The Kipling Strategic Income Fund had a solid August 2022 relative to its benchmark. The M series of the fund generated a return of +0.1%, while the benchmark returned -2.2%. We have positioned the fund to have a shorter duration than the benchmark. This positioning benefitted our unitholders in August.

The bond market seems to be searching for direction and trying to decide if inflation or recession is the bigger risk. On July 27th, the Federal Open Market Committee (“FOMC”) in the United States raised the Fed funds rate by 0.75%. However, comments made in the press release and at the press conference by FOMC Chair Jerome Powell were deemed “dovish” by the market and the bond market rallied (interest rates went down/bond prices went up). The following Friday, strong employment data in the U.S. caused the market to fear that more interest rate increases were likely, and the bond market sold off. The following week, U.S. inflation data was slightly lower than forecast and the bond market rallied yet again. As August wore on, the bond market generally drifted lower.

We believe central banks in Canada and the United States are very focused on reducing inflation. Consequently, central banks will continue to increase short-term interest rates through at least late 2022 and will be reluctant to reduce interest rates. In early August, markets were pricing in four interest rate increases from the FOMC, followed by three interest rate cuts before the end of 2023. In our opinion, this bordered on irrational exuberance.

In a speech on August 31, Loretta J. Mester (President of the Federal Reserve Bank of Cleveland and a FOMC voting member) said of interest rates that “I think we’re going to have to move them up … above 4% and probably need to hold them there next year,”. Similarly in an August 30 speech, John C. Williams (President of the Federal Reserve Bank of New York and FOMC Vice Chair) said that the possibility of interest rates cuts in 2023 was “very unlikely”.

The yield curve is relatively steep in the extreme short end, but flattens in the 2-5 year range. Based on this yield curve, moving from 2 year (4.99%) to 5 year (5.05%) only adds 6 basis points in yield, but should increase interest rate sensitivity (which could be a proxy for volatility) by 150% all else equal. That is not a worthwhile trade-off in our opinion. Consequently, the duration of the fund is approximately 1.91.

Figure 1: Bloomberg Canada BBB+, BBB, BBB- Yield Curve

We have positioned the Kipling Strategic Income Fund to have a shorter duration than the benchmark (1.91 vs. 5.34) and to have a higher yield-to-maturity than the benchmark (7.1% vs. 4.4%). In an environment where all interest rates move higher, the fund should outperform the benchmark due to its’ shorter duration and higher yield-to-maturity. In an environment where interest rates are unchanged, the fund should outperform due to its’ higher yield-to-maturity. In an environment where all interest rates move lower, the fund should underperform. However, the underperformance should be mitigated by the higher yield-to-maturity and should still be positive as all bonds would increase in value (all else equal). We think this is the best way to position the fund in the current environment.