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Q: Briefly describe your strategy/strategies.
A: RP Investment Advisors is an alternative fixed income manager specialising in corporate bonds and active interest-rate management. We seek to generate positive returns through all phases of the market cycle with a primary focus on capital preservation. The Funds we manage fall into two categories – alternative strategies and core bond replacements. The former Funds are focused on relative value investing and the ability to short securities means we can fully neutralise interest rate risk. The Funds in the latter category are more “traditional” in the sense that they don’t use leverage, but they also have the tools available to manage interest rate risk in a dynamic fashion.
Q: How does your strategy add value for investors?
A: Credit markets are opaque and characterised by inefficiencies. A few minor technological innovations aside, the way bonds trade today hasn’t changed much since the 1980s. Securities change hands via bilateral negotiation rather than in an open and transparent marketplace, with limited post-trade disclosure. Different investors have access to different prices and liquidity terms, while information is often disseminated in an asymmetric fashion. We feel these inefficiencies represent an opportunity for expert investors to add value. The founding partners at RP Investment Advisors collectively have more than 140 years of experience in the bond business.
Q: Why should investors consider the alternative credit space right now?
A: This has essentially been a bull market for yields since the early 1980s – and over much of this period even passive bond funds have posted positive equity-like returns. Our view at RP Investment Advisors has been simple – it will be incredibly difficult to predict when yields will start to normalise, but when it happens it will happen very quickly.
Having said that, one thing we have felt certain about is that the risk-return proposition for traditional fixed income hasn’t made sense for quite some time. In the third quarter of this year the 10yr Government of Canada dipped just below 1% in yield. At that point, the instrument had a sensitivity to interest rates such that an increase in rates of 1% would have eroded more than 8 years of income! A trade-off like that simply doesn’t make sense from a long-term risk-reward perspective, in our opinion.
Against a backdrop where the traditional approach to owning fixed income doesn’t make sense, we believe alternative approaches start to look a lot more interesting. In our case, we proactively hedge out interest rate risk, and use our expertise in credit markets to take advantage of pricing anomalies and inefficiencies that are a structural part of global bond markets. We only invest in liquid securities, and look at bonds issued in different currencies as that broadens the opportunity set and we have the tools available to fully hedge currency risk.
Since the surprising result of the US election yields in North America have corrected violently. The risk-reward proposition from owning bonds has improved but still doesn’t seem compelling. The value offered by alternative credit managers should be apparent to investors when they look at monthly returns for October and November relative to the traditional, long-only credit space.
Q: How can a credit manager differentiate himself in this landscape?
A: In the kind of bull market for yields I mentioned above, it’s harder for good managers to demonstrate their skill or “alpha”. Generally speaking, almost all fixed income managers – whether active or passive, global or domestic – have posted decent looking returns over the last few years, so it’s a natural inclination for investors to think about investing in the lowest fee option as a way to get exposure to the asset class.
I’d make two comments on this. Firstly, when comparing managers, we feel it’s important not to just look at returns but also to gauge how much risk is being taken to generate those returns. The Sharpe ratio is a shorthand way of capturing how much return a manager is
RP Investment AdvisorsRP Fixed Income Plus, RP Debt Opportunities, RP Select Opportunities, RP Strategic Income Plus
Strategies Hedged credit, hedged rates
Firm AUM $3.3 billion
Strategy AUM Approx. $430 million, $1.15 billion, $300 million, and $630 million, respectively
Based in Toronto
Firm inception 2009
Speaking with Liam O’Sullivan, Partner and Portfolio Manager
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making per unit of risk. It’s not a perfect measure – it assumes returns are normally distributed which is often not the case in practice – but it’s a useful data point to consider, particularly for Funds that have existed through at least one full business cycle.
Secondly, it’s during periods of volatility and market distress when manager skill becomes most apparent. That will be the best opportunity for credit managers to demonstrate that they are able to protect investor capital and set themselves apart from the crowd. In the meantime it’s important for alternative managers to stay on strategy and retain discipline.
Q: Are bond markets becoming more or less efficient over time?
A: The notion of efficiency is an interesting one. On a macro level, year to date almost 1.2 trillion dollars’ worth of USD-denominated investment grade corporate bonds have been placed into the market. The market is clearly operating efficiently in the sense that it is allowing corporate borrowers to raise funds at competitive rates and allowing investors to put money to work in the asset class.
However, on a micro level our view is that there are intrinsic characteristics of the corporate bond market that make it resistant to standardisation and full transparency in the way equity markets are. Take TransCanada Pipeline Ltd as an example of a bond issuer. That company has a single stock which trades on the TSX at a price observable to all investors whether retail investor or sovereign wealth fund. Then consider the TransCanada Pipelines bond universe which has 70+ debt-like instruments. There are senior CAD bonds and USD bonds of various different maturities from 1yr to 30yrs. These instruments have a number of distinct and predominantly institutional buyer bases – typically money market funds for the short-dated securities, asset managers for the intermediate maturities and insurance companies for the longest dated instruments. Then there are C$ preference shares – some with floors, some without – generally owned by Canadian retail. In addition there are corporate hybrids outstanding issued out of two different entities – TransCanada Pipelines Ltd and TransCanada Trust. These are in many ways like preference shares but have tax-deductible coupons and are generally owned by US retail, asset managers and hedge funds. Disclosure as to where each of these instruments is trading varies across security type and currency.
In other words, in contrast to the one way available to invest in TransCanada stock, there are multiple ways to invest in the debt of TransCanada Pipelines, and the participation of so many different types of investor with their own investment restrictions and perceptions of value means the pricing of these different securities more often than not doesn’t make intuitive
Interview with Liam O’Sullivan, RP Investment Advisors, continued…
sense. For investors like us with the flexibility to invest across these various instruments, these persistent dislocations in value represent an opportunity to take advantage of mispricings, particularly in the funds where we can go both long and short.
