IA Clarington U.S. Dollar Floating Rate Income Fund
Manager commentary - December 31, 2018
The fourth quarter of 2018 was a challenging one for risk assets. Global equity markets posted sharp declines as investors grappled with a myriad of issues, including continued U.S. central bank interest rate hikes, slowing global growth and rising geopolitical concerns (Brexit, Italian politics, continued trade tensions between the U.S. and China). Equity market weakness spilled into the credit markets, resulting in materially wider credit spreads in investment grade, high yield and senior loans. One of the few bright spots during the quarter was government bonds, as they lived up to the traditional role as a safe haven for investors in time of market turmoil.
Both senior loans and high-yield bonds posted outsized negative returns in the fourth quarter, the bulk of which came in December. Record-setting outflows from U.S. retail loan funds and ETFs caused the average price of the loan index, as represented by the Credit Suisse Leveraged Loan Index, to plummet in December. In the six-week period ended December 27, 2018, outflows totaled almost $15 billion, representing approximately 13.5% of assets under management. While retail investors form only a small part of the loan buyer base, they at times can move prices materially as the incremental seller. These investors have been selling due to reduced expectations for further U.S. rate hikes in 2019 combined with heightened concerns around weak loan covenants (covenants are put in place by lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business) in recent new issues that may result in higher default loss in the future. We believe that the decline in average loan price is due to technical conditions in the marketplace and not based on fundamentals that would lead to above-average credit loss. Despite the sharp sell-off in December, loans still posted a positive calendar year return in 2018, one of the few asset classes that can make that claim.
The 3-month London Interbank Offered Rate (LIBOR), the floating component of most loan coupons, increased by 41 basis points over the quarter to 2.81%. LIBOR has been steadily increasing through 2018 in tandem with U.S. Federal Reserve (Fed) interest rate hikes. However, a less hawkish forward guidance by the Fed during its policy meeting in December has resulted in the market expecting fewer rate hikes in 2019 than originally anticipated.
The Fund’s bias towards higher-rated credit benefitted relative performance over the quarter, as higher-quality loans outperformed during the sell-off. The average credit rating of the Fund over the quarter was B.
Notable contributors to the Fund’s performance included holdings in Confie Seguros senior secured term loan (LIBOR + 5.25%, 10/19/2022), AGT Food and Ingredients Inc. senior unsecured bonds (5.875%, 12/21/2021) and Array Canada Inc. senior secured term loan (LIBOR + 5.0%, 02/09/2023). Notable detractors from the Fund’s performance included West Corp. senior secured term loan (LIBOR + 4.0%, 10/10/2024), Virgin Media Bristol LLC senior secured term loan (LIBOR + 2.5%, 01/15/2026) and Telsat LLC senior secured term loan (LIBOR + 2.5%, 11/17/2023).
We believe this recent market volatility reflects a reset in valuations as the market comes to grips with a lower level of global growth caused, in part, by the removal of central bank liquidity. We do not believe the market is pricing in an imminent recession, as recent data suggests the economy remains on a solid footing. In our view, the Fed’s intention to continue increasing interest rates into 2019 is a further indication of a stable U.S. economy. Nonetheless, we need to be mindful of tail risks from escalating trade tensions between the U.S. and China and oil price weakness.
We remain constructive on credit overall as our base case does not call for a recession or a spike in default rates in 2019. Additionally, the meaningful increase in yield caused by recent widening of credit spreads and higher overall interest rates provides additional cushion for further spread widening. We do not see material spread tightening next year and believe that astute credit selection and a bias towards higher-quality issues will be critical to success in 2019.
In general, we continue to position the Fund quite conservatively in order to limit price volatility and surprise risk. Our loans are focused on issuers that we believe can weather an economic downturn. We also favor larger issues to enhance liquidity within our portfolio. As usual, we avoid companies with cash flows linked to commodity prices, which are inherently volatile.
|Fund and benchmark performance as at December 31, 2018||1 year||3 year||Since inception (Dec. 2015)|
|IA Clarington U.S. Dollar Floating Rate Income Fund - Series A||1.4%||2.8%||2.8%|
|Credit Suisse Leveraged Loan Index USD||1.1%||5.0%||5.0%|
Learn more about IA Clarington U.S. Dollar Floating Rate Income Fund
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 benchmark is the Credit Suisse Leveraged Loan Index USD which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. The Fund's geographic, sector and credit quality exposure may differ from that of the benchmark. The Fund can invest in high yield corporate bonds and government bonds, which are not included in the benchmark. For this Fund, performance is reported in USD and any investments in non-U.S. based issuers (including Canadian issuers) may be purchased in currencies other than U.S. dollars. When these non-U.S. investments are purchased in a currency other than U.S. dollars, the value of the investment will be affected by the value of the U.S. dollar relative to the value of the other currency. If the U.S. dollar rises in value relative to the other currency but the value of the non-U.S. based investment otherwise remains constant, the value of the investment in U.S. dollars will have fallen. Similarly, if the value of the U.S. dollar has fallen relative to the other currency, the value of the U.S. Dollar Fund's investment will have increased. As the Fund’s performance is reported in USD, the U.S. indices referenced within are also quoted in their native currencies of U.S. dollars to reflect the performance of the holdings. 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.