On the Money with Dynamic Funds

PARTICIPANTS

Jeremy Lucas
Vice President and Portfolio Manager

Tom Dicker
Senior Portfolio Manager

Speaker 1: You're listening to On The Money with Dynamic Funds. From market insights and analysis to personal finance, investing, and beyond, On The Money covers it all, because when it comes to your money, we're on it.

Tom Dicker: Welcome to another edition of On The Money. I'm your host, Tom Dicker, Vice President, and Senior Portfolio Manager on the Equity Income Team. Today, we're going to talk about what specialized credit is, where the opportunities and risks are in fixed-income markets after 2023, which was just full of surprises. We have with us today, Jeremy Lucas of Dynamics Specialized Credit Team.

Jeremy is Vice President and Portfolio Manager and has over 20 years of experience in fixed income, including the last seven, working with Marc-Andre Gaudreau and team at Dynamic. Prior to working with us, Jeremy worked on the sales side at Scotia Capital on everything from fixed income to energy derivatives, and before that was an accountant at Ernst & Young. The Specialized Credit Team at Dynamic manages a number of fixed-income funds, and they also manage the fixed-income portion of many of our balance funds, including Dynamic US Strategic Yield. Jeremy, welcome.

Jeremy Lucas: Thanks, Tom, and thanks for having me.

Tom: For many listeners, the different areas of fixed income are a little unclear, especially for equity people like me. Can you just start with the basics? What is specialized credit?

Jeremy: Everything that is not a traditional fixed-income product. From an asset class perspective, you'll find us in preferred shares, high yield, loans. Then also we work on structures or mandates that may not necessarily be what you would consider core credit. We'll be involved in discount bond mandates. We'll be involved in mandates that are multi-asset class that will involve high-yield loans, investment grade, and preferred shares, and different structures, levered mandates that are designed to isolate the attractive nature of fixed income and generate returns for our clients.

It's everything that is not captured in a traditional fixed-income format. When you think also about our style in specialized credit, one of the things I always like to point out to our clients is we're very much rating agnostic. We ignore the rating agencies in our approach for the most part. We do our own fundamental work. Ratings, in fact, drive a lot of alpha for us because we can often find opportunities where valuations are skewed as a result of a rating from a third-party rating agency that we may or may not agree with. It's all those elements blended together that drive what we do in the specialized credit team.

Tom: Given that you're doing things that don't sound very indexy and non-traditional, how do you think about evaluating your returns? Do you put yourself against a benchmark? Are you agnostic to benchmark, similarly to the way you are with rating agencies?

Jeremy: Some of our mandates, for example, our standard high-yield bond fund would be very much evaluated against its high-yield benchmark. It's specifically designed to target that asset class, and we're looking to drive alpha over that particular benchmark. In those cases, we do look at the bench and consider the risk-reward in our mandate versus the bench. In other mandates, we are generating or looking for absolute returns. Our new liquid alt products, Dynamic Credit Absolute Return Fund, and our new Dynamic Credit Opportunities Fund would be focused on generating absolute returns.

Completely un-benchmarked, 100% focused on absolute returns over a market cycle. Then some of our mandates will be a little bit more specialized in terms of the niche that they target. Our ETF, the Dynamic Active Discount Bond Fund, or ETF, that particular mandate is focused on discounted price bonds within the three to seven-year part of the credit curve. That's focused entirely on bonds that are, by definition, not entirely within the benchmark or a subsector of that part of the benchmark. It really depends on the type of mandate that we're looking at whether we're looking at relative returns or generating absolute returns.

Above all, whenever we're looking at it on a relative or an absolute basis, our overarching guiding principle would be to evaluate the risk-reward of the particular investment in the context of generating returns for clients.

Tom: You brought me exactly to my next point, which was, is specialized credit more risky or less risky than traditional fixed income investing?

Jeremy: Depends. If we dial back to 2022, if you were in traditional fixed income, you were looking at eight years of duration and yields in the low single-digit range. You weren't getting paid a lot for the type of risk you were taking, the type of sensitivity you were taking to a change in rates. Of course, as stagflation rooted itself within the economy, traditional fixed-income products had a terrible year of 2022. Our liquid alt, Dynamic Credit Absolute Return Fund, generated a positive return in 2022. This is by structure; it doesn't take any interest rate risk.

We hedge out all of our interest rate risk and just isolate credit spreads. There's an example where a traditional fixed-income product, in our view, was riskier than our Liquid Alternative. It really does depend by asset class and the individual returns you're targeting as to whether or not you're looking at a riskier proposition. Another example might be high yield. If we're looking forward and thinking about a growth shock in the economy, lagging impacts of rising rates slowing down growth through the economy, that probably will have a bad outcome for high-yield credit spreads.

