After a crushing first half of 2022, the bond market rallied this summer as investors observed early signs of inflation peaking and became hopeful for a U.S. Federal Reserve (Fed) Policy pause. The reprieve was short-lived as the Fed reinforced their hawkish stance and their commitment to do whatever it takes to bring inflation down.
While the gap between interest rates and inflation remains wide, the question is whether inflation will fall soon enough to allow the Fed and other central banks to back off their aggressive tightening posture before the economy is seriously affected. In addition to tighter monetary policy, there are several significant geopolitical risks to consider including China, Eurozone, and Ukraine/Russia.
What does all this mean for the global economy? And more importantly, what should investors do with fixed income allocations right now amidst the uncertainties? In this note, we provide a business case as to why our hedged long-short credit strategy has the potential to generate attractive risk-adjusted returns in this environment, and why investors should consider an allocation today.
Year-To-Date Fixed Income Recap
Year-to-date, our long-short income funds have held up well against broad fixed income markets. Defensive positioning, single-name shorting, and portfolio hedging all contributed to protecting the portfolio on the downside. Coming into the summer, we started taking advantage of market dislocations and put money to work by increasing portfolio yields across the strategies (as seen in Exhibit 2), thereby boosting investors’ total return potential going forward.
Current Market Setup
Historical data suggests a strong relationship between starting credit yield and subsequent total return. As shown in Exhibit 3, when the starting yields on the ICE BofA Global High Yield Index were between 8% and 10%, 94% of the time the subsequent 2-year return was positive. With the remaining 6% of the time being minor losses of -1% to -2%. While history may not repeat itself, we believe the attractive yield in credit markets today provides a strong cushion for investors going forward.
That being said, despite the attractive return potential in the medium term, uncertainties around monetary policy, geopolitics, and an economic slowdown remain high in the near term. Therefore, a hedged long-short strategy may be a better choice as it allows investors to get invested, while taking the edge off by dampening potential volatility.
Our strategies aim to hedge four key risks of fixed income: Interest Rate Risk, Credit Spread Risk, Currency Risk, and Liquidity Risk.
We use various hedging tools including single name bond shorts, index/ETF shorts, put options on credit and rates, and other derivatives including FX forwards, CDS/CDX, and swaptions. These hedging strategies have contributed significantly to our performance YTD and we believe hedging is critical to success in today’s uncertain fixed income market.
Case for a Long-Short Approach
As we often say, volatility shakes good bonds out of weak hands and we want those bonds. Given the Over-The-Counter nature of the market, investors generally benefit from being contrarian: buying as others are selling. A par guarantee (and corresponding pull-to-par), positive coupon carry, as well as maintaining shorts and hedges all provide additional comfort as we put capital to work at these higher yields.
A long-short approach also enables our investors to capitalize on the potential market dispersion across geographies, sectors, and individual securities. Exhibit 4 shows the dispersion in the broad credit market, which tends to spike during times of uncertainty – scenarios that tend to impact lower-quality corporations more negatively. In this regard, resilient process and credit-picking matters. As a result, the role of our fixed income team is to take a bottom-up approach, and forensically read financials and covenants to sniff out or short potential troubled firms that could get into distressed situations.
Portfolio Positioning
In terms of portfolio positioning, we continue to focus our buying on high-quality (BB and BBB rated) short-duration (3 to 5 years) corporate bonds yielding 6 to 8% which we believe represent outstanding risk/reward — attractive yields with capital gains potential, given many of these bonds are trading below par.
The Parkland Corp 3.875% 2026 is a good example of this type of opportunity. As illustrated in Exhibit 5, purchasing the bonds at $91.875 provides a yield of 6.3%. Further, from a downside protection perspective, the total return on the security would be positive even if yields were to increase by 250 bps in a severe risk-off scenario over the next 12 months. In other words, the potential return distribution is significantly skewed positively given the pull-to-par dynamics, short duration, and high starting yield of the bond.
Bottom Line
In the current environment, it is impossible to know how far the Fed will push on policy, how inflation will evolve, and how much damage will be done to the economy. Allocating in fixed income is a tough question to answer. Given the yield opportunity coupled with our demonstrated downside mitigation, resilient process, and long-short flexibility, we see our alternative income strategies as part of the solution. Let us know how we can help.
Appendix
This material has been published by Picton Mahoney Asset Management (“PMAM”) on September 9, 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 confidential and is intended for use by accredited investors or permitted clients in Canada only. Any review, re-transmission, dissemination or other use of this information by persons or entities other than the intended recipient is prohibited.
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.
All projections provided are estimates and are in Canadian dollar terms, unless otherwise specified, and are based on data as of the dates indicated.
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.
The offering of units of the Picton Mahoney Authentic Hedge® funds are made pursuant to an Offering Memorandum only to those investors in jurisdictions of Canada who meet certain eligibility or minimum purchase requirements. Prospective investors should consult with their investment advisor to determine suitability of investment. Please see the fund’s Confidential Offering Memorandum for more information, including investment objectives and strategies, risk factors and investor eligibility. Past performance is no guarantee of future performance. Class F performance for the fund(s) shown is net of management fees, performance fees, transaction costs and expenses.
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