Commentary

Fixed Income Q1 2016

04/01/2016

Market Overview

Rick Brown

As the new year began, the outlook for the year ahead was generally optimistic, owing to the Fed’s interest rate increase on the back of a strengthening economy. This optimistic view was quickly shattered over concerns that China was slowing much faster than anticipated, and rumours of large portfolio reallocation taking place by large sovereign wealth funds. On this news, bids quickly evaporated and the market for risk assets sold off through most of January, bottoming out in mid-February. We don’t believe anyone anticipated such a weak start to the year. Although many had hoped for a market correction, when it came, those same people were challenged to find an entry point. Cash and short positions began to build as the market tried to avoid further pain.

Then, as quickly as it fell, the market started to recover. The main catalyst was Mario Draghi’s testimony to EU parliament that futher stimulus was imminent and that “the ECB is ready to do its part”. After those comments, markets started to rally, with the Nikkei leading the way with a one-day gain of 7%. As extreme as the sell off was, the recovery was equally extreme as shorts scrambled to cover, and risk appetite came roaring back.

Most risk assets had a terrible start to the quarter, but ended up being close to flat after a roller coaster ride. Fixed income spreads widened and then tightened as the quarter came to a close. Spreads traded in a staggering 200 basis point range during the first quarter, but ended around 10 basis points wider than at year end. In term of interest rates, the 10-year yield rallied from 2.27% on December 31 to a low of 1.66% on February 11, before ending the quarter at 1.77%.

Interest rate sensitive products, such as government bonds, performed better than most segments of the bond market as interest rates moved lower. Energy continued to weigh on market performance as low oil prices continued to stress the balance sheets of the highly levered companies in the sector. Longer-duration assets (those with greater interest rate sensitivity) performed best as investors scrambled for the safety of bonds. Those same assets may suffer as cash and risk appetite returns to the market. We anticipate that interest rates will reverse course and start to move higher from current levels as data in the U.S. will likely lead to a higher probability of further rate hikes by the Fed than what is currently priced into the market.

Front Street 
Tactical Bond Class

The Front Street Tactical Bond Fund returned -0.33% for the period, underperforming the Bank of America Merrill Lynch U.S. High Yield Index as a result of the fund’s conservative credit position. Within the high-yield segment, the fund lacked much exposure to the higher risk companies that rallied the strongest in the later half of the quarter. Despite this underperformance relative to the benchmark, very few funds would have beaten the benchmark due to the weighting required in a number of distressed companies in the energy sector. That being said, we are not disappointed with the fund’s performance given all that occurred during the quarter.

In general terms, the move in interest rates provided positive returns, which were offset to some degree by the move in spreads.
We increased the fund’s telecommunications exposure given the sector’s defensive nature, and reduced our risk slightly in chemical companies. Given the move in the market, we took a very defensive stance and held a decent cash position in the fund, and were very active trading rates given the opportunities created by market volatility.

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The opinions expressed herein reflect those of the individual portfolio manager. These opinions are subject to change at any time based on market or other conditions, and Front Street Capital disclaims any responsibility to update such views. These opinions may differ from those of other portfolio managers or of Front Street Capital as a whole.

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