Q4 2016 Commentary

Mackenzie Fixed Income Team

Outlook & Strategy

The Impact of Central Banks

Central Banks have given us a lot to think about over the last few years with respect to yield curves and positioning fixed income portfolios. In 2016, one of the key drivers of bond markets has been liquidity provisions by other Central Banks – not by the Fed – but by the Bank of England, the Bank of Japan and the European Central Bank. Through the middle of 2016, the nuances of change began around the debate about the effectiveness of monetary policymaking in general, and more specifically the ways that negative interest rates and quantitative easings affect banking systems. Led by the Bank of Japan’s late summer statements regarding its QE program, developed market yield curves steepened, and the USD strengthened into year-end. Throughout Q4, the Fed was expected to hike rates, which they did in mid-December.

As we look into 2017, the Fed, through their statements and their December “dot-plot” has turned slightly more hawkish, but not dramatically. With the Fed and the bond market aligned – both are projecting two or three hikes in 2017 – for the first time in years, combined with a Republican sweep of the elections in the US, there are many new growth and inflation uncertainties to discount over the coming year. This has caused some instability in the U.S. yield curve, as well as global markets. We will likely see a little bit of volatility around the higher end of the yield range the bond market has experienced over the last few years. There are also many different implications of the fiscal and monetary policy mix on the U.S. dollar, as well as for other credit markets like emerging market credit and high-yield and investment grade corporate bonds.

High Yield Credit Markets

Last year was actually a very good year for high-yield credit investors. The first quarter was a little bit rocky through January and February, but the rest of the year was very much defined by rapid spread tightening across most of the high-yield spectrum, including the commodity areas that experienced rising default rates through the year.

As we go into 2017, we believe some areas of the high-yield bond market are a little bit rich, particularly those areas where the yields have come down below 5%. The big BB high yield bond issuers— some of those credits that are at the higher quality-end of the high-yield spectrum—are reflecting both interest rate risk and credit risks, which we would like to avoid in 2017. In contrast, some of the middle market-sized high yield bond deals are still offering good value and good yield for investors, without as much embedded interest rate risk. This is where we are likely to focus in terms of exposure to high-yield bonds. We believe loans offer a good risk-adjusted return potential for 2017 relative to the more expensive part of the high yield bond market. This is in-part due to their generally higher position in the capital structure, and their floating rate coupon structure. With the recent move higher in the Fed Funds rate pushing the three-month US Libor rate to about 1%, some loans should experience a small coupon reset higher this quarter. If the Fed continues to hike this year, more loans should experience additional coupon resets as the year progresses. This element of their structure may draw increased attention from investors to the credit sector. We are starting the year overweight loans compared to high-yield bonds in Mackenzie’s Core Plus portfolios. We also think that investment grade corporate credit offers some value. Spreads are still wide in that area of the market, so we are reflecting that in an overweight position in our portfolios.

Alongside our corporate credit overweight, we have had shorter durations in our portfolios during Q4. In particular, we sold 30-year bond duration out of our portfolios because it was our opinion that there would be a yield rise through the third and fourth quarter. That has paid off in helping to protect capital for our investors during the rising yields markets recently experienced. Going forward, as 2017 begins, our portfolios are maintaining the shorter duration posture.

During the coming year the bond market will contend with a slate of potentially market moving macro events. These range from the handover of the US legislative and administrative branches to the Republicans and President-elect Trump, several important European elections, the commencement of the formal Brexit process, and an engineered slowdown of China’s housing markets. Even as potential growth and optimism are discounted in the near term, there are many imbalances globally that are not easily remedied. The large debt overhang faced by most nations should act as a natural brace against rising yield curves, as the cost of carrying that debt can quickly become punitive. While a small move higher in longer term yields should not be ruled out in 2017, we believe that possible events and yield levels themselves should keep the rise limited to a range experienced in the last several years.

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