The Research Bulletin for August 3, 2021 includes commentary from our Portfolio Managers and Head Trader. View online, or download the printer-friendly version.

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Bonds & Fixed Income
from Jason Weaver, CFA®, Head Trader & Portfolio Manager
The FOMC, though increasingly leaning on its “transitory” inflation stance is closely being pushed toward setting out a timeline for the inevitable “taper” or slowdown/end to its purchases of treasuries and mortgage-backed securities (“MBS”). While timelines have a way of changing in response to conditions, we would be surprised if we are not given an estimate from the fed before the end of 3Q, with an end to MBS purchases expected in early 2022. However, we note that Powell & Co. rate very hesitant to move too early and risk a 2013 taper tantrum that may erode much of the progress made, or even worse, a 1937 mistake that could risk another recession. What does this mean? JPMorgan expects the cumulative effect of quantitative easing since early 2020 to be worth approximately 44bp on the 10Y treasury yield. While 1.70% on the 10Y does not seem extreme in the slightest, the main thing to remember is that, looking back into history, these predictions are almost universally WRONG, and the knock-on effects from a rapid rise in rates poses painful potential risks for many asset classes – namely equities.

Treasury yields remain well bid in this environment, mostly owing to fears surrounding the newer Covid-19 variants and concerns over a lack of progress in vaccines and possible “breakthrough” cases in already vaccinated individuals. We are skeptical about this rally for 2 primary reasons: 1) Given the longer experience of the UK with the delta variant, infection rates may be up among vaccinated and non-vaccinated alike, but at least among vaccinated populations, hospitalizations and deaths have only trended up slightly (i.e., the vaccine is not perfect but remains very effective at countering the worst outcomes.) 2) Media coverage of the delta variant has apparently spurred once-skeptical populations in the least vaccinated states (AL, AK, LA, TX) into the highest growth rates of vaccine uptake in the US. In this environment, we would expect that some enhanced protection measures may come about (indoor mask wearing, for example) but the likelihood of large-scale lockdowns is diminished.

Convertible Securities
from Stan Rogers, Senior Portfolio Manager
I have discussed in the past what happened to the portfolio during the sell-off last year, especially the violent downdraft of the mandatories and the negative impact versus the index (which does not include mandatories). Below shows the up/down capture for 2020, along with 5- and 10-year returns ending in 2019. Excluding the 2020 period, the up/down capture is right on top of what the goal is: 70-80% of the upside of the S&P and 30-40% of the downside. Also, the returns are right in line with the index for the longer time periods, but 2020 really skewed the up/down last year.

The clampdown on Chinese tech companies has garnered a lot of attention recently. Within the US convertible index, Chinese converts account for 26 issues and $23.1 billion in market value (5.8% of the total index market value), so the exposure is a meaningful amount (Barclays). These convertibles have drastically underperformed with the underlying common sell-off. We have not been involved in these issues.

News & Earnings

• Twitter (TWTR) reported Q2 earnings and revenue that were above expectations, while monetizable daily active users (mDAU) were in line. The quarter showed strong advertising revenue growth, and new products are showing momentum that should continue into the second half of the year.
• Southwest Airlines (LUV) had a mixed Q2 report where earnings were light, and revenue was above consensus. The company guided Q3 in line, taking a cautious tone due to the emergence of new variants of COVID.
• Danaher (DHR) released Q2 numbers that were above consensus and raised guidance. The company is still riding the tailwinds of COVID testing and diagnostics. All three divisions (Life Sciences, Diagnostics, and Environmental and Applied Solutions) produced solid revenue growth.
• Fortive (FTV) reported a beat and raise quarter. Earnings and revenue were above consensus estimates, and the company guided numbers higher for H2. Margins were impressive and free cash flow was strong.
• FTI Consulting (FCN) also had an impressive Q2, with earnings and revenue both well above expectations. For the year, the company also raised guidance. Forensic and Litigation Consulting and Technology and Economic Consulting segments aided the earnings beat, while Corporate Finance and Restructuring was slightly lower.
• Southern Company (SO) reported earnings and revenue above estimates. More importantly, the company updated the progress on the Vogtle nuclear complex. Hot functional testing was completed on Unit 3 with no significant issues, which is a meaningful step for completion. Management pushed out the expected in-service dates for Units 3 and 4 by 3-4 months and increased their total costs by $460 million. This was not unexpected due to COVID disruptions.

