To the Limited Partners of the Ewing Morris Flexible Fixed Income Fund:

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In 2021, the Flexible Fixed Income Fund Returned 8.3%.  Since the Fund’s inception in early 2016, it has delivered a compound annual return of 7.1%.
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This return compares to our long-term return expectations of 5% to 7% and our publicly traded high yield and investment grade benchmarks, which in 2021 returned +3.6% and -1.8%, respectively. 2021 was a very solid year for the Fund; overall, there were many sources that drove returns in the Fund, with the unifying theme being idea-specific value add, which was punctuated in a handful of positions producing outsized results in the year. In addition, contributions came from both long and short positions, as was well-evidenced by the Fund’s positive performance in November, when credit and equity markets saw a notable correction on the back of the Omicron variant’s proliferation.

Performance reflects Class P- Master Series, net of fees and expenses. Inception date of the Fund is February 1, 2016. U.S. High Yield Bonds are represented by the iShares U.S. High Yield Bond Index ETF (CAD-Hedged). Canadian Investment Grade Bonds are represented by the iShares Canadian Corporate Bond Index ETF.

The largest contributors to performance in 2021 were our investments in securities of Ziff Davis and Shaw Communications.

Since the mid-summer of 2020, we have owned a conviction-sized position in the convertible bonds of Ziff Davis (formerly known as J2 Global). Ziff Davis has been a staple of our equity strategies and one of the top-performing underlying businesses that we own at Ewing Morris. As we have been well-acquainted with the company, we were able to take full advantage in mid-2020, when an opportunity arose to enter the company’s convertible bonds at a record discount to par (the bonds traded as low as 77 cents on the dollar). Throughout 2020 and 2021, Ziff Davis has grown its earnings ahead of street and investor expectations by a wide margin, benefiting its convertible bonds which over the last year, has traded from a 103 dollar price to end the year at 122. Currently, the company is growing revenue organically in the low teens and, net of its cash and investments, has effectively no debt. In addition to its strong growth profile, the quality of the company’s earnings is excellent; Ziff Davis expects to convert 60% of its EBITDA into free cash flow. Despite these excellent attributes, Ziff Davis trades for less than 10x EBITDA. Similar digital media businesses frequently fetch multiples exceeding 15x. In our view, the investment opportunity in Ziff Davis’ bond is excellent, and what we like most is the location of the strike price of the security: $107. With the stock itself around this same price, the bonds would participate in the upside potential of the stock, yet the bonds ultimately have limited downside to par at its 2026 maturity.

In the case of Shaw Communications, we took advantage of purchasing the company’s Class 2 Preferred Shares in March, following the announcement that Rogers Communications had agreed to buy Shaw. We built our position over the first three days following the announcement. Our success with this investment was a function of several things. First, we had a solid familiarity with similar precedent transactions of this kind. A similar situation that immediately came to mind was Lowe’s acquisition of Rona, where we successfully monetized Rona’s preferred shares in the context of that deal in 2016. Second, our fund’s relatively nimble size allowed us to attain our desired position size quickly. Third, our ability to glean insight into the legal structuring and funding nuances of the transaction allowed us to conclude that there was a high likelihood that Shaw’s preferred share issue would be redeemed at its optional June redemption date at a price 25% higher than the price at which we were able to accumulate our position in March. What we liked best about the situation is that the thesis did not actually rely on the greater corporate transaction closing. We will continue to look at opportunities such as these when they arise in the Canadian preferred space as we are continually surprised to see marked deviations between price and value in relation to corporate transactions.

Everybody’s Talking About Inflation: Not a Friendly Investment Character

Inflation is the principal macro-level risk we see in today’s pricey fixed income market. While speculation about future inflation is fraught with error, there is high investment risk associated with a complacent view at today’s level of interest rates. Our thinking is that, contrary to central bankers’ public narrative, inflation has a risk of becoming less anchored than most would like. This is a concern because we are observing whole markets of fixed income securities - mainly securities residing in the investment grade space - that we expect to realize guaranteed losses of purchasing power over their investment life.

Our risk assessment is informed by both valuation risk and fundamental risk. From a valuation perspective, it is easy to make an argument that a 2% rate on a 30 year US Treasury bond does not adequately compensate investors when monetary policy itself seeks to achieve a 2% inflation rate.

From a fundamental perspective, there are some very deep-rooted inflationary factors emerging. Declining international trust and consumer expectations for inflation are two factors we see that are among the most important.

