Manager commentary - December 31, 2018

In the fourth quarter of 2018, IA Clarington Inhance Bond SRI Fund Series B generated a return of 0.6%, compared to 1.8% for its benchmark, the FTSE Canada Universe Bond Index. Market sentiment shifted dramatically negative in the fourth quarter of 2018 amid signs of slowing global economic growth. Risk assets sold off sharply and bonds rallied around the globe in the flight to quality. Government of Canada bond yields were 24 to 46 basis points lower across the curve, mirroring the move in U.S. Treasury yields.

The front-end of the yield curve continued to flatten on the back of expectations that central banks will pause their rate hiking/normalization cycles. The 2s5s curve (the difference between the 5-year yield and the 2-year yield) briefly inverted in both Canada and the U.S., though the 2s5s curve does not have the same signal value as the 2s10s (the difference between the 10-year yield and the 2-year yield) curve. The 2s10s curve, which has inverted prior to every U.S. recession over the past 50 years, ended the period at 19 basis points, although it did fall as low as 11 basis points in mid-December. While very flat relative to historical levels, the 2s10s curve could stay flat for an extended period without a recession (e.g. 1994-1999).

In the context of the continued flattening of yield curves, it is important to note that although every U.S. recession in the past 50 years has been preceded by an inversion of the yield curve, not every yield curve inversion has been followed by a U.S. recession (e.g. the brief inversion in 1998). Furthermore, the time between yield curve inversion to the start of the next recession can vary greatly, ranging from 1.2 to 2.0 years in the last three U.S. recessions.

The U.S. Federal Reserve (Fed) raised its policy rate range by 25 basis points (2.25% to 2.5%) at its December meeting, its fourth such hike in 2018, going against a rising chorus of high-profile investors suggesting the Fed may be overtightening. The Fed’s median forecast at that meeting had two further rate hikes expected for 2019, an interesting divergence from the market, which ended the year pricing in no Fed hikes in 2019 and rate cuts in 2020/2021.

The Bank of Canada (BoC) raised its policy rate 25 basis points to 1.75% at its October meeting, the third and final hike of the year. At its December meeting, the BoC had a slight dovish tilt in its statement, recognizing the weaker macroeconomic developments and indicating it was in no hurry to get its policy rate to neutral. The market ended the year pricing in less than a 50% probability of a BoC hike through all of 2019.

The Fund’s preferred share holdings dropped sharply in the quarter and accounted for the majority of the Fund’s underperformance against the benchmark. Preferred shares were hit hard by weak market risk sentiment, widening credit spreads and lower bond yields. Tax-loss and ETF-driven selling caused further declines in December, making the fourth quarter of 2018 the worst quarter for preferred shares since Q3 of 2015 and the third-worst quarter since the start of S&P/TSX Preferred Share Index data in 2002.

Also detracting from relative performance was the Fund’s underweight allocation to federal bonds, the strongest-performing sector in the flight to quality and risk asset sell-off during the quarter. Security selection in the Fund’s corporate bond holdings contributed to the Fund’s relative performance, driven by the Fund’s bias towards higher-quality corporate issuers.

The Fund purchased a green bond issued by South Coast British Columbia Transportation Authority (TransLink), ending the quarter with 16 green bond holdings, which represent 10.25% of the Fund’s market value.

With corporate credit spreads near their widest levels since early 2016 and preferred shares near their lowest levels since mid-2016, there will be relative value opportunities available as we enter the new year. In the view of the PM, the Fund is positioned for steadily higher bond yields, utilizing a combination of preferred shares and duration management.

Fund and benchmark performance as at December 31, 20181 yearSince inception (Dec. 2016)
IA Clarington Inhance Bond SRI Fund – Series B-0.3%0.5%
FTSE TMX Canada Universe Bond Index1.4%2.0%

 

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The performance data comparison presented is intended to illustrate the Fund’s historical performance as compared with historical performance of widely quoted market indices. There are various important differences that may exist between the Fund and the stated indices that may affect the performance of each. The Fund’s benchmark is the FTSE Canada Universe Bond Index, which is comprised of Canadian investment grade bonds and has significantly different portfolio duration characteristics. The FTSE Canada Universe Bond Index consists of a broadly diversified selection of investment-grade Government of Canada, provincial, corporate and municipal bonds issued domestically in Canada. The Fund's geographic, sector and credit quality exposure may differ from that of the benchmark. The Fund may hold cash while the benchmark does not. It is not possible to invest directly in market indices. The performance comparison is for illustrative purposes only and does not imply future performance.