Reflation was a dominant theme for fixed income markets in the third quarter of 2020. The U.S. Fed extended its emergency liquidity provisions through the end of the year. It also unveiled a new policy framework that will effectively require inflation to be above 2% and an extremely low unemployment rate before they will consider raising interest rates. These actions, along with investor optimism from economic reopening and potential COVID-19 treatments, resulted in the U.S. dollar continuing its decline from its March peak. The Bloomberg Dollar index fell approximately 3.5%, high yield bond spreads rallied 1.6% and the 10-year breakeven rate rose 0.3%.
The Fund is generally positioned for this reflationary outlook. During the quarter, the Fund realized positive contributions from each major component of the portfolio including strategic sector (+1.5%), market neutral (+0.8%) and tactical (+0.8%) outperforming the Barclays Global Aggregate hedged to Canadian dollar.
Within the strategic sector allocations, the strongest contributor was associated with the Activist Government theme, including global-inflation-linked bonds, U.S. agency MBS, investment-grade corporate bonds and municipal bonds. The Fund’s Activist Government theme is based on the view that: unprecedented levels of monetary and fiscal stimulus could manifest in higher inflation expectations and lower real yields, and; that Fed intervention within investment-grade credit markets will continue to be a tailwind to higher-quality fixed income sectors.
The second largest contributor within the strategic sector allocations included both investment-grade and high yield corporate positions associated with the Credit Dislocation theme. These strategies performed well, capturing the tailwind of a 100 basis point tightening in high yield spreads, and benefitted from the selection of issuers and sectors that gained the most in the current environment.
The Fund also realized positive contributions from strategic sector positions in structured credit and emerging markets local and external debt. Holdings in residential mortgage-backed securities contributed to performance, as the U.S. housing sector has been resilient benefitting from increased demand for suburban housing fueled by COVID-19.
The sector rotation strategies within the tactical bucket were strong contributors to returns, generating 1%. While credit spreads have compressed, there is still substantial dispersion within and across credit sectors that portfolio managers have been able to take advantage of. Absolute Return Bond and Currency strategy was also a strong contributor and benefited from its short U.S. dollar exposure.
Yields are low and many investors are likley reassessing the role of fixed income in their portfolios. At the end of September, the yield on the Barclays Aggregate was 1.18% and the yield on high yield was 5.77%. With yields this low, there is a question of whether investment grade fixed income will provide the negative correlation to equities in the next downturn. At the same time, yields on non-investment grade sectors are not providing the same level of income they historically have, with likely higher volatility. The goal of the Fund is to generate 5-6% total return with volatility in-line with investment grade fixed income. This has become more difficult in the current environment than at the end of March when yields were substantially higher. Nevertheless, the portfolio manager is optimistic about the future and believes, in many ways, there are opportunities in the current fixed income environment.
First, while yields are currently low, there are several catalysts on the horizon that may change that. The U.S. election, continued global monetary and fiscal coordination, further economic reopening and possible COVID-19 treatments all have the potential to benefit reflationary assets, which, despite their rally since March, remain cheap over a longer-term perspective.
Second, while this may be a low yield environment, the portfolio manager does not believe it will be a low-volatility environment. While it may seem tempting to go down in credit quality to generate higher returns, the portfolio manager believes the uneven opening of global economies could mean a still-elevated default environment and increased volatility. Within the Fund is the ability to allocate to absolute return allocations that may take advantage of the dispersed reopenings and any resulting volatility. This has already been observed within the credit space, but the portfolio manager believes this volatility and dispersion will make its way to currency markets, as they are typically the one outlet for relative economic performance when policy rates are at zero. For this reason, the portfolio manager increased the allocation to currency absolute return strategies in Q3. The opportunity for highly dynamic currency-relative value strategies has improved, as cross-correlation among currencies included in the Bloomberg Barclays U.S. Dollar index (DXY) has declined.
Finally, the Fund enjoys a benchmark-agnostic approach to investing in fixed income markets. The portfolio manager resists having a bias toward a particular country or region simply because it’s home base for many fixed income investors. While yields in the U.S. and similar markets are low, that is not necessarily the case for all global markets. For example, the yield on Chinese 30-year government bonds was 3.87% at the end of the quarter, which is high for a country with core inflation (CPI) of only 0.5%. Within the Core Challenges theme, the portfolio manager is searching the globe, adding to duration markets they believe offer attractive yield and could protect the portfolio in the next equity downturn while offering attractive currency-hedged yields.