Fixed Income Strategies

July 2024

 

The disappointment over the rise in bond yields in the first quarter was reversed in the second quarter. Investors welcomed the moderation in U.S. inflation and the labour market with little loss of economic momentum. Corporate earnings are reasonable and the boom in artificial intelligence is driving gains for investors.

The U.S. Federal Reserve left its federal funds rate unchanged at its June meeting, keeping it between 5.25% and 5.5%. The central bank acknowledged that economic activity is expanding solidly and job gains have been strong. The unemployment rate is low, and while inflation has moderated over the past year, it remains above target.

In contrast to the Fed, the European Central Bank and the Bank of Canada (BoC) lowered interest rates during the quarter. The BoC cut its benchmark interest rate to 4.75%, the first reduction in more than four years. In making its decision, the central bank cited slower economic growth and employment.

Other measures of economic activity, namely consumption growth, business investment and housing transactions, remain strong in Canada. Inflation has moderated but remains above the BoC’s target. Shelter price inflation and wage pressures are also still elevated.

Corporate Bond Strategy

Pembroke’s corporate bond strategy outperformed its benchmark for the second quarter and year to date, returning 1.15% and 3.31% respectively. The strategy benefited from a continued rally in Limited Recourse Capital Notes (LRCNs) issued by banks and insurance companies as risk premiums narrowed. Year-to-date, these LRCN securities, which are not included in the strategy’s benchmark, narrowed by 145 to 262 basis points.

The portfolio’s short relative duration also contributed to performance as yields rose in maturities over one year, but was weighed down by a 28.7% allocation in floating-rate securities. Spread tightening in Air Canada, a long-dated floating rate issue of TransCanada, Pacific Life and LATAM Airlines were notable contributors to performance over the period.

The strategy’s position in the shares of Bird Construction Inc., acquired through a restructuring, also had very strong returns during the period as the company continues to focus on high-margin sectors and manages its recent acquisitions well.

Going forward, the strategy maintains a conservative approach with a focus on short-term, high quality and liquid instruments such as Government of Canada bonds, National Housing Act Mortgage-Backed Securities (NHA MBS) and bank covered bonds that can be efficiently sold to fund future credit opportunities. In addition, the strategy continues to hold select high yield issues that are well structured and remain attractive on a risk-adjusted basis.

The strategy enters the third quarter of 2024 with a healthy yield to maturity of 6.8%, while maintaining a shorter duration of 2.1 years, which is defensive against volatile government bond yields as inflation remains above central bank targets.

Canadian Bond Strategy

Pembroke’s Canadian investment grade bond strategy outperformed its benchmark in the second quarter and year to date, returning 0.85% and 0.20% respectively. The portfolio’s position in an LRCN issued by Great West Life led performance as spreads tightened 215 basis points during the year-to-date rally.

The strategy’s relatively short duration and underweight in long-term bonds also contributed to performance as yields rose at the long end of the curve. Short-term issues from TWDC, Toyota and Honda benefited from spread tightening over the period and were notable contributors to performance.

Going forward, the strategy continues to maintain a significant position in short-term discount Canadian bonds, which can be used to take advantage of future credit opportunities. The strategy enters the third quarter of 2024 with a healthy yield to maturity of 4.6% and a duration of 6.7 years, which remains slightly short of the benchmark.

 

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