The Bank of Canada's hawkish shift
In an interview with CNBC at the end of June, Governor Poloz communicated a surprisingly hawkish tilt at the Bank of Canada (BoC). The markets, unready for this degree of hawkishness, sent yields screaming higher. By the time the BoC raised its overnight rate 25 bps only a couple weeks later, thereby unwinding half of the stimulus injected into the Canadian economy during the oil downturn, the Canadian government ten-year bond yield was up over 40 bps to 1.88%.
We were also surprised by this level of hawkishness and believed the BoC would not start raising interest rates in 2017 even if the U.S. Federal Reserve continued their hiking path. There were good reasons to keep rates on hold:
- Inflation had softened to 1.3% in May from 1.9% in the first quarter of the year.
- Western Canada was still recovering from the oil downturn.
- We felt that the lack of clarity on trade agreements and import tariffs related to the Trump agenda warranted a “wait and see” policy approach.
- While the Canadian economy was doing well, Canadian households faced a heavy debt burden that amounted to over 165% of disposable income. In the U.S., households maxed out around this level just prior to the Financial Crisis. By raising rates, the BoC would risk pressuring household balance sheets and having a dramatic impact on personal spending. Time will tell.
- The markets were in agreement with our view pricing in little or no hikes into the Canadian government yield curve at the start of the year. Thus, we saw the yield curve as fairly valued and focused less on the direction of rates (or duration) to add value. Instead we looked for alpha in other areas like foreign holdings and credit.
Finding alpha in foreign holdings and credit
The Cambridge Bond Fund generated a total return of 3.2% and outperformed the FTSE TMX Canada Universe Bond Index by 82 basis points in the first half of the year. The Cambridge Bond Fund is not available to the public but is enjoyed by investors in the Cambridge Asset Allocation Corporate Class and the Cambridge Global High Income Fund.
We drove a large part of this outperformance by overweighting foreign bonds. Our foreign holdings made up greater than 20% of the total portfolio for most the year with U.S. dollars bonds constituting the vast majority. We hedged out our U.S. dollar exposure for these investments. We took an overweight position in U.S. dollar bonds because we believed they were an attractive investment compared to Canadian dollar bonds. The U.S. Treasury yield curve was pricing in more Federal Reserve rate hikes than what we thought were likely. This meant we could purchase bonds with a higher yield and generate stronger capital appreciation should yields fall in anticipation of fewer rate hikes.
We also generated alpha through an overweight in corporate bonds and by focusing on bonds with higher relative spread. Spreads were at a reasonable level and the large demand for corporate bonds suggested spreads could compress further, which ultimately happened. Our corporate weight was as high as 50% of the portfolio and helped drive capital appreciation. We were able to selectively generate alpha in corporate bonds through our credit research and relying on Cambridge’s equity analysts who look for core companies with a sustainable competitive advantage and a strong history of capital allocation.
Scanning the market for new alpha-generating opportunities
Today, the hawkish tilt of the BoC has changed market dynamics and the opportunities to generate alpha. The U.S. Treasury yield curve is becoming less attractive than the Canadian government yield curve. As a result, we started to lower our foreign bond holdings. We have also been lowering our corporate weight and high grading the credit quality of the corporate portfolio. Spreads have compressed to fairly tight levels, making the risk/reward less compelling, especially if global central bank tightening drives credit spreads wider. Finally, we believe the market is pricing in too many rate hikes and an overly aggressive pace of tightening from the BoC. Thus, in contrast to the first half of the year, opportunities to add alpha in duration or the shape of the yield curve could potentially present themselves. In the second half of the year we hope to continue our performance by continually monitoring the market to find the best opportunities for reward while minimizing risk.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This commentary may contain forward-looking statements about the fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share or unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.