Alternative Absolute Return – Manager’s Commentary – January 2022

Written by Justin Jacobsen

Dear Unitholders,

The Pender Alternative Absolute Return Fund finished January with a unit price of $10.02 and distributions of $0.06 per unit[1].

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January 2022 was the worst month for the high-yield market since March 2020 and the worst January total return ever. The ICE BofA High Yield Index returned -2.75%. The negative total return was driven by both higher underlying treasury yields as well as wider spreads with the OAS increasing by 53bp on the month to finish at 363bp. Yield to worst (YTW) increased by 99bp to finish at 5.31%. It was notable to us that on January 3, which is typically a very quiet day for markets with many participants still on holiday, the 10-year treasury sold off by over a point without any significant news. This set the tone for the rest of the month, with markets focused intently on communication from the Federal Reserve. Volatility peaked late in the month with January 27 presenting the worst 1-day performance for the high-yield market since October 2020.

Portfolio Update

The volatile market environment provided the Fund with ample trading opportunities as the sell-off in credit lagged equity and government bond moves, allowing the Fund to sell bonds at attractive levels early in the month. As the month wore on and risk assets sold off, the Fund covered most individual short positions while maintaining hedges to broad index risk. While valuations in risk markets have unquestionably improved, they do not appear to be compelling in credit yet. With the potential for volatility to persist in the months ahead, the Fund continues to maintain relatively defensive positioning, selectively taking risk where we are well-compensated to do so, while maintaining significant duration and risk hedges.

In January, the Fund added positions in Bath & Body Works, Inc. (NYSE: BBWI), Iron Mountain Incorporated (NYSE: IRM) and CCO Holdings, LLC (Nasdaq: CHTR). The Fund added the CHTR new issue that had sold off with the market late in the month despite the company reporting quarterly results that caused its stock to appreciate by 5% on the same day. The Fund sold out of issues from Asbury Automotive Group, Inc (ABG: US) and Parkland Corporation (TSX: PKI) as spreads had reached our target levels for both bonds, which had been purchased at issue in November 2021.

It was an active month for the Fund’s Current Income strategy, as positions in Scott’s Miracle-Grow Company (NYSE: SMG) and Enviva Inc. (NYSE: EVA) were added, while positions in MPT Operating Partnership, L.P. (NYSE: MPW), ACI Worldwide, Inc. (Nasdaq: ACIW), CCO Holdings, LLC and Spectrum Brands Holdings, Inc. (NYSE: SPB) were sold. The Fund received call notices for positions in AutoCanada Inc. (TSX: ACQ) and Mednax, Inc. (NYSE: MD), which we expect to roll off in February. While the Fund will maintain some core Current Income positions, with interest rates, spreads and volatility all rising, the bar has clearly been raised for our short duration book.

The Current Income strategy is best employed in relatively stable and expensive markets where there is significant downside to prices further out in the credit curve; it can provide a bridge of positive income and absolute returns to a market where there is better value. When the Fund launched last year, the YTW on the ICE BofA High Yield Index was 3.95%, a level that had no precedent prior to 2021, making a clear case for short duration.

Over the near term, we believe there is potential for negative convexity in many short duration bonds as both rising rates and widening credit spreads could materially impact the market’s view of a breakeven coupon for issuers. We are focused on avoiding positions that have the potential for mark to market volatility in this strategy with a significant margin of safety. The potential for ongoing volatility has elevated the value of liquidity in our view.  

The Fund closed January with a defensive stance overall, with long positions of 107% – 46% of these positions in our Current Income strategy, 50% in Relative Value and 4% in Event Driven positions. The Fund had a 42% short exposure that included 24% in government bonds, 11% in credit and 7% in equities. The Option Adjusted Duration was 0.4 years which we believe effectively limits the portfolio’s exposure to rising interest rates.

We believe that January was a good test of our portfolio’s positioning but are constantly evaluating portfolio structure in response to new information. We believe that the portfolio is well-positioned to protect capital if volatility continues and risk premiums increase over the near term. If valuations improve in the months ahead, it may be appropriate to reduce risk hedges and pivot our positioning to focus more on generating capital gains. We believe that there are strong mean reverting characteristics in credit markets over time and that, with disciplined security selection, there are opportunities to add meaningful value in weak market environments.

Market Outlook

While January was a volatile month for assets, particularly for equities, ultimately the 10-year treasury finished the month at 1.78%, only 27bp higher than at year-end. With US CPI currently at 7% and real rates near record lows, the rates market is clearly pricing in a quick and painless return to targeted inflation levels, despite some metrics signaling that this cycle may be different than any in recent memory. Comparisons to the 2013 taper tantrum are natural for the current market environment, and while equity volatility has matched or exceeded that market event, from a fixed income perspective, January 2022 was a relatively mild episode. In 2013, the 10-year treasury yield reset from 1.6% to 2.6% in less than two months, while ultimately peaking at 3% later that year. We saw several comments that yields were elevated or that treasuries offered good value in January which, in our view, reflects anchoring and recency bias as nominal yields are lower than the average experienced last economic cycle. The last time that real yields were within 200bp of current levels was 1980.

High-yield spreads widened by over 100bp in the 2013 taper tantrum, peaking at over 500bp. While value has unquestionably improved from late December prices and there are some select pockets of value in the market, by historic standards, the market has moved from expensive to something closer to average value.

With the North American economy along with demand for goods and labor continuing to run hot, we think the biggest risk to markets over the near term is that inflation continues to be underestimated and that the central bank response will be to rein in price increases. With a 2022 midterm election looming and inflation a political liability for Democrats, it is clear that Chairman Powell got the message from President Biden that it was time to reset market expectations, given his hawkish responses to questions at the press conference following the FOMC meeting on January 26.  

Markets have been conditioned to rely on a “Fed put” to support all assets, particularly by the experience of proactive rate cuts in 2019, taking quantitative easing to extreme levels in 2020 and going as far as buying high-yield ETFs. There is not much the Fed can do to support asset values at this time without magnifying the risk of creating bigger problems in the future. For most of 2021, the Fed went out of its way to promote market stability while hoping that inflation would prove transitory. This was a calculated risk that could turn out poorly. Short-term stability creates excesses and future instability. With CPI at 7%, while policy rates are at their lower bound and asset purchases are still ongoing for a few weeks, we don’t believe there is a “Fed Put” anywhere on the horizon for markets.

The Bank of Canada is arguably even further behind the curve than the Fed, considering Canada’s terms of trade and real estate markets. Countries in a similar position to Canada, like New Zealand and Norway, have already implemented two rate hikes this cycle. Much like the Fed in 2021, the Bank of Canada is prioritizing short-term stability at the potential expense of future stability as excesses in the economy risk becoming embedded.

While growth, profit margins and a diminishing impact of COVID-19 are reasons to be optimistic over the near term, the potential for higher yields along with greater risk premiums in the coming months is driving our relatively conservative portfolio positioning.

Justin Jacobsen, CFA
February 7, 2022

[1] All Pender NAV data points are for Class F of the Fund. Other classes are available. Fees, NAV price and performance may differ in those other classes.