With the recent pull back in January, credit spread dispersion between sectors remains the lowest it has been in over seven years. Weaker credits have not moved any wider versus higher quality names. With this comes opportunity. Senior Portfolio Manager, Andrew James Labbad, discusses why Wealhouse is becoming increasingly bullish on credit.
“By failing to prepare, you are preparing to fail” – Benjamin Franklin
Over the past year, we wrote about Amplus Credit Income Fund’s flexibility and having the use of many tools at its disposal to protect investor capital in any market environment. We stressed our priority to new and existing investors of outperforming in volatile markets, with the goal of preserving their hard-earned wealth. As credit spreads and overall valuations were getting stretched, we spent the last three months adjusting our portfolio into higher quality and more liquid securities, all the while reducing overall risk. To ensure limited downside in the event of a market pullback, we added insurance-like contracts as hedges.
Increased geopolitical risks, elevated inflation, hawkish Fed comments and new Covid variants were the quad-fecta that finally broke the markets – by January 24th, the S&P 500 had dropped -11% for the year. This would represent the worst start for the S&P in over 90 years, eventually closing down -5.26% on the month. Fixed income did not fare much better, as higher inflation forced the Fed to finally deliver a less market-friendly tone. A faster hiking cycle got repriced into the bond market, forcing yields to rise as forecasts for 2022 total Fed hikes increased from three to as many as seven. Fixed income indices closed on average down -2% to -3%.
Amplus Credit Income Fund finished -0.07% in January after costs. Canadian credit spreads were 10bps wider on the month, marking the widest index spread levels since November 2020. Supply was front-loaded with multiple banks issuing debt before market volatility caused primary markets to slow. As new issue concessions became larger, existing debt was being repriced cheaper.
We remained disciplined throughout the month, finding profit-taking opportunities to shore up for the purchases we made. Our overall risk for January ended roughly at the same levels as it started. As the momentum of spread widening continued, we felt that the path of least resistance would remain wider. With many credits moving in lockstep, we saw it as an opportunity to add exposure to energy names on weakness. WTI has been one of the bright spots so far in 2022, as inflation and lack of supply have pushed oil prices to multi-year highs. We took comfort in buying one of our go-to credits at a discount. North West Redwater (NWR), a joint-venture between Canadian Natural Resources (CNQ) and the Province of Alberta, saw its debt trade lower, despite cheap valuations for its 3-5yr bonds when compared to CNQ and Alberta debt. As oil prices continue to rise, we see NWR as a top upgrade candidate from a BBB-rated credit to an A-rated. When that happens, we expect NWR spreads to compress and trade closer to utility-like names.
GO FORWARD OUTLOOK
With the correction in January, credit spread dispersion between sectors remains the lowest it has been in over seven years. Weaker credits have not moved any wider versus higher quality names, and with this comes opportunity. This reinforces our view of remaining in higher quality, more liquid names until a bigger dispersion between credit quality occurs.
As we get closer to late 2018 spread levels, we are increasingly bullish on credit. We view this as a buying opportunity to add overall risk to the portfolio. While interest rates have significantly risen, our portfolio’s current yield is the highest in over 14 months.
Central banks remain supportive, consumer savings are at multi-year highs, we see this as fundamentally positive for credit. As of January, cumulative outflows stood at $11bn in high grade bonds. Technical tailwinds including less debt supply in 2022, and record levels of dry powder to the tune of 1.6 trillion dollars parked in the Fed’s overnight reverse-repo facility yielding 0.05% provide comfort against the recent outflows we have seen.