It’s all about Rates… right? Vertex Enhanced Income Fund

  • Can the economy and market adapt to higher rates?
  • Positioning a credit fund to succeed under rising rates.

It’s easy to get caught up in the current movement of selling everything income related and moving into equities, as we’ve seen over the last few months. There’s an element of FOMO (fear of missing out) and there’s a fear of rates going ever higher, with a Fed trying to stoke the flames of inflation. The January 2018 BAML Fund Manager Survey showed us that bond weights among Institutional Money Managers are at historically low levels; which makes moving away from yield a crowded trade.

We’ve seen hyper-inflationary bond yields before, there’s nothing new with this move. It’s not so much the move that should scare investors but the speed of the move. The speed of hyperinflation in economies is more the problem than the actual level of inflation itself. In the 1980’s companies and real estate buyers adapted to rates around 20%, so don’t think that a rate of 3% in the 10-year or 4% in the 5-year is going to cause a recession. If rates changed from from 1% to 4% in the 30-year overnight, that could impair the economy as it doesn’t have the time to adjust to the new prices. Venezuela has some experience with waking up in the morning to find bread and milk cost 25% more, and wasn’t pretty.

Every time we’ve seen the 10-year bond move up 10% over the past 5 years, to the point where the market gave a eulogy for bonds, it’s dropped right back down, tempering the move.

 

As of Feb 27/2018 Source: Bloomberg

Looking at this chart of the 10-year, the peaks have been around 3%. More importantly, look at what happened every time we had a large move up. The advance was followed by either a retracement or consolidation. While it’s true that the economy is functioning well, and the Fed is doing its best to entice inflation, the reality is that companies need time to adjust to a new rate environment. The marginal buyer is gone. The Commitment of Traders report is showing a crowded short in the 10-year note. While the VIX ETN blow-up did scare investors (see here), the product was almost 100% retail focused. So when investors worry there might be derivative structures based on a 3% rate for the 10-year bond, remember that institutional investors don’t typically use one-touch options. They progressively hedge exposure as yields increase.

In Canada, we need to be more concerned about the crowded trade in TSX index stocks then we do with bond yields. Whether it be through structured products or passive index investing, Canadians are exposed to more risks then they realize. What happens if there is a real shock and everyone wants out simultaneously? Those exit doors are not wide enough for the sheer volume of selling that is possible. Passive investing works, until it doesn’t…then it gets ugly.

When viewed over a longer time-horizon, the Vertex Enhanced Income Fund is a credit fund and we are confident we will have better performance under increasing rates. Positions in offshore drillers and copper miners will perform better in an inflationary/growth environment. The fund also has a 12% weight in floating-rate securities that move up with higher yields, and our exposure to commodities in the 33% range (which benefit from rising rates). Most of the fund’s high-yield bond exposure is credit specific, meaning the security risk was mispriced relative to the market, reducing the correlation to rates.

The fund’s bond duration has remained consistent around 2 years for the past 12 months, with a 9.5% yield-to-maturity. When including equity and preferred shares positions, the fund’s duration is closer to 1.5 years, with a 7.5% yield-to-maturity.

Have a great weekend!

Vertex Enhanced Income Fund 

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