2022 in general was a very poor year for long duration bonds, with the iShares 20 Plus Year Treasury Bond ETF (NASDQ: TLT) down over 30% for the year. While we were not completely immune to the difficulty, our short duration and high-quality positioning enabled robust outperformance of indices.
In the latter part of the year, several of our longer dated positions performed well with the Fairfax Financial Holdings Ltd. 3.95% of 2031 notes up 1.8%, the BCE Inc. 3% of 2031s up 1.7% and the Loblaw Companies Limited 2.284% of 2030s up 1% in the fourth quarter. In terms of the Fairfax 2031s specifically, we added to our position later in 2022. Positive performance here was the result of a combination of rate retrenchment towards year-end and spread compression. Fairfax continued to see strong underwriting performance as pricing and demand remained solid for their North American operations.
As we well know…it’s all about inflation. At the end of November Jerome Powell gave a progress report, and in it, he discussed how Personal Consumption Expenditure (PCE) inflation (their preferred measure) ran at 6% through October – a surprise to the downside. This measure for November came in at 5.5%. Even though we are a long way from the Fed’s ultimate target and two months of movement in the right direction does not necessarily indicate a trend, we will take this as good news.
As we look forward to 2023, we are seeing some additional promising signals relating to what may be in store for Investment Grade…
Third - there is currently a lopsided market participant positioning on UST futures. At the end of December, the short interest on five-year treasuries was just shy of three standard deviations below the mean, revealing significant bearishness and therefore the potential for mean reversion in the future.
In the event that we do see inflation ease consistently and with it, the Fed’s actions on rate hikes, the impact that even a 100bp decline in yields would have on bond prices is significant and worth considering as we move forward into 2023. For instance, even a relatively shorter dated four-year bond with a 5% coupon and a 5.75% YTM currently would see an 8.6% one-year total return for a 100bp decline in yields… not bad.
As we say goodbye to 2022, various signals, including those discussed above, are combining to make us positive on the prospects for Investment Grade.
The level of the term premium signals the degree of compensation offered for taking on the increased duration risk inherent in longer dated bonds. It’s a key factor that informs the duration positioning of The Bond Universe Fund. We may extend duration as the term premium cycles higher, and reduce overall duration when it falls. With the term premium dipping below 0 in the latter part of 2022, duration of the Fund remains relatively tight.
The duration of the Fund was 3.5 years at the end of Dec 2022 and yield to maturity was 5.3%. The Bond Universe Fund held a 24.4% weight in Pender Corporate Bond Fund units at the end of December giving it 18% in overall exposure to non-investment grade securities.
Emily Wheeler & Geoff Castle
January 13, 2023