Kipling Strategic Income Fund
The Kipling Strategic Income Fund had a solid August 2022 relative to its benchmark. The M series of the fund generated a return of +0.1%, while the benchmark returned -2.2%. We have positioned the fund to have a shorter duration than the benchmark. This positioning benefitted our unitholders in August.
The bond market seems to be searching for direction and trying to decide if inflation or recession is the bigger risk. On July 27th, the Federal Open Market Committee (“FOMC”) in the United States raised the Fed funds rate by 0.75%. However, comments made in the press release and at the press conference by FOMC Chair Jerome Powell were deemed “dovish” by the market and the bond market rallied (interest rates went down/bond prices went up). The following Friday, strong employment data in the U.S. caused the market to fear that more interest rate increases were likely, and the bond market sold off. The following week, U.S. inflation data was slightly lower than forecast and the bond market rallied yet again. As August wore on, the bond market generally drifted lower.
We believe central banks in Canada and the United States are very focused on reducing inflation. Consequently, central banks will continue to increase short-term interest rates through at least late 2022 and will be reluctant to reduce interest rates. In early August, markets were pricing in four interest rate increases from the FOMC, followed by three interest rate cuts before the end of 2023. In our opinion, this bordered on irrational exuberance.
In a speech on August 31, Loretta J. Mester (President of the Federal Reserve Bank of Cleveland and a FOMC voting member) said of interest rates that “I think we’re going to have to move them up … above 4% and probably need to hold them there next year,”. Similarly in an August 30 speech, John C. Williams (President of the Federal Reserve Bank of New York and FOMC Vice Chair) said that the possibility of interest rates cuts in 2023 was “very unlikely”.
The yield curve is relatively steep in the extreme short end, but flattens in the 2-5 year range. Based on this yield curve, moving from 2 year (4.99%) to 5 year (5.05%) only adds 6 basis points in yield, but should increase interest rate sensitivity (which could be a proxy for volatility) by 150% all else equal. That is not a worthwhile trade-off in our opinion. Consequently, the duration of the fund is approximately 1.91.
Figure 1: Bloomberg Canada BBB+, BBB, BBB- Yield Curve
Source: Bloomberg as of September 2, 2022
We have positioned the Kipling Strategic Income Fund to have a shorter duration than the benchmark (1.91 vs. 5.34) and to have a higher yield-to-maturity than the benchmark (7.1% vs. 4.4%). In an environment where all interest rates move higher, the fund should outperform the benchmark due to its’ shorter duration and higher yield-to-maturity. In an environment where interest rates are unchanged, the fund should outperform due to its’ higher yield-to-maturity. In an environment where all interest rates move lower, the fund should underperform. However, the underperformance should be mitigated by the higher yield-to-maturity and should still be positive as all bonds would increase in value (all else equal). We think this is the best way to position the fund in the current environment.
*Cumberland and Cumberland Private Wealth refer to Cumberland Private Wealth Management Inc. (CPWM) and Cumberland Investment Counsel Inc. (CIC). NCM Asset Management Ltd. (NCM) is the Investment Fund Manager and CIC is the sub-advisor to the Kipling and NCM Funds. CIC is also the sub-advisor to certain CPWM investment mandates. This communication is for informational purposes only and is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. Any comments, statements or opinions made herein are those of the author and do not necessarily reflect those of Cumberland Private Wealth Management Inc. (Cumberland) and are not endorsed by Cumberland. The communication may contain forward-looking statements which are not guarantees of future performance. Forward-looking statements involve inherent risk and uncertainties, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. All opinions in forward-looking statements are subject to change without notice. Past performance does not guarantee future results. CPWM and CIC may engage in trading strategies or hold long or short positions in any of the securities discussed in this communication and may alter such trading strategies or unwind such positions at any time without notice or liability. CPWM, CIC and NCM are under the common ownership of Cumberland Partners Ltd. Please contact your Portfolio Manager and refer to the offering documents for additional information.