. Layering in our long/short income strategies can increase an allocator's overall portfolio yield while remaining defensive. 
In the current environment, it is impossible to know how far the Fed will push on policy, how inflation will evolve, and if the economy will be able to avoid a recession.  Allocating in fixed income is a tough question to answer. Given the yield opportunity coupled with our demonstrated downside protection, resilient process, and long/short flexibility, we see our alternative income strategies as part of the solution. Let us know how we can help.

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

Please join your bond desk for the next Picton Live: Breaking Down Bonds for a market discussion.

Wednesday, July 20, 2022

2:00pm ET

This material has been published by Picton Mahoney Asset Management (“PMAM”) on June 3, 2022. 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. This information is not intended to provide financial, investment, tax, legal or accounting advice specific to any person, and should not be relied upon in that regard.  Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional.

This material is intended for use by accredited investors or permitted clients in Canada only.  

This material contains “forward-looking information” that is not purely historical in nature.  These forward-looking statements are based upon the reasonable beliefs, expectations, estimates and projections of PMAM as of the date they are made.  PMAM assumes no duty, and does not undertake, to update any forward-looking statement.  Forward-looking statements are not guarantees of future performance, are subject to numerous assumptions, and involve inherent risks and uncertainties about general economic factors which change over time. There is no guarantee that any forward-looking statements will come to pass. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made.   

There is no guarantee that a hedging strategy will be effective or achieve its intended effect. The use of derivatives or short selling carries several risks which may restrict a strategy in realizing its profits, limiting its losses, or, which cause a strategy to realize or magnify losses.  There may be additional costs and expenses associated with the use of derivatives and short selling in a hedging strategy.

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