Q: How have changes in bond market liquidity impacted your management style and strategies?
A: Bond market liquidity has received a lot of press in recent years but the reality is that liquidity has always been problematic in the bond market. One interesting aspect of liquidity is that it tends to move in cycles. Periods of stability tend to encourage banks to extend liquidity and firms to borrow more. This build-up of risk in the financial system makes the system more vulnerable to negative shocks, whereby liquidity can diminish quickly. So liquidity is ephemeral and cyclical by nature.
Without a doubt, post-financial crisis, the supply and demand dynamics of liquidity have changed. On the one hand, banks – the traditional suppliers of liquidity – have been forced by regulators to post more capital against market-making operations, so the cost of providing liquidity has increased for them. On the other hand, recent years have seen the proliferation of products such as ETF’s that are “demanders” of liquidity, particularly during periods of volatility. This combination of increased demand and reduced supply means liquidity is costlier than ever before. In practice, this means we can expect the enhanced volatility of asset prices to continue.
We look at this new liquidity landscape as an opportunity. Arguably, investors are better compensated for providing liquidity now than has been the case in the past. Enhanced volatility is also a source of opportunity for nimble and less constrained funds. In the long-short mandates, we manage we try to be positioned in such a way that we can provide liquidity when it makes most sense to do so – for instance, when an ETF is a forced seller of securities we like. In the bond replacement strategies we tend to construct portfolios with better liquidity characteristics than we may have chosen in the past. Above all, we don’t take liquidity for granted and when it is there we take advantage of it.
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Q: Record low interest rates and record high stock prices: who is right?
A: In a “normal” environment the correlation between stock prices and bond prices is negative for obvious reasons – the former asset being risky and the latter risk-free. Quantitative easing unleashed a flood of liquidity globally that found its way into all asset classes – not only stocks and bonds but also real estate and infrastructure. One by-product of this is that in recent times the stock-bond correlation has for extended periods actually turned positive. That phenomenon is problematic for investors who think that their 60/40 portfolio contains in-built diversification and downside protection. It is difficult at this juncture to say who is “right” – but it may turn out that as a result of unconventional monetary policy the answer is “both” or “neither”. That does not fit well with traditional finance theory.
Q: What do you see as the biggest risk over the NTM?
A: Within corporate credit, the most notable flow of the last few years has been global funds – both Asian and European –flowing into high quality USD-denominated credit. With the Bank of Japan and the European Central Bank both using quantitative easing to drive yields down, funds have been drawn to the higher yields to be found in the US credit market. This huge thirst for bonds has been sufficient to soak up large volumes of primary market issuance, as borrowers have returned money to shareholders via “balance sheet optimization” or embarked on M&A transactions.
In our opinion, anything that disrupts this seminal flow would be hugely impactful for credit markets – that could be a pick-up in foreign growth that leads to higher yields domestically for those buyers, a change in investment philosophy at these institutions, or pronounced weakness in the US dollar.
The second risk we’re mindful of is the risk of a rapid increase in yields acting as a destabilising force for credit markets, particularly given the amount of money that has flowed into fixed income products in recent years that is sensitive to capital losses (via ETFs for example). We monitor mutual fund and ETF subscription / redemption data very carefully to get a handle on the flows these investment products are experiencing.
Interview with Liam O’Sullivan, RP Investment Advisors, continued…
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The Scotiabank Canadian Hedge Fund Index returns are calculated using both an equal weighting and an asset-based weighting of the funds. The index includes both open and closed funds with a minimum AUM of C$15 million and at least a 12-month track record of returns, managed by Canadian-domiciled hedge fund managers. For more information about the Scotiabank Canadian Hedge Fund Index, including sub-index performance, constituents, and index rules, please go to gbm.scotiabank.com/hfpi.
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SCHFI Asset Weighted SCHFI Equal Weighted S&P TSX
S&P 500 DEX 91 Day Treasury Bill Index DEX Universe Bond Index
Global Banking and Markets Scotiabank Canadian Hedge Fund Index
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Calendar of Events
MARCH 2017
Scotiabank Prime Services Alternatives Summit featuring Curvature/CHS Asset Management, Edgehill, Picton Mahoney, RPIA, Vantage - Calgary
7
JANUARY 2017
Scotiabank Prime Services Alternatives Breakfast featuring Connor, Clark & Lunn, Polar, and RPIA - Toronto
24
FEBRUARY 2017
Scotiabank Prime Services Alternatives Breakfast featuring Alignvest, Picton Mahoney, Waratah - Toronto
28
JUNE 2017
Scotiabank Prime Services Family Office Roundtable featuring Ayal, Lumen, and Pine River- Toronto
14
APRIL 2017
Scotiabank Prime Services Founders’ Summit featuring Crystalline, Connor, Clark & Lunn, Kawa Capital, Polar, Waratah, and others TBD- Montreal
25
MAY 2017
Scotiabank Prime Services Founders’ Summit featuring Connor, Clark & Lunn, Gluskin Sheff, Kawa Capital, Polar, Waratah, and others TBD- Toronto
31
JANUARY 2017
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Prime Services Contact InformationJulie CowanManaging Director and Head, Canadian Prime Services Sales and Capital Introduction [email protected]+1.416.945.4402Toronto
June Anne ReidAssociate DirectorCapital [email protected]+1.416.945.6717Toronto
Judy TredgettAssociate DirectorCapital [email protected]+1.416.945.4156Toronto
JANUARY 2017
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