Lower Trust = Higher Inflation

It turns out that changes in trust between nations produce economic consequences. Increasing trust is deflationary and decreasing trust is inflationary. The reason for this is that trust is a prerequisite for ongoing trading relationships. If trust between countries declines sufficiently, the countries will eventually look to in-source the goods or services they are seeking. The production of formerly imported goods or services are brought back into countries that are not best suited to produce them and thus have higher costs of production. This simple change is quite obviously inflationary. Furthermore, history tells us the tides of geopolitical trust are measured in decades and not in years. We would not define a multi-decade dynamic as “transitory.” The reality is that the deflationary effects of globalization we have enjoyed for decades are indeed reversing. For example, in the semiconductor space, for the first time in more than two decades, TSMC is building a fabrication plant in the US at the cost of 12 billion dollars. In late 2020, China officially put a blockade on coal from Australia, relying on higher cost supply from its own domestic production and other trading partners. This is not a dynamic we expect to show up in inflation numbers in the short term, but this is the type of inflation that interest rate hikes may not be able to moderate.

Higher Consumer Inflation Expectations = Higher Inflation

A very pernicious driver of inflation is the mere expectation of higher inflation. For this reason, it’s not a surprise to us that the Federal Reserve downplayed inflation effects as “transitory,” given that there’s no upside in setting persistently higher inflation expectations. The canaries in the inflation expectation coal mine are “cost-of-living-adjustments” embedded in labor contracts. These COLA provisions contribute to a “wage-price spiral” and durable inflation. And we are seeing COLAs take root once again. In November 10,000 union workers at John Deere successfully negotiated quarterly inflation adjustments in addition to a 10% raise, two 5% raises and two large bonuses through 2026. Unionized employees at Kellogg also recently ratified a labor contract with COLA provisions. Finally, in a thoroughly ironic development, central bank staff are arguing for more pay based on inflation as a Bloomberg headline recently read: “ECB Staff Union Demands More Pay to Guard Against Inflation.” Developments like these may be hair raising for central bankers and fixed income investors alike.

What Inflation Means for “Low-Risk” Investment Strategies

A principal goal of our approach is to minimize the risk of permanent loss (what we consider to be true investment risk) and control volatility. We would posit that “permanent loss” can also be considered “permanent loss of purchasing power,” a concept that takes into account the impact of inflation on capital. Even at Central Banks’ long-term expectations for inflation, one dollar today needs to grow by about 2% on an after-tax basis to avoid loss of purchasing power. From this perspective, it can be understood that long term allocations to cash or investment grade securities effectively ensures permanent loss of purchasing power. Even at a 2% rate of inflation, a five-year holding period would result in an approximate 10% impairment on cash relative to the future cost of living. Our view is that higher yielding fixed income investments and strategies that carry low-risk, mid-to-high single digit returns are one of the few conservative means of minimizing loss of purchasing power while also maintaining potential for accumulation of substantial real returns over the long term.

Our Approach in the Current Situation

The challenges that confront us are clear: inflation running well-ahead of prevailing interest rates, and we see elevated valuations in risk markets. There are no obvious traditional solutions to these challenges but due to our flexible, unconstrained approach, we see avenues to thrive in this market context.

With excesses, bring opportunity and we are taking advantage of several dynamics.

First, an important investment dynamic that arises from such easy credit conditions is plenty of corporate actions - mergers and acquisitions being the most common form. These events tend to have important consequences for the pricing of corporate debt securities of all companies involved and we seek to identify and monetize the sources of “Structural Value” in securities involved with or prospectively exposed to corporate actions. We have seen M&A activity at a record pace in 2021 and as of this writing, the conditions for this continue.

The reason why Structural Value investments are appealing to us is because bond investors typically focus on traditional drivers of credit pricing such as a company’s financial condition, cash flow characteristics, leverage, management’s capital strategy and the term structure of a given debt security. Often, that is where the analysis ends. However, there are special circumstances where value in a debt investment is ultimately driven by dynamics that reside outside of these conventional models for credit pricing. Investments in securities with Structural Value have different, often hidden, drivers of returns. The most common structural sources of value can be found in a bond's covenant structure, its call (refinancing) structure and its capital or corporate structure positioning. Looking carefully at the subtle aspects unique to the structure of each debt security can uncover exceptional, unrecognized value; value which typically becomes recognized by the market within foreseeable time horizons and most often in connection to capital market activity and corporate actions. This year’s investment in Shaw Communications was an excellent example of this. Approximately 40% of the portfolio is invested in the “Structural Value” category, which dramatically reduces the Fund’s exposure to interest rates and inflation.