A growth shock might be a terrific outcome for traditional fixed-income products as rates plummet and traditional fixed-income products rally. It depends on the context and the mandate to answer that question. Generally speaking, risk is something that we manage actively through all of our mandates. We're looking at the reward offered by our investments and the risks that we're taking, how tight are credit spreads relative to our view of the macroeconomy? How tight are they relative to their historical ranges? Are we getting paid appropriately for the risk? Then what actions can we take to mitigate that risk to improve the overall returns for our clients?

Tom: What I'm getting is that specialized credit, it's another very broad tool in the toolbox. It sounds like it's in many ways a complement to traditional fixed income investing. Is that traditionally how you've positioned yourself? Exactly.

Jeremy: Yes. There's plenty of room for traditional fixed income in one's portfolio. You might argue that today, with rates where they are, the 60-40 portfolio has never been more relevant. We would make a counterargument to that if we go back to 2021 when rates were de minimis and you were incurring a lot of duration risk. The point of specialized fixed income is to complement your existing traditional fixed income portfolios and add some enhancements perhaps to the overall return profile mix within your portfolio construction.

Tom: Can you just give us a bit of history of what's happened in credit markets and fixed income markets over the last couple of years and how is the market positioned right now?

Jeremy: To answer that question, I'd like to go all the way back to the global financial crisis in 2008. If you think about what happened in the response after that crisis, we had massive stimulus, very loose monetary policies, quantitative easing, price suppression, yields were on the floor. It was a very hard time to scratch out decent positive returns in fixed income. Investors were forced further down the risk curve in order to generate a return. Issuers during that time period took advantage of investors. They issued bonds at very low coupons.

I think the record for the lowest coupon in high yield was 2 5/8%. We were not getting paid a lot for the risks that were being taken. Issuers were taking this money and they were doing things that were not in alignment with bondholder objectives. They were paying out massive dividends, buying back stock or entering into risky growth capital projects. The punishment, if they got it wrong, was not very big because the Fed was there to bail them out. Their balance sheet, their fixed charges, their cost of capital were tiny. They were getting away with a lot of bad things in the eyes of bondholders.

As we go through COVID and the post-COVID world with an inflationary cycle through 2022 and with investment grade yields in the mid-upper single digit zone and high yield in the higher single digit zone, all of a sudden, the return on capital or your cost of capital has skyrocketed. What we've seen more recently is incredible alignment with stakeholders. Bondholders and subordinated stakeholders like equity holders are on the same page. It's all about de-levering your balance sheet, paying down debt, getting rid of high cost coupon debt.

If you get it wrong or you invest in a risky growth capital project and you lever yourself up to do so, there's enormous risks attached to that. The Fed is no longer there to bail you out as an issuer. Investors aren't there with very low costs of capital to help fund your mistakes. We're finding this alignment between stakeholders to be at an all-time high, the highest I've seen it in my career. It's a wonderful thing from a credit perspective, because a lot of our exposures, a lot of our bonds that we own in our portfolio, they're actually improving. They're de-levering, they're paying down debt, they're using free cash flow to improve their balance sheet.

It's encouraging as a bondholder to see that. A 180 degree difference from where we were only a few short years ago.

Tom: Issuers were, not to be too hyperbolic, but they were getting away with murder for a long time. Then as the Fed policy changed, you're seeing behavior change itself. Are you getting paid less as the risk has gone down?

Jeremy: We measure what we're getting paid in risk in terms of credits spread. All in yields. The yield is a combination of the risk-free rate, the government of Canada or U.S. Treasury rate, plus a spread on top of it to compensate us for the risk premium attached to investing in a corporate issuer. Credit spreads are actually at a very low level as it stands today. This is all following the Powell pivot of late 2023. The markets went through a significant rally. Credit spreads tightened because investors were rejoicing the fact that the Fed was apparently done with its rate hiking cycle, and nothing seems to be broken yet.

Everyone's in a euphoric mode. To answer your question about whether we're getting paid for the risk as it stands right now, I'd argue that has deteriorated. At the same time, the issuers themselves are still in a path of improving because the all-in yields are still quite high. They're still motivated to improve their balance sheets, pay down debt, and de-lever. From a credit spread perspective, the returns just aren't as good as they were. We saw some wonderful returns post-COVID. We saw some wonderful returns in 2023. At the end of 2023, as we look at forward-looking yields and spreads, we're getting a little bit more concerned now with the degree of compensation we're getting for the broader macro-economic risks that may still be lurking out there.

