Norrep Credit Observations

July 18, 2016 Bill Holy MBA, CFA

Market Update
The rally in high yield bonds and loans experienced since mid-February was interrupted temporarily in June as the surprise decision by UK voters to leave the EU brought political and fundamental uncertainty. Global growth concerns also resurfaced as the month progressed, and oil prices experienced volatility. However, fears of a spike in volatility eased in the final days of June, as central bank policy appeared to turn decidedly dovish (and therefore easing concerns it would present an additional headwind to global growth). The S&P/TSX and S&P 500 rebounded in the week following the UK referendum vote, effectively erasing earlier losses. Post-Brexit, losses for high-yield bonds and loans were limited (the BofA Merrill Lynch U.S. HY Inde and the Credit Suisse Leveraged Loan Index were both essentially flat from close of June 23 to June 30). Despite the risk-on trading environment, government bond yields barely moved after collapsing post Brexit; 10yr U.S. Treasury yields of 1.47% remain within range of the record low of 1.39% in July 2012 and were down 38bp in June alone.

Total returns for U.S. and Canadian capital markets are ;positive for year-to-date (YTD) 2016 across most asset classes. This is due to the reversal of a general downward trend in economic data for the better part of a year, stabilization or improvement of commodity prices following a period of decline, increasingly dovish central bank plans in several jurisdictions, easing fears of interest rate hikes.

  June YTD / QTD
B of A Merrill Lynch U.S. High Yield Index (HOAO) 1.1% 9.3% / 5.9%
B of A Merrill Lynch Canada High Yield Canadian Issuers Index (HCCO) 1.9% 8.4% / 6.4%
S&P/LSTA Leveraged Loan Total Return (LLI) 0.0% 4.5% / 2.9%
S&P 500 Total Return 0.3% 3.8% / 2.4%
S&P/TSX Total Return 0.3% 4.5% / 2.9%
  Dec. 31, 2015 Jun. 30, 2016
U.S. 10-Year Treasury Yield 2.3% 1.5%
CAD 10-Year Treasury Yield 1.4% 1.1%

High yield bond returns in both the U.S. and Canada have rebounded sharply since early to mid-Feb., and prices surged through the end of May. Spreads for the U.S. HY index tightened from almost 900 bps over U.S. treasuries in mid-Feb. to approximately 550 bps over U.S. treasuries at the end of May. In June, while returns remained positive (+1.1% in the U.S. HY market, and +1.9% in the Canadian HY market) they failed to maintain the pace of the prior 3 months, primarily due to fears and uncertainty caused by the Brexit result.

The YTD performance was generally broad-based, but those bonds and sectors who suffered the most in the 2015 and early 2016 downturn have rebounded the highest YTD (e.g. Mining +26.2%, Energy +22.5%, CCC rated or lower bonds +18.6%) and longer duration names.

Outlook and Fund Strategy
As of June 30, 2016, Norrep Short Term Income Fund had an internal weighted average current yield of 6.3%, with a modified duration of 2.3 years. Approximately 63% of the Fund was invested in investment grade and high yield bonds, while 32% was invested in loans.

At the end of June, Norrep High Yield Class fund had an internal weighted average current yield of 7.9% with a modified duration of 2.7 years. Approximately 73% of the Fund was invested in high yield bonds while 16% was invested in loans. Please see the monthly fund summaries for complete performance statistics.

We believe the high yield market to be fairly valued, with yields near or slightly above the long-term, historical mean. We could see yields increase over the next six months due to a variety of factors, namely: Leverage across the market is rising, YTD new high yield issuance decreased significantly (-36% year-over-year), and the future direction of energy prices. These factors are potentially offset by the dovish stance of the Federal Reserve and the expectation that rates will stay the same until at least December. Expect the remainder of the year to have coupon like returns with potential for capital appreciation coming from tactical positioning that takes advantage of the above mentioned factors.

In Norrep Short Term Income Fund we continue to hold shorter dated names and 1st lien term loans, both of which have shorter durations. These should buffer against any rise in defaults and / or flight to quality while mitigating the impact of rate rises if and when that occurs. In Norrep High Yield Class, we continue to add higher quality names due to the risk factors listed previously, while keeping duration low. We also hold a reasonable amount of cash (10%) which we will tactically deploy to take advantage of any volatility. We continue to believe the funds are well positioned to weather a downturn, and to prosper in buoyant markets.

About The Author

Bill HolyPortfolio Manager, Fixed Income - Cumberland Investment Counsel Inc. Affiliate of NCM Asset Management

Bill is a Portfolio Manager in fixed income, co-manages NCM Short Term Income Fund, and is part of the asset allocation team for NCM Pension Portfolios. Bill is a CFA charterholder, holds a Master of Business Administration from the Rotman…

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