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Bond market outlook not all bleak
1/19/2019 7:36:39 AM
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By Fund Library News Wire  | Monday, December 10, 2018


 



By Geoff Castle, Portfolio Manager, Penderfund Capital Management

In the last week of November, Federal Reserve Chairman Jerome Powell made statements that hinted at a slowing of the pace of rate hikes, an event which was cheered by equity markets. With this temporary “ceasefire” in effect, we emerge from our foxhole to survey key elements of the credit market.

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 premium.

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 looks attractive.

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 industry.

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 position weights.

Geoff Castle 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 (1996).

Notes and Disclaimer

© Copyright 2018 by PenderFund Capital Management Ltd. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

 
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