Second, we are starting find excellent value in two parts of the market that feature high quality credits with low dollar price bonds. These two areas are BB rated traditional high yield bonds that were issued in mid 2021 and “busted” convertible bonds that were issued mostly in 2020 and 2021. In the case of the traditional high yield bond opportunity set, the BB high yield bond market saw a low in yield of just under 2.8%  last year.  It is not a surprise that many companies were issuing high yield bonds at these extremely low costs of capital.  Since then, we’ve seen a meaningful increase in interest rates, which has taken the prices of these bonds down into the 90’s or even the 80’s.  Given many of these BB-rated issuer’s credit condition is largely unchanged, the bonds offer better value than they did before.  In the US convertible bond arena, we’re seeing scores of bond issues trading in the 80’s and lower, but the driver of the declines in this space are different.  Most of these convertible bonds were issued in the last two years and we have seen the optionality of the convertible bond vanish as the price of the stock underlying the bonds have declined dramatically.  What is most interesting, however, is that many of these issuers have high quality underlying businesses and their declining stock prices were a simple recalibration of unrealistic market expectations that we saw assigned to high quality growth stories; similar to the BB space described earlier, the credit quality of many of these businesses hasn’t changed either, yet valuation has improved.  The fly in the ointment of these emerging areas of opportunity, however, is that the yields of these securities are still generally modest.  However, we believe an underappreciated quality of the securities is the Structural Value angle where bonds that are priced with large discounts to par now carry hidden option value.  Namely, through the “change of control” covenant found in high yield bonds and the “fundamental change” covenant found in convertible bonds.  These covenants can easily introduce nice overnight surprises of 10-25 percent, as a result of a company takeover.  By selecting bonds in safe credits that have takeout optionality, the 4-5% yield we may be harvesting can turn into substantially more.  An active M&A environment is exactly one that increases the option value of covenants like these, and that is the environment that we find ourselves in currently.  To see evidence of this emerging dynamic in the market we need to look no further than this week’s announcement of Take-Two Interactive’s move to merge with Zynga.  Zynga has convertible bonds trading around 90 cents on the dollar, which promptly moved up 10 points on the news on account of the bond’s Fundamental Change covenant.  This option value is demonstrably real and we will seek to monetize it in 2022.

Third, as a consequence of the central bank intervention, the market remains awash with capital and distortions remain in credit, particularly in the long-dated investment grade market.  We have communicated about the dynamics of this in past letters, and we have acted with conviction to take advantage of historically low long-term corporate bond credit spreads.  It is with reasonable frequency that the corporate credit market sees large increases in credit spreads, comfortably averaging more than one percent in magnitude.  It is difficult to predict exactly when, but widenings like these have happened in four out of the last ten years - a 40% “base rate.”  Given the very long duration of these investments, corporate bonds can generally be expected to drop about 20% in price in an such a circumstance .  Currently long-dated credit spreads are about 1.3%, meaning that if things don’t go wrong, investors can expect to bag an extra 1.3% for taking that bond’s credit risk.  But if the environment changes as it has in the past, losses of 20% or more could be the base case.  To us, it does not take much number crunching to figure the risk reward in this sector is so bad that it is worth betting against.  And that’s what we have done.  In our view, the hedge substantially reduces the Fund’s overall risk to market shocks, while also carrying a positive expected return over its holding period.  However, we would offer a word on expectations: it is useful to note that while our hedges in investment grade should provide excellent protection for the portfolio over time , the tracking of the hedge against our long positions in non-crisis market backdrops may see some deviation.  History tells us that this deviation could easily be measured in months, so evaluation of this hedge’s effectiveness is best measured over quarters rather than over shorter time periods.

Outlook

The market is entering the new year much the way it entered 2021: with a 4.3% yield and a lot of capital markets activity.  We are most excited about the latter as corporate transactions create opportunities for us to bring our skills to the table, identifying mispriced securities in the context of announced or prospective corporate transactions and creating upside optionality in discounted bonds of high-quality issuers.  

We can see markets fluctuating against a more delicate narrative, where concerns of inflation, continued economic threats from the pandemic and geopolitical tensions are colliding with artificially low  rates and expensive valuations in risk markets.  Given this dynamic, it wouldn’t be a surprise to us to see a volatile year ahead.  Despite this, given the portfolio’s position and opportunity set, we look forward to what this year has to bring.

Thank you for your investment in the Ewing Morris Flexible Fixed Income Fund.