Tom: Are you positioned accordingly? Have you shortened your duration? Have you taken the quality in the portfolio up?

Jeremy: The number one thing is improving quality in the portfolio. We've high-graded portfolios. We look at our high-yield mandate. We own virtually a very small amount of CCC issuers. The ones that we do own are extremely well-researched names that, frankly, I would disagree with the rating agency that that should be rated CCC. I often disagree with rating agencies, Tom, as you know. In our liquid alternatives, we have positioned the mandates to trade short credit. We are buying protection on investment-grade credit spreads. We are shorting single-name bonds that we think have the potential for spreads to move wider.

All of this, in our minds, is putting the fund in a position to benefit from a growth shock that we think could come from the lagging impact of the rising rate environment. Keep in mind, we went from zero to five in rates in a very short period of time. It takes time for that to find its way through the economy to slow down the economy. It's been a real shock higher. The question to whether or not we're going to have a soft landing has yet to be answered. Consequently, our positioning has been changed materially to reflect the uncertainty that we think is still out there.

Following Powell's pivot in late 2023, it's as if he's flying a plane. He started to position the plane to come down out of the sky. He's lowered the flaps to slow the plane down. He's got the air brakes on. He's about to lower the wheels. We haven't landed yet, and everybody in the back is applauding. In our minds, it's a bit early for the markets to be euphoric with valuations. Consequently, we've raised the defense levels up in the portfolios.

Tom: In light of that, do you think it's still too early to tell whether or not we're going to have multiple rate cuts in 2024?

Jeremy: It's still too early to tell. If you think about either side of those rate cuts, we have a mid-single-digit number of rate cuts that are priced in. What happens if that's too high? It probably means inflation didn't come down as quickly as everybody was thinking, or it means that everyone overpriced in the Fed rhetoric, and the Fed started to walk back their rhetoric, started to coach the market back towards a lower number of cuts. I'd be concerned about risk asset valuations in that type of scenario. Conversely, what happens if we get a lot more rate cuts? It's probably because something went wrong. It could be because that growth shock showed up all of a sudden. We're walking this tightrope. We're walking the soft-landing tightrope. It's a pretty steep fall on either side in our minds on valuations. Consequently, again, that's driving that defensive positioning stance.

Tom: It sounds like the market is pricing in a Goldilocks type of environment. You're saying, "Well, there's still a fair bit of risk later in the year." You've made the portfolios much more defensive.

Jeremy: Correct. Going back to the early comments at the beginning of the podcast related to our conversations around risk and reward, we're looking at what we think is priced in and the reward attached to what we think the risks are out there in the economy. To give you an example, BB spreads, which is half of the high-yield market. Half of the high-yield market is rated BB. Those spreads are trading today at the tights, the historical all-time tightest level they've been. Single B's represents another 40% of the high yield market also at the tights.

Being defensive isn't exactly all that costly. I'm not getting paid to take significant amounts of risk. We're really evaluating that whole scenario, the entire macroeconomic backdrop from the perspective of risk-reward. In our minds, the risks are asymmetrical to the downside. It doesn't get that expensive to be defensive in this market today. Consequently, that's driving it. That's informing our decision-making.

Tom: Could you talk a little bit about the case for not a whole lot of rate cuts because inflation remains pretty strong? How do you think about that scenario and how would you probability-weight that versus the other scenario where things get much worse? The Fed has clearly tightened too much, we have some sort of accident. How do you think about the probabilities and what will cause those scenarios?

Jeremy: Yes, I wish I had a crystal ball, and I could give you a real concrete answer here. I think it's important that we're honest, which is we don't really know. If I was to probability-weight it, I'd skew it towards the growth shock, the recessionary environment. I think inflation, it's pretty clear there's a lot of forces that are now talking about deflation. It's definitely a lot easier to talk about deflation than it was two years ago. To go back to an inflationary or a stagflationary environment, it's probably a lower probability than in our minds, a recessionary or a growth shock where the lagging impact of a rising rate environment we're all currently living, that starts to manifest through the economy.

It's going to happen in certain jurisdictions before others. In our minds, Canada will go through a growth shock a lot earlier than the U.S. Canadians are just simply more sensitive to rates as it stands today than Americans, given the structure of our housing market. I think we'll start to see this in the economic data. We'll start to see this in the employment data. That's the last shoe to drop, is employment. When we start seeing employment data slow down, we know that that potential for a recession is around the corner. That's more near-term in our view in terms of the potential for that to occur.

