Starting with credit spreads, we note that both the investment-grade
corporate bond spread (recently +148 basis points over U.S. Treasuries) and
the high yield bond spread (recently +433 basis points over U.S.
Treasuries) have widened significantly from their recent multi-year lows.
The premium paid to high yield investors to compensate for the risk of
default is now the highest it has been since 2016. Other areas we follow,
including bank loans, preferred shares, convertibles and credit oriented
closed-end funds, all show a similarly striking increase in the risk
With the widening of spreads, sentiment in corporate credit has swung from
general happiness to dark negativity. Bids are harder to find. One of the
market’s largest dealers is currently circulating a short-selling basket
idea loaded with high-leverage BBB credits it sees as potential downgrade
candidates. These are no joyous times.
Grim Reaper or Goldilocks? Finding opportunity in moderation
We feel no obligation to act as a public relations outfit on the part of
capital markets. However, having been through a few cycles, we recall that
there are usually silver linings in even the darkest cloud-filled skies.
Against widespread expectations of a Grim Reaper arriving to lay waste
indiscriminately across credit portfolios, we do consider areas that may
benefit from slower American growth.
To begin, we believe the risk-free rate looks attractive for a change. Thus
we view AAA sovereign obligations of the U.S. and Canada, of limited
duration, as offering some of the highest probabilities of profit in the
year that starts today. AAA strength may result from a softer economic
outlook which includes credit problems for some companies struggling to
refinance maturing debt. With TIPS markets pointing to falling inflation
and with some dislocation in corporate credit, a year with at least stable
pricing for government bonds seems to be a reasonable bet. We have no
heroic assumptions about the level of return from AAA, but we do
view this area constructively.
Taking a step forward into moderate risk, we still observe the closed-end
funds that track the U.S. Municipal bond market trading at discounts of
15%-17% from daily struck-NAV. We believe that U.S. states are, as a group,
relatively low risk credits. Sticking with the better “AA” credit states,
we see 4%-5% portfolio yields in closed-end municipal funds trading at over
15% discounts. This applies to national funds and also funds focused on
very solid credits such as New York, Pennsylvania, Maryland, and
California. Closing these NAV discounts even halfway to average over the
coming year could provide more than 10% total return to holders. This risk
Taking yet another step forward along the risk spectrum, we view with some
excitement the depressed state of securities prices in the area of U.S.
residential real estate. We think the fundamentals of U.S. housing, given a
moderated interest rate environment, are at least OK, and possibly very
good. Good consumer debt service ratios on the part of Americans, a degree
of pent-up demand in terms of household formation levels, decent asset
valuations, and a relatively strong current employment situation all
support a stronger U.S. housing market. Even in a slowdown scenario, we
expect U.S. housing to be resilient. We note that recently Berkshire
Hathaway Inc., a capital allocator with above-average insight
in our estimation, has increased its investments in the home-building
The Goldilocks scenario (an inflation outlook that is cooler, but not cold
enough to turn into a deflationary spiral) could reverse trends in some
beaten-up areas thR may turn into 2019 winners. We are paying careful
attention to U.S. dollar credit of a number of emerging market issuers, as
well as the credit of non-oil commodity producers and related shipping
companies. If higher U.S. dollar rates have hurt this part of the market,
could lower rates help spur a revival? We have small toe-holds in these
areas, waiting for confirmation of more robust fundamentals to expand
is the Portfolio Manager of the
Pender Corporate Bond Fund. He began his investing career in 2000 and has experience in both
public mutual funds and proprietary investment fund management for
ultra-high net worth individuals. In addition, Mr. Castle’s background
includes more than five years of industry experience in trade credit
and general corporate management. Mr. Castle holds a Bachelor of Arts
degree from UBC (1989) and a Master of Business Administration from the
Richard Ivey School of Business at the University of Western Ontario
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