Transactions:
We took advantage of the recent stock price weakness in Pioneer Natural Resources (PXD) to add approximately 1% to our existing position. High delta name, so it is very sensitive to the underlying stock.

Upcoming maturities/redemptions:
CNP.B 7% mandatory convertible preferred goes ex on 8-15, so will sell after the last remaining dividend and prior to the 9-1 maturity date.
IFFT 6% mandatory convertible preferred goes ex on 9-11 and matures on 9-15, and we will try and sell in this narrow window.

Equity Hedging
from David Jeffress, Portfolio Manager
Last week, we acquired another round of put options to add to our existing positions. In addition to the put options we previously held that expire on September 17, 2021, we have added contracts at the same strike price of $205 but with an expiration date of October 15, 2021.

We are in an environment where put options are being priced higher than their predecessors for similar strike prices, which we can infer to mean that the options market makers are factoring in higher levels of risk, coupled with higher demand for downside protection, despite the equity markets continuing to move higher for the year.
With this most recent purchase, we are 80 percent invested for the quarter, and feel the potential for additional savings on the options contracts we bought did not justify waiting and incurring additional exposure to the downside that would come from not holding these contacts going into August.

We still have roughly 20 percent of our capital for the quarter to invest and may allocate that money to call options on the VIX Index if volatility falls back toward it’s longer-term average. Should the opportunity to purchase VIX calls at an attractive price not present itself, we will redirect that money to a final round of put options later in the quarter.

Global Revolution
from Jonathan Berkowitz, Securities Analyst
Putting A Price on Carbon May Save The World! So They Say…
Over the last year World leaders have taken dramatic steps to fight climate change. When the Biden Administration announced that the United States had formally rejoined the Paris Agreement in February, it underlined the global nature of efforts to reduce greenhouse gas emissions and decarbonization of the world economy.

Today, 189 countries have joined the Paris Agreement, which includes commitments from all countries to reduce their emissions and work together to adapt to the impacts of climate change and calls on countries to strengthen their commitments over time.

While serving as Secretary of State, John Kerry said, “One of the most powerful ways to reduce emissions…is to move toward carbon pricing that puts basic, free-market economics to work.” So, will a price on carbon push companies to emit less greenhouse gasses? In 2017, Senator Lindsay Graham endorsed a price on carbon. Speaking at a climate change conference he said, “I’m a Republican. I believe that the greenhouse effect is real, that CO2 emissions generated by man is creating our greenhouse gas effect that traps heat, and the planet is warming. A price on carbon – that’s the way to go in my view.”

Say hello to Emissions Trading Systems (ETS)…
A carbon Emissions Trading Systems (ETS), also referred to as Cap and Trade, is a market for trading carbon allowances which are regulated by governmental organizations such as the European Union Emissions Trading System (EUA), the California Cap and Trade (CCA) and the Regional Greenhouse Gas Initiative (RGGI). The price of carbon is driven by emissions limits and the number of carbon allowances within circulation. A regulated entity must comply with emissions limits within its jurisdiction by buying carbon allowances. Emissions Trading Systems (ETS) create a price for the negative impact of carbon emissions while incentivizing investment into cleaner technology.

According to IHS Markit (a global diversified provider of critical information, analytics, and solutions), as of December 31, 2020, the global price of carbon was $24.05 per ton of CO2. It is estimated that carbon allowance prices need to reach $147 per ton of CO2 to meet a 1.5⁰C global warming limit.

We are starting a position in the KraneShares Global Carbon ETF, which invests in European Union, California Carbon and Regional Greenhouse Gas Allowance Futures. The KraneShares Global Carbon ETF fits into the Global Revolution strategy because it provides an alternate investment, it is a non-correlated commodity and allows us to piggyback on the inflows from ESG impact investors.