Tom: Big picture macro views like that, when you're thinking about that across your team, how do you guys work together and how do you guys come up with your top-down macro view? Are you more bottom-up investors or top-down?

Jeremy: We're both. Our team works really well together as a meritocracy. We're led by Marc-André Gaudreau. We have wonderful debates and discussions as we punch ideas around and think about our portfolio construction and the risk rewards in the various asset classes that we're investing in and the various structures that we're deploying capital through. When it comes to top-down versus bottom-down, we're a mix of both.

We're very valuation driven. When valuations get to a point where we're concerned that there's not much more upside, and we're also looking at our macroeconomic picture and saying, "We've got some big questions about how the next few years will play out," all of a sudden, we start to get more defensive as a team and the convictions in getting more defenses as a team grow. Conversely, if we look at April 2020, which was a wonderful time to take exposure, we had just come through COVID. There was significant dislocation in the market, lots of panic. In that realm, we were looking at significant loose monetary policies.

The Treasury, they were buying back high-yield bonds. There was an incredible amount of government support. Our team was able to position itself with a high degree of conviction about getting along the market and getting exposed to attractive credit spreads because we viewed the risk-reward to be skewed in our favor. That's not how we look at the risk-reward today. Right now, the debate is really a mix of looking at the top-down risks, the macroeconomic risks, coupled with, I would say, the improving credit fundamentals that we're talking about where issuers are trying to pay down debt.

Tom: Can they de-lever quick enough?

Jeremy: Before the macroeconomic wave consumes them? That's the big debate that we're having on the team.

Tom: How do you generate ideas like the one you had to really invest heavily in the market and make a big call at a time like that?

Jeremy: I'm a big fan of having our entire team build and maintain an investable set. You need to have issuers that you've been following for decades, for years. You're having quarterly update calls with the management team. You're meeting them at conferences. You're looking at industry-related news that's helping to inform you about how they're performing. This is this inventory of names. Your job as an investor is to pull from that inventory at various points in time. If I want to be more defensive, I have my names and my issuers that are defensive that actually will perform in a growth shock.

If I want to get more aggressive, I have my issuers that are a bit more levered. They may have a little bit more torque to the broader economy. I can pull from that investable set. How are you looking at the macro, the individual valuations, and then what makes sense within that investable set? Right now, I'll give you an example, the things that we're looking for, we're very defensive. That doesn't mean that we've sold everything. That means that we've skewed our portfolio to issuers that have de minimis amounts of debt, that have what we call high nuisance value debt. There're some existing bonds that are still out there that were issued during the panic of COVID.

They've got huge coupons and massive structural advantages for bondholders. Covenants, and off-market covenants and collateral. These bonds are very attractive. They'll perform very defensively and they're of a significant nuisance value to the issuer. Meaning that the issuer is looking to take these bonds out at a premium to current market valuations. They want to get rid of the nuisance. I like being a nuisance. I like investing in nuisances because it means that there's alpha there and they have very low correlations to the broader market.

I look at these securities with collateral and structural seniority and covenant terms that are off-market and in my favor as a bondholder and I view them as extremely defensive positions that help to protect capital in a growth shock.

Tom: Does that apply as well to the short side? Do you keep a large investable set on the short side?

Jeremy: Oh, absolutely. This is currently, our favorite topic, talking about our shorts. Credit is an interesting asset class because if you think about the risk-reward, I give an issuer all our money at the beginning of our investment in that particular bond, the issuer pays us a small coupon defined contractually over the life of the bond, and at the end, at the maturity, we get all our money back. Our risk reward is skewed. Our upside is capped. It's effectively the yield of the bond is our upside. That's as good as it's going to get. There's moments where maybe if the yield goes down, we can generate capital gains.

Obviously, that's what we're trying to do. For the most part, if you just held its maturity, you're going to get the yield in the absence of a default, and that's fine. We give up that convexity or that upside in return for a structural senior position to equity holders. If we look at shorting an instrument, we can flip that relationship, that lack of upside relationship on its head, and we can short a bond. Now we're the ones paying the yield to whoever bought it. That is our max it's going to cost us. It's just that yield. That cost of borrowing, cost of shorting the bond is just the yield.

We know our downside is capped now, but our upside is potentially 100% if the bond goes to zero through some form of a default. When the market's rallied as much as it has at the end of 2023, and certainly here we are in early 2024 with credit spreads at near all-time tights, it's a wonderful time to start shorting credits that we think have the potential to deteriorate. This is what we're layering into our liquid alternatives, Dynamic Credit Absolute Return Fund and the new Dynamic Credit Opportunities Fund. We're layering in shorts. The shorts are an exciting part right now of our liquid alternatives.

