Although rate hikes are all part of the normalization process after the COVID-19 pandemic, there are ways to take advantage of the central bank’s inflation-fighting program, according to fixed-income specialists Geof Marshall and Darren Arrowsmith.
Fixed income markets are in turmoil as the Bank of Canada raised its so-called key rate to 1%, following a 25 basis point (bp) hike in March and a 50 bp hike in April. They were followed by talks from Governor Tiff Macklem about possibly bigger hikes to come, to stifle inflation.
“What we’re seeing here is central banks reverting to a normalized, post-COVID rate environment. Central banks were already cutting rates pre-COVID and after the last hike cycle,” says Geof Marshall, head of the High Yield and Senior Vice President of Toronto-based CI Investments and co-manager of the $66.1 million 5-star neutral CI Floating Rate Income F-rated.
“We’ve had a lot of monetary and fiscal stimulus and we currently have very strong inflationary pressures and very low unemployment. We have about 200 basis points, or 2 percentage points, of interest rate hikes in the market here and in the United States. To us, that seems over the top, more so in Canada than in the United States. They are further behind the curve.
Demand inflation is next
The evolution of interest rates in Canada, according to Marshall, depends on the reaction of inflation and economic growth to monetary policy. “Two things are at play. One is where we have a ‘baseline effect’. This is where inflation will fall based on a year-over-year comparison. Supply chain issues, in terms of bottlenecks and how that affects prices, is what we call “cost pull” inflation. We took care of it. But in the future, it will be “demand-driven” inflation. Marshall observes that people are traveling again, dining out, and spending more freely, contributing to inflationary pressures. But once that spending activity is over and higher rates take effect, he maintains that inflation will gradually decline.
The base case is moderation
“I suspect inflation will be more subdued in the second half and central banks won’t have to be as aggressive as they were in the first half,” says Marshall, a 24-year industry veteran who joined CI in 2006. “It seems overkill at this point. Our base case is that inflation will moderate. According to him, the Bank of Canada will raise interest rates by 150 to 200 basis points over the rest of the year.
CI Floating Rate Income Fund may benefit from rising rates as the fund is primarily invested in business loans. “Term loans are at the top of the company’s capital structure,” says Arrowsmith, a vice president and 21-year industry veteran and high-yield bond specialist who joined the firm in 2012 after having worked for GE Capital in London, UK, and Stanton Asset Management in Montreal, where he was involved in the management of global high yield bonds and leveraged loans.
Term loans often come with stronger covenants and creditor protection than other elements of the capital structure. “They reset monthly or quarterly, depending on short-term interest rates, which can provide income and price stability in a rising rate environment,” says Arrowsmith. “Floating rate loans are ideal for investors who want to diversify some of their credit-sensitive fixed income investments and potentially benefit from higher interest rates in a rising rate cycle.”
Since the beginning of the year (April 26), the fund has posted a return of -1.37%, compared to -1.24% for the variable rate loan category. Launched in June 2017, the fund has returned 1.76% over the past 12 months, compared to 1.31% for the category. Over the past three years, the fund has posted an annualized return of 3.88%, versus 1.05% for the category. The fund has a current yield of 5%. On April 19, the product was launched as an exchange-traded fund, with the symbol CFRT. It has a management fee of 35 bps.
Marshall points out that because it’s a floating-rate asset class, it’s secure, it’s always been more stable than, say, high-yield bonds, which are typically unsecured. “I see them as a lower-beta, or less volatile, version of the high-yield bond space. They’re especially useful for investors who are worried about rising rates or rising government yields. an investor thinks 5% of his portfolio should be in high yield bonds, he’s just as well served by holding that 5% in floating rate loans, and he gets the same effect. They really are good insurance in the period where rates are rising.
Recession risks are real
Nevertheless, investors should be aware of the risks involved, and in particular credit risks. “If, for example, the Federal Reserve tightens financial conditions too much, then it is possible that economic growth will contract or even precipitate a recession,” says Arrowsmith. “We don’t expect this in the short term. But it is something to consider. Generally, he adds, loans will outperform in a rising rate environment and can also outperform when the economy is in the latter part of the cycle. “The secure nature of the asset class should help protect it on the downside due to higher recovery values, should default occur,” he says, reiterating that if interest-rate loans bonds exhibit less volatility than other types of corporate fixed income classes, there is still a risk of default, a factor that puts it on par with high yield bonds.
From a strategic point of view, the portfolio is made up of approximately 80 holdings and is based on a credit and security selection system. “We categorize holdings into three different categories,” says Arrowsmith, adding that he and Marshall are supported by three other portfolio managers and analysts. “There are core positions, catalyst-driven situations where we have strong convictions where the investment can be called or redeemed, and so-called ‘call yield’ situations where we also have strong convictions. which, given the fundamentals and techniques that the loans will either be repaid or refinanced in the short term.The asset mix of all these categories allows for greater flexibility.It also promotes a high active share relative to the index S&P/LSTA leveraged loans and helps preserve capital.
Ready for cruises
A representative security of the portfolio is a term loan from Carnival Corp. (CCL), a major cruise provider. “Before COVID, we weren’t involved with cruise operators. Their incomes have fallen to zero, or almost. And their credit ratings were downgraded in April 2020,” says Arrowsmith. “It has generated some forced selling from quality investors, some of whom may not hold high yield securities. When you get a forced sell, you get entry levels that are quite attractive to high yield investors. .
Arrowsmith says cruise lines borrowed during the COVID crisis and strengthened their balance sheets. “They have made deleveraging their balance sheet a priority on the other side of the pandemic when business volume returns. We’ve seen this story before, given our experience in high-yield credit. A basic holding in the fund, it yields around 6%.
Another representative item is a floating rate loan from Air Canada (AC). As restrictions eased, “airlines were able to deal with higher fuel costs and other inflationary factors,” says Arrowsmith. “It’s because there are so many pent-up requests to travel that they’re immune to the price difference, at least for now.”
In April 2021, Air Canada secured a $6 billion government support package, which included debt and equity elements. “In August, they decided to tap public markets under a secure, multi-tranche deal to refinance existing debt, add liquidity to the balance sheet and mitigate the need to dip into these emergency government facilities,” adds Arrowsmith. The portfolio holds a senior secured loan that matures in 2028. Based on the so-called call protection available until 2023, the loan is earning approximately 5%.
Best case is income and coupons too
Looking ahead, Marshall argues that, in the best-case scenario, the central banks of Canada and the United States stage a soft landing and avoid a recession. “In this case, you will earn your income and higher coupons in the future, based on future interest rate increases.” But that scenario depends on a resolution of the Russian-Ukrainian conflict and the reduction of some of its hawkish policy and the Bank of Canada lowering energy prices, Marshall adds.
In the worst case, however, inflation proves to be much more resilient and does not react easily to higher interest rates. “It’s a stagflation environment where inflation is consistently high and we get negative growth,” Marshall says. “In this case, loans will likely outperform other asset classes. But nothing in fixed income will work well. Investment grade and high yield bonds will trade lower due to rising government bond yields and widening credit spreads. Still, loans, as the shortest duration asset class, will likely do the best.