Amplus Credit Income Fund Marks 3rd Anniversary: A Tale of Unique Performance & Systematic Hedging Strategies
July 19, 2023|Commentary
By:Andrew LabbadSenior Portfolio Manager
Amplus Credit Income Fund has produced cumulative returns since inception of +49.04%, showcasing its unique approach that allowed it to outperform during volatile times. The current market environment is marked by a strong focus on Artificial Intelligence (AI) and overall positive returns in financial markets, but with concerns about complacency and potential risks. The Q2 2023 performance saw gains attributed to credit spreads tightening and strategic decisions. However, concerns remain about the deeply inverted yield curve, rising interest rates, and economic indicators showing signs of slowing. The fund believes that owning fixed income securities offers an attractive opportunity set and prefers higher quality and more liquid investments in specific sectors.
“During the Gold Rush, most would-be miners lost money, but people who sold them picks shovels, tents and blue-jeans made a nice profit” – Peter Lynch
GROWTH OF $100,000
As we mark our 3rd anniversary for the fund, Amplus Credit Income Fund (ACIF) produced cumulative inception returns of +49.04% after cost to investors. We are pleased with these results and thankful to our investors and partners for their continued trust and confidence in us. While we appreciate a truly exceptional three years of steady positive returns, we are increasingly pleased that our unique approach allowed us to outperform. 2022 showcased how resilient the strategy was in the face of increased volatility. Despite many reasons to be celebrating, we continue to remain focused on the present-day investment climate and our goal in growing your wealth while protecting it from market risk.
We want to also take this opportunity to reintroduce Michael Douramakos to Wealhouse’s clients. Michael joins us having spent several years at a leading Toronto-based hedge fund, bringing with him an expertise in funding and U.S. credit. Having worked alongside Michael for the past month, I am already impressed by his breadth of credit knowledge and strong U.S. dealer relationships. His addition increases our investment universe, which helps us remain liquid and nimble, while Amplus continues to grow its asset base.
Current Market Environment
So far in 2023, Artificial Intelligence (AI) has taken center stage. Financial markets have responded with strong overall returns despite continued underlying risks surrounding the global economy. Fear and Greed indicators are currently displaying ‘extreme greed’ vs ‘fear’ from one year ago. With all the hype surrounding AI, we decided to ask ChatGPT for a real-life sports analogy dealing with complacency and greed. ChatGPT’s response relives a heavyweight boxing match between Mike Tyson and Buster Douglas on February 11, 1990. During that time, Mike Tyson was known for his ferocious punching power and dominant performances. He entered the fight as the undefeated reigning heavyweight champion. Buster Douglas, on the other hand, was considered a significant underdog and had little chance of winning. Leading up to the match, Tyson’s camp showed a lack of preparation and failed to take Douglas seriously as a challenger. When the fight finally took place, Tyson appeared uncharacteristically sluggish and lacked the sharpness that had differentiated his previous matches. Meanwhile, Douglas, motivated by his mother’s recent passing and fueled by the underdog status, fought with determination. The result: Douglas dominated the fight and delivered a powerful knockout punch to Tyson in the 10th round, securing a monumental upset victory. This bout highlights the damaging effects of complacency and serves as a reminder that underestimating opponents and failing to maintain focus and preparation can lead to unexpected defeats, regardless of previous success or reputation. Similarly, complacency in financial markets can have severe consequences regardless of previous market gains. When investors become complacent, they may neglect thorough analysis, fail to adapt to changing market conditions, and underestimate potential risks. Staying vigilant, disciplined, and adaptive are crucial to achieving sustained success and avoiding unexpected setbacks. While AI is far from perfect, we can appreciate the very quick and accurate response given.
The first half of 2023 saw the S&P up 16%, Nasdaq up 38%. Meanwhile, public credit markets have a much smaller weight towards tech, with Canada having virtually zero exposure. When excluding the tech bubble and pandemic-induced rally, current P/E at 21x for the S&P is highest level in 50 years. This mean a lot of good news may already be priced into the market. With recent Fed talk affirming interest rates being higher for longer, inflation still above 3%, elevated geopolitical risks, increasing commercial real-estate defaults, and upcoming regional bank earnings, we see a lot of merit in adding to our overall hedges against market risk. We do believe the market has become complacent and greedy with participants abruptly changing views, chasing momentum and trends while ignoring continued risks facing the economy.
We view the most startling dislocation for Q2 2023 occurred between the relationship of long-duration equities (tech) and interest rates. Since 2021, as interest rates went higher, NDX went lower. Even when the regional banking crisis began in March 2023, market participants quickly started pricing in rate cuts, a pivot by central banks and ultimately a lower terminal rate. Long duration assets such as long-dated debt and tech-focused equities rallied.
Since then, terminal rate expectations have retraced their move back higher reaching new highs, with an additional 1-2 hikes being priced for 2023. Treasury markets have given back all their gains. Shockingly, long-duration equities such as tech and growth stocks broke higher, separating themselves from U.S. interest rates. The AI frenzy is one of the main reasons for this.
NASDAQ VS THE NEGATIVE MOVE IN 10YR U.S. RATES
We do believe that this relationship should revert and normalize over time. As we wait, Canadian corporate bonds and fixed income markets are yielding more than the average earnings yield of the S&P 500 for the first time in over 20 years.
S&P EARNINGS YIELD VS CANADIAN CORPORATE BOND YIELDS
In Q2 2023, Amplus saw gains of +2.25%, with year-to-date gains at +5.82%. Meanwhile, interest rates continued to put pressure on bonds, with fixed income benchmarks on average flat to down -1%. Both Canadian and U.S. corporate spreads were about 15bps tighter.