Flipping the risk-reward of credit on its head to your advantage is one of the most wonderful things you can do when you're looking at shorting bonds.

Tom: It sounds like there's a lot of opportunity in the short market. How about on the long side? What are the areas that you're focused on the long side right now?

Jeremy: Sectorally, we're still a very long energy. In particular, we're overweight and long Canadian energy producers and midstream and oilfield services. In my view, this is an area of the market where rating agencies are lagging, the improvement in these particular issuers. Also, when I look at the balance sheets, there's not much left. The energy sector has de-levered materially. You want to be involved as a bondholder in a de-levering sector. In our view, the stakeholder alignment, the improvement in the balance sheets, and the continuous improvement that we're seeing in the balance sheets in this sector is a great place to generate alpha.

We like the Canadian names because, frankly, they have lower decline rates than their U.S. peers. In our view, they're a little bit less aggressively managed, so the stakeholder alignment is even higher. There's a sector that we think there's terrific long ideas. The nuisance value securities, there's a lot of potential there. Our Dynamic Credit Absolute Return Fund has some exposure to nuisance value securities. Our new Credit Opportunities Fund, now roughly, half the mandate is currently invested in what we would call nuisance value securities, where we're expecting takeouts at a premium to current market values.

Then finally, we're skewing ourselves towards high collateral type of positions. I'm a really nice person, but if you don't pay us back, I get a little bit ugly. We have legal means to enforce our claim on a company's asset. If you put a lien, so if I invest in a bond that is secured by assets, what we'll do is we'll send in the local sheriff and put a padlock on the front door until you pay us back, plus our accrued interest. There's a lot of defensiveness in secured credit. We've made some large weights there in our mandates as we think they've some low-hanging fruit and decent returns.

I really like discount price bonds. If you think about what the Fed did to us post the GFC and pre the bond bust of 2022, we lived in that world of terrible coupons. Those bonds are all still out there. The difference is they're now yielding a lot higher than they were when they were issued at a low coupon back in the day. What that means is in order to get that high yield with a low coupon, the bond prices are trading at enormous discounts. From a fixed-income perspective, it's driving capital gains. Those bonds will mature at par, and they may be trading at 85, 90 cents on the dollar.

A lot of your return profile looking forward with those discounted price bonds is actually going to be driven by tax-efficient capital gains. We think it's a great place, low-hanging fruit for investors to take advantage of today.

Tom: You talked earlier on in the podcast about rating agencies and about how you're ratings agnostic. Can you talk a little bit about the good and bad of rating agencies?

Jeremy: I often talk about rating agencies as being our best friends. The reason is that in fixed income and in credit in particular, there is a massive amount of capital that blindly follows rating agencies, whether it's passive index funds, whether it's closet indexers. There's a considerable amount of capital that blindly follows rating agencies. In my view, rating agencies are a terrible means to deploy capital. For an active manager, it creates these wonderful opportunities to generate alpha. Ratings tend to be lagging the fundamentals not by months, but by years. It takes them forever to change the rating depending on as an issuer's fundamentals change.

Not only that, they're conflicted. The rating agencies are paid by the issuers to rate them. You've got this conflict of interest. You've got this lagging rating methodology. Yet all of this capital follows it blindly. If you're active and you're using your fundamental process coupled with your top-down view to determine which credits make the most amount of sense, you can generate significant alpha from the valuation dislocations that are caused by rating agencies. An example would be an issuer who's investment grade and gets dropped into high-yield. Typically, that involves a wave of force selling as investment grade mandates can't hold high-yield.

This issuer might be a great issuer, not going to default anytime soon. In fact, they're never going to default, but just because it went from BBB to BB doesn't mean it's the end of the world. Often when they do that, management has this moment where they say, "I really want to get back into investment grade. We're going to start de-levering and paying down debt." That's the point in time when they actually start improving their fundamentals. Yet credit spreads have widened materially because all this passive capital is selling these bonds indiscriminately.

For an active manager like our team, it's a wonderful way to generate alpha and generate returns for our clients. That's why rating agencies are our best friends. They create the opportunities for our investors.

Tom: Thanks very much, Jeremy. I think that was a wonderful conversation about specialized credit and fixed-income investing. I really appreciate it. Thanks to all our listeners. Again, this is another edition of On The Money. On behalf of all of us at Dynamic Funds, we wish you all continued good health and safety. Thanks for joining us.

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