Sanguine in a Rising Interest Rate Climate?
The business news headlines, along with a growing chorus of our clients are alive to the fact there are meaningful investment challenges in fixed income, particularly in a rising rate environment.
Interest rates are arguably the most important driver of fixed income returns. Factors including inflation, fiscal and monetary policy, unemployment and other measures of economic health or price stability make it a mug’s game to predict changes in rates. As a result, at Ewing Morris & Co., we generally refrain from directionally trading interest rates.
While interest rates drive the fixed income asset class as a whole, they do not drive all areas of fixed income equally and in the same direction. Where we focus our time in the North American high yield market, historical data indicates that high yield bonds often move in the opposite direction of government bonds. The reason is that the return of high yield bonds is driven disproportionately by company-specific factors rather than from movements of interest rates. For instance, an unexpectedly strong economy could trigger inflation fears leading to higher interest rates (and thus lower investment grade bond prices). However, a strong economy usually strengthens the credit quality of marginal (i.e. high yield) borrowers which can justify a lower credit premium (and higher high yield bond prices). The performance history of high yield bonds demonstrates that the benefits of favourable economic and corporate developments usually outweigh the headwinds created by rising interest rates.
Although our Ewing Morris Flexible Fixed Income Fund has a flexible mandate to invest in any fixed income securities, the Fund primarily favours high yield debt, as its core focus in the Canadian fixed income landscape. Historically, investing in high yield debt outperforms investment grade bonds and government bonds during periods of rising interest rates.
While high yield bonds can insulate investors from the gradual course of interest rate increases, prices can fall sharply during times of stress, such as the recessions of 1991 and 2008, which typically follow interest rate “hiking” cycles. Our prescription is to always be prepared for changing economic conditions, with our emphasis today on reducing risk through equity and credit hedges.
Equity Hedging as a Source of Risk Reduction
The Ewing Morris Flexible Fixed Income Fund is unique as we utilize equity hedging as an additional source of risk reduction.
The business-related factors that cause a company’s credit rating to be classified as ‘high yield’ typically undermine a company’s ability to build shareholder value. This dynamic can actually make the equities of high yield companies particularly compelling short candidates. By shorting an appropriate amount of a company’s stock, we are essentially acquiring insurance against unforeseen company developments, while, at the same time, we are able to continue harvesting a high income from the bond investment in the company. We take comfort in how direct this form of risk management is; if our debt investment is not paid back 100 cents on the dollar, the underlying equity becomes generally worthless, resulting in a profit on the hedge.
The combination of strong results from our core high yield bond holdings, plus additional upside from our equity hedging program has allowed the fund to earn equity-like returns, since inception, while tightly controlling risk. This has resulted in Fund volatility that is materially lower than comparable high yield and investment grade bond ETFs. The first quarter of 2018 exemplified the unique characteristics and resiliency of the Ewing Morris Flexible Fixed Income Fund, as many asset classes struggled.
It bears mentioning that with the rising rate environment becoming a consensus narrative within the financial community, we would not be surprised to see rates move in the opposite direction. While the high yield sector has historically experienced headwinds when rates move sharply lower, our equity-hedge play is designed to provide insurance against a risk of loss of capital in a declining rate environment. We have constructed the portfolio to defend against a wide range of outcomes and in doing so, strive to create a safe harbour for our limited partners’ capital.
We have recently added a mutual fund trust on top of our Flexible Fixed Income Fund now making the strategy available for registered plan investment (RRSP, TFSA, etc.). We would be pleased to discuss the benefits of the fund strategy for your portfolio.
This document does not constitute an offer to sell units of the Ewing Morris Flexible Fixed Income Fund LP. Units of the Ewing Morris Flexible Fixed Income Fund LP are only available to investors who meet investor suitability and sophistication requirements. The Fund has a flexible investment mandate. Therefore, the Fund’s composition is materially different than major indices.
 Wall Street Journal (Junk Debt is Outdoing Its Peers, June 25th, 2018)
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