The fund performance in Q2 can be attributed to the following:
With credit spreads tightening, the strategy saw natural gains from being long risk, notably in financials.
The portfolio was yielding 8.5-9% on average throughout Q2, accruing positive interest during that time.
In the first week of April, Ventas Inc chose to refinance early some of their existing debt maturing in the next 18 months. They tendered for their shortest maturities at healthy premiums compared to current market levels. We benefited from this by owning some of the 2024 bonds outstanding.
We continue to have no direct exposure to office real-estate which remains under pressure, as many related credits have seen their downgrades by rating agencies.
We slowly started unwinding more interest rate hedges and increasing our outright long rates exposure throughout the quarter. This weighed on performance, but we are excited about the risk-reward of being outright long bonds, as a natural premium-free hedge against a large risk-off event.
Our tail-risk hedging program saw a drag of about 0.4% on performance, with market volatility subdued and risk going one-way higher.
Go Forward Outlook
Having now worked for over three years with some of the smartest risk managers, I have seen firsthand the benefits of a systematic approach to portfolio hedging. My colleague and Senior Portfolio Manager of Lions Bay, Justin Anis, summarised our system very well in his Q3 2021 commentary. He used an analogy that is very topical right now: Wildfires.
“Regardless of our market view, we will almost always have some protection in the portfolio in the form of put options on equity indexes such as the S&P 500 and the Nasdaq. This is the systematic portion of our risk management, and its function is to protect our investors from unforeseen market risks and black-swan type tail-risk events. […] We believe that the phenomenon of forest fires is analogous to the way we think about risk management. […] As long periods pass without fires, excess dry brush and dead vegetation build up, leading to more catastrophic fires in the future. The same dynamic plays out in volatility markets. As markets continue to march higher in an orderly fashion, investors get more comfortable with risk, financial leverage increases and complacency sets in, setting the stage for more catastrophic sell offs in the future. As this happens, the price of volatility declines, meaning it is increasingly cheaper to hedge a portfolio against declines while the potential hedging gains and have only increased in magnitude and probability. Put simply, investors think that because there hasn’t been a fire recently, the likelihood of a fire in the future has decreased. The reality of course is just the opposite, and it is this inefficiency that we seek to capture by opportunistic hedging.”
Fast forward to the end of Q2 2023, as the portfolio continues to yield 8.5-9% invested in high quality, short-dated senior debt, we see this as a great time to hedge our portfolio and ensure preservation of capital due to unforeseen market risks. We believe that a high degree of volatility and uncertainty is not currently being properly priced by risk assets as many unknowns highlighted below remain. As we plan accordingly, we are thankful in having access to cheap options. With risk markets trading close 52-week highs and volatility indices hovering levels last seen in December 2019, these options and hedging tools have high-return potential.
This is uncharted territory for many, and there is strong reason to believe unforeseen surprises such as SVB’s collapse are possible in the near future. Below, we share some of our concerns.
The deeply inverted yield curve is the most negative in close to 30 years. Inverted yield curves are a good predictor of future recessions: with the global financial crisis and the pandemic both seeing a brief inversion in curve right before a recession ensued.
YIELD DIFFERENCE BTWEEN 2YR & 10 YR TERMS
Both Fed Funds and BoC overnight rates at over 5% with a strong possibility of additional hikes in 2023. Seeing the fastest move higher in rates in over 30 years.
Global Central bank balance sheets priced in USD continue to grind lower by over 4.5T from all-time highs. This has a direct impact on bank lending conditions which is a central part of economic growth.
GLOBAL CENTRAL BANK BALANCE SHEETS IN USD
M2 contraction: surprisingly negative for the first time in over 60 years, following the largest growth in supply.
M2 SUPPLY YEAR OVER YEAR CHANGE
Leading economic indicators show a slowing economy. Household real net worth is lower, excess savings are being depleted, tightening lending standards will add pressure to consumer spending.
Soft Landings Are Preceded By Easy Lending Standards, Hard Landings By Tight Lending Standards
U.S. Personal Savings (Cumulative) – Apr 2023: $0.54 T vs Pre-COVID Trend
U.S. Net Worth by Income Quintile 80% – 99%
U.S. Bank Willingness to Make Consumer Loans Net % of Banks Easing
U.S. Nominal Consumer Spending
With interest rates having risen sharply over the last year, fixed income securities are yielding more than the earnings yield of the S&P 500. The opportunity set of owning fixed income continues to be the most attractive it’s been in over a decade. The inversion of the yield curve continues to benefit owners of short-dated debt. Carry strategies such as Amplus are designed to thrive in this type of environment. Being long short-dated high-quality credits, yielding close to 9% should provide a high margin of safety for investors. With vol so low, we can increase our tail-risk hedges on the cheap and protect investors from potential risks that lay ahead as we navigate uncharted territories.
As we remain optimistic about credit, our preference is to own higher quality and more liquid names. We view energy, infrastructure, telecom, senior bank and GIC insurance debt as favourable investments.
Amplus, an innovative and flexible fixed-income strategy, is the place to be during good times and bad. It aims to protect investors during a downturn and maximize returns in a rising market. We invest in high-quality companies that are raising debt to invest in the growth of their businesses. We support their mission by purchasing bonds, preferred shares, and convertible notes, increasing our investment when the time is right. A small and agile fund combined with active trading, we can take full advantage of market volatility. Because Wealhouse’s goal is to make as much money for our investors as possible, we do not have layers of bureaucracy that hinder time-sensitive trades. During a sell-off, we can buy quickly. And during a market rally, we can sell just as fast.