Head On A Swivel

February 2022

Entering the year, we anticipated that 2022 would be more volatile. January exceeded our expectations. Concerns about inflation, the start of a central bank hiking cycle, and uncertainty over a reduction in market liquidity through the end of asset purchases and a shrinking of the Federal Reserve balance sheet, have underpinned a shaky start to the year for risk assets. As we have not witnessed a prolonged central bank hiking cycle since before the Global Financial Crisis, this pivot, and the associated market recalibration, will take some time to play out.

The investment grade market easily outperformed the equity market. Despite a widening of risk premiums to their high of the past year, activity remained orderly, with no sense of panic or forced selling. New issuance was higher than the historical monthly average, and coupled with the market tone volatility, concessions rose, often repricing secondary markets. In the US buying resumed with each period of market calm, while in Canada, investors remained cautious. Short-dated securities retained a bid, as higher all-in yields attracted buyers.

Why the relative calm?

The credit markets are still supported by positive fundamental tailwinds:

• We are not expecting a recession in the foreseeable future.
• Corporate fundamentals remain in good shape.
  • Typical re-leveraging patterns have been delayed over the pandemic.
  • Earnings continue to grow.
  • Margins remain healthy, despite cost pressures.
• Supply/demand backdrop realigned as volatility increased.
  • New issuance abated as equity volatility rose.
  • Foreign investor flows continued to support the market, attracted by higher all-in yields.

When to buy, not if

While we continue to believe that credit will outperform government bonds over the course of the year, we have not been aggressive to add additional credit risk credit this month as we believe that risk premiums are likely to widen in the near term. The supply calendar will likely be brought forward as issuers attempt to get ahead of rising yields, especially with a growing M&A pipeline. We will also need to see a greater confidence on path of interest rates and the extent to which liquidity may be drained from financial markets. The latter point will take time to play out.

We are allocating capital with the following considerations in mind:

• Ensure we are compensated for providing liquidity. In the current market it has been companies needing to issue debt, such as supply relating to latest M&A activity, like Rogers Communications, that are the most willing to pay higher market premiums.
• Adding investments that are more likely to withstand a move higher in yields, for example hybrid securities lower in the capital structure, with a large enough credit spread to better offset yield increases.

The portfolios remain skewed to lower duration assets, as risk premiums have not risen substantially to materially extend term.

Over the upcoming months, we will focus particular attention on macroeconomic factors and changes in liquidity, both market and access to capital, to ensure that the fundamental basis for our investment positioning remains intact.