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RP Investment Advisors – Active Management in Fixed Income & Home Capital Group

RP Investment Advisors – Q2 2017 Newsletter

Case for Active Management of Fixed Income Intact with Interest Rate Volatility

  • Q2 saw interest rates move higher in Eurozone, US and Canada as market participants continued to hear from central bankers that monetary stimulus will need to be withdrawn soon
  • Fact that inflation data in the G7 continues to come in below target suggests that economic data is not the sole determinant of policy at this point
  • June was a challenging month for many funds with interest rate risk – FTSE DEX Mid-Term Bond Index lost 2.27% during June
  • Continue to position the non-levered funds conservatively with a duration around 2 years, while the long-short funds have negligible exposure to interest rate risk given their focus on credit
  • Recent softness in global inflation could prove to be transitory but volatility in interest rate levels will continue to create opportunities that play into the hands of active managers
  • Positive returns are achievable by actively extracting value from less efficient credit markets and are managing interest rate risk

Difficulties at Home Capital Group (“HCG”) A Function of Corporate Governance Issues

  • Does not have exposure to HCG but feel it would be remiss not to provide our view on developments at the alternative mortgage lender
  • In April of this year, regulators accused the company of misleading disclosure pertaining to alleged fraud in 2014
  • Following this announcement there was a sharp decline in the firm’s share price and the rapid depletion of company’s broker deposits
  • These developments raised existential issues for HCG and the commensurate increase in funding costs brought into question the sustainability of profits for competitors in the non-traditional mortgage segment
  • Major Canadian banks aren’t very active in the subprime space – share of low quality mortgages as a proportion of the mortgage book ranges from 5-11% for the Big 6
  • Analyzing the Banks’ balance sheets shows that while earnings are sensitive to these stresses, it would take a considerable shock to the system to see a bank lose a Quarter’s worth of net income
  • The situation has once again illustrated the importance of strong corporate governance
  • It was possible to make the argument that there was value in the HCG bonds when they dropped 10 points in April of this year but the downside risk tied to the name was inconsistent with the focus on capital preservation that our investors have come to expect
  • In any case, the “bailout” by Berkshire Hathaway announced in June has taken the story off the front page for the time being at least

May Highlighted the Value of Being Flexible Across Global Credit Markets

  • Month of May in Canada saw record-breaking issuance with approximately C$17 Bn of primary supply coming to market against a risk-averse backdrop given the drama unfolding at HCG
  • Supply was a combination of domestic issuers refinancing maturities and foreign borrowers issuing maple deals
  • Credit spreads in Canada widened quite dramatically versus other markets, finishing anywhere from 10-20 bps wider m-o-m, depending on the sector
    • In percentage terms, for a 5yr security this underperformance would be a drop in price of approximately 0.5% to 1%

Don’t Be Fooled – Lurking in the Background are Many Risks for Fixed Income Investors

  • At present time, we’re mindful that by most traditional measures, all risk assets look expensive and also at an unprecedented point in monetary policy history – late cycle after unprecedented amounts of stimulus and liquidity have been injected into financial markets globally
    • Typically, orderly increase in rates leads to credit spread compression
  • Concern this time is that spreads have consistently narrowed for so long that it’s questionable whether there is much buffer left
  • Also, there have been unprecedented inflows into the fixed income asset class
  • Big question now is how investors will react to the capital losses that will likely come to pass as rates start to rise and what this means for asset flows
  • In the short term knee-jerk behavior from these investors could be very destabilizing and several regulators have expressed concern around the systemic risks that are posed by the explosive growth of the fixed income ETF product

A Disruption of the Flow of Foreign Capital into N.A. Credit Could Mark an Inflection Point

  • On top of domestic inflows into credit, over recent years yield-sensitive foreign investors have increasingly been sizeable net buyers of USD-denominated credit
    • Bulk of this flow has come from jurisdictions with ultra-low interest rates like Eurozone and Japan
    • Does this flow cease or reverse as central banks globally start tighten monetary policy?
  • While a look at stock market and credit returns might suggest the environment is benign for fixed income investments, in the background are some large risks
    • For this reason, positioning is on the conservative side with duration around 2yrs for the long-only funds and low margin utilization for the long-short funds with a bias towards short-dated securities
  • While overall valuations look rich and its incredibly hard to identify value, ability to invest globally continues to be a key competitive advantage

Image Source: University of Toronto Asset Management Corporation

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