Following a challenging Q1 for interest rates, Q2 saw fixed income investments perform more positively. The tone of the interest rate cycle changed in June. First, the Bank of Canada cut rates by 25 bps on June 5th, to bring the overnight rate to 4.75%. This was the first cut by the Bank since the outset of the pandemic. The European Central Bank (ECB) followed suit the next day, cutting rates by 25 bps as well, to bring its headline rate to 3.75% (its first rate cut since early 2016).

The month of April saw income yields rise, as economic data, here domestically and from the US, provided evidence that inflation was continuing to prove tough to extinguish. For example, in early April, US ISM, which summarizes the economic activity in the manufacturing sector, was stronger, and prices paid by purchasing managers were higher than expected. The same reaction occurred again in mid-April and late April in response to higher than forecast US CPI (inflation) and US PCE (Personal Consumption) figures.

Recall that in last quarter of calendar 2023 the yield curve decreased markedly (and as you readers and investors know, when yields drop, bond prices rise). The resulting bond price rally that occurred was the strongest quarterly return performance by Canadian bonds in over 20 years. At the time, some believed there was a reasonably good chance interest rate cuts by the Canadian and US central banks might start as early as March 2024.

It would be difficult to repeat such a strong performance, as a result, the first quarter of 2024 always had a tough act to follow and the bond market return performance was in fact a mixed bag. Interest rates drifted slightly higher (see Canadian Yield Curve chart below), which is a negative factor for bond return performance. Inflation continued to trend downwards at a slower than anticipated pace, but the Canadian economy remained stronger than expected with a very modest beat in GDP growth in January (the latest data released), thus creating the environment for mixed bag return profile.

Well, 2023 was one of the most challenging years for fixed income investors with the converging challenges of combating inflation by governments around the world, regional wars, political instability, global warming and the impact and threat of economic recession all playing a role in determining what investors were looking for with respect to fixed income returns.

Despite a challenging first 9 months of the year, fixed income investors were rewarded for their patience in the final quarter of 2023, with the FTSE Universe Canada Bond Index gaining +8.27% for the quarter, bringing the YTD return to +6.69%. The rally in bond prices was remarkable in November (+4.29% for the month, the second largest monthly gain in over 20 years) and continued in December (+3.43%). There was outperformance in credit as well, helping further.

In a reverse from Q1, the Canadian yield curve level (the general, reflecting overall value of interest rates across the curve) shifted higher in Q2, with the more pronounced moves occurring in the short to medium term tenors (encompassing the 3 month to 7 year bonds). This is shown in the Canada Yield Curve chart below. Rates moved higher by an average of almost 60 bps across the curve. As bond investors, you know that when interest rates (yields) rise, bond prices fall, albeit modestly in this case.

The drivers of positive fixed income returns for Q1 2023, in no particular order, were the effective management of the isolated bank liquidity crisis, the central banks’ (Canada and the US) higher interest rate policies and the increase in corporate interest rate spreads (incremental return over government bond yields). After this positive start for fixed income investors, based on the fundamentals we continue to see, we retain our positive bias for income investments for the remainder of the year.

During the last quarter, fixed income markets continued to wrestle with
(i) inflationary data and expectations,
(ii) global central banks’ attempts to tame inflation through ongoing interest rate hikes and reducing money supply
(iii) the elevated recessionary risk concerns for the economy, both domestically and globally.

The drivers of fixed income valuation and thus its performance in Q3 2022 remained similar to those we spoke about for the first half of the year, resulting in a modest quarterly gain in total return. Inflation remained public enemy number 1,peaking at 9% in the US and 8% in Canada during the quarter, before receding through quarter end due primarily to declining energy prices.
Both the Federal Reserve and the Bank of Canada hiked their benchmark interest rates very aggressively during the quarter in response to extended inflation concerns.

Discussion of a global recession continued with increasing prices, consumer debt burden, employment levels and supply chain issues consuming the majority of the bandwidth for slowing growth theories in several key markets.

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.

The second quarter of 2022 echoed many of the themes evident in the first quarter. Inflation in both US and Canada exceeded already lofty expectations and climbed to levels not seen since the early 1980s. The Federal Reserve and the Bank of Canada hiked rates sharply and aggressively in response. Oil, a primary driver of inflation, hit multi-year highs as well, as the conflict in
Ukraine entered a new, possibly more protracted stage, roiling energy markets. The impact to financial markets, although not as severe as the first quarter, was steeply negative across most asset classes.

Q1 started with Omicron, the COVID-19 variant being front and center: countries around the world re-imposed lockdowns and travel restrictions. Not sure anyone was “ready” for another wave and being under restrictions again, but as the French say … “c’est la vie”. While working from home continued for most of us, it was far from boring for bond portfolio managers: it was like watching the greatest bond movie in history unfold.