In September, the U.S. Federal Reserve made a bold move by cutting the federal funds rate by half a percentage point. The central bank acknowledged that while economic activity is expanding solidly, job gains have slowed.
U.S. inflation eased to 2.5% in August, but the core measure, which excludes food and energy costs, is still above 3%. Rising tensions in the Middle East could also affect the Federal Reserve’s plans to cut interest rates. In addition, the upcoming U.S. election poses a challenge, as both candidates are unlikely to be committed to prudent fiscal policy.
North of the border, the Bank of Canada cut its overnight rate to 4.25% as economic activity weakened. The central bank is cautious about the slower pace of hiring combined with elevated wage growth. Headline inflation has slowed further to the bank’s 2% target, but core inflation remains higher.
Bond markets rallied over the period as interest rates fell across the government yield curve. Longer-duration indices benefited most from the decline. In parallel, corporate credit spreads tightened further in the third quarter. They have made a positive contribution on a year-to-date basis.
Corporate Bond Strategy
A decline in yields and tighter corporate credit spreads positively impacted fixed income markets in the third quarter. Pembroke’s Corporate Bond Strategy returned 3.25% in the quarter. However, this strong absolute result lagged the benchmark return of 4.7%, which benefited from a longer duration.
Positive contributors to the portfolio included Avis, Corus and Hertz, along with limited recourse capital notes that continue to drive year-to-date outperformance. Year-to-date, the portfolio is up 6.67%, ahead of the benchmark by 0.79%.
Overall, the portfolio’s credit quality improved as it reduced high yield issues and corporate floating rate notes in favour of AAA-rated National Housing Act Mortgage-Backed Securities and Canada bonds. Floating rate holdings dropped by 20.3%, ending the period at 8.4%, while the Federal Government weight increased by 17.3%, ending the period at 41.3%.
Proceeds were primarily reinvested in five to seven-year Canada bonds, increasing the midterm cohort by 17.3%. As a result, portfolio duration also increased by 1.5 years, ending the quarter at 3.6 years, still meaningfully below the benchmark duration of 5.8 years. Falling interest rates and a move to higher quality holdings reduced the portfolio yield to 5.4%, which remains above the index by 1.3%.
The strategy continues to hold select high yield issues that are well structured and remain attractive from a risk-adjusted perspective. It is postured conservatively with emphasis on liquid and high-quality instruments, such as Government of Canada bonds and National Housing Act Mortgage-Backed Securities, which can be used to fund future credit opportunities.
Canadian Bond Strategy
Pembroke’s Canadian Bond Strategy returned 4.47% over the third quarter, slightly underperforming the benchmark return of 4.67%. Positive contributors included long-dated issues from Coastal GasLink Pipeline, Hydro One, Enbridge and 407 International. Limited recourse capital notes continue to be a driver of outperformance on a year-to-date basis. The portfolio’s year-to-date return of 4.68% is 0.41% above the benchmark.
The strategy extended duration by 0.8 years through a reduction of the allocations in short-term and floating-rate securities. Despite the increase in duration over the period, having a shorter duration than the benchmark during a period of falling yields detracted from performance.
As a result of falling interest rates, the strategy’s yield fell by 0.6% to end the period at 4.0%. It remains 0.5% ahead of the index. The strategy is conservative, with a focus on liquid, high-quality instruments, such as Government of Canada bonds and National Housing Act Mortgage-Backed Securities, which can be used to fund future credit opportunities.