Sprott Strategic Fixed Income Fund

Fund Performance as at April 30, 2013

1 Performance since inception does not take into account $0.56 per share, or 5.6% of the inception NAV, in agency and issue fees incurred at the launch of the Fund.

Q1 Commentary

Going into 2013, we had braced ourselves for a bit of turbulence due to the strong rally of 2012 and concerns around the U.S. “Fiscal Cliff” and Europe. As it turned out, while problems did resurface out of Europe, the Fiscal Cliff issue was delayed and the economic data out of the U.S. was fairly strong. As a result, we began to see growth expectations, and correspondingly risk appetites, decouple across different regions. The North American markets became more optimistic around a recovery, while the European and Emerging markets were a bit more subdued.

China is one area of the world where growth is clearly decelerating, and few countries are more concerned about this than Japan. The Japanese economy has been struggling for nearly two decades due to challenging demographics and burdensome debt levels, and a slowdown of one of its largest trading partners would only exacerbate their problems. After taking office in late December of 2012, Japan’s new Prime Minister Shinzo Abe vowed to “do whatever it takes” to restore economic growth and inflation in the country. He followed this up by replacing the incumbent BOJ governor with well-known inflation advocate Haruhiko Kuroda, who has since launched a quantitative easing program in Japan that makes Ben Bernanke’s efforts look mild in comparison. We started building a bearish position in the Yen late 2012, which worked in our favor early in the quarter but moved against us in February when the markets became nervous. Kuroda’s large QE announcement came after quarter end and while the Yen has sold off dramatically in April, we expect further Yen weakness in the near term.

Outside of the Yen, our funds had mixed results from our foreign exchange positions in the quarter. Our bearish CAD bias performed well for us as both employment and GDP data out of Canada has been disappointing. On the other hand, one of our largest positions, long EUR/CHF cross, underperformed despite rallying significantly in January, as events in Cyprus and Italy caused capital to flee the Euro and into the Swiss Franc. We have since cut down our EUR/CHF exposure but we continue to like this trade.

In rates, we found our biggest opportunity to be in the UK, where the market had gotten overly bearish on inflation prospects. With growth in Britain stagnated by both private and public sector deleveraging and overall weakness in the Eurozone, UK inflation breakevens fell to their lowest level in nearly three years last summer. We went long UK breakevens and took profits on this trade in the first quarter as breakevens rallied from early signs of a recovery and a decision to maintain a positively biased calculation of the retail price index.

Our credit portfolio continued to perform well to start 2013, led by strong returns in high yield bonds. We had one of our largest positions, a convertible bond in Sea Trucks, get called at a 20% premium to trading levels. Sea Trucks is an oil and gas services company that operates primarily in the North Sea and Africa. Our bonds were secured on a second lien basis and had a high coupon that rose periodically until maturity (2015). At the time of the call, our bonds had a coupon of 13%, which was set to rise to 14% in July if the company had not called them.

We have maintained our sizeable allocation to high yield bonds during the quarter. While the index continues to make new all-time lows in terms of yield (YTW is under 5.5% as of writing), the spread at 470 bps still represents relatively attractive returns when compared to treasuries and investment grade corporates. With corporate balance sheets remaining generally conservative and the funding environment continuing to benefit from quantitative easing programs of central banks globally, it is difficult to envision a spike in default rates in the near future.

The Strategic Fixed Income Fund finished the quarter relatively flat, with a total return of 0.11%. Our bias entering the quarter was fairly neutral, with a few thematic and high conviction trades in the EUR/CHF cross, USD/JPY cross, and UK breakevens overlayed on top of our broader long credit and relative value positions.

Problems out of Italy and Cyprus renewed fears around the banking system in Europe, causing a flight of capital out of European system and into more perceived safe havens such as the USD and Swiss Franc. Meanwhile, the Yen caught a mild bid towards the end of the quarter as the sell-off appeared extended and the markets became nervous about what Kuroda would say when he stepped into office. As a result, our profits in short Yen and credit were largely offset by the underperformance in EUR/CHF in the quarter.

It is worth noting that both the EUR/CHF and USD/JPY crosses have since moved sharply in our favour, resulting in strong gains for the Fund in the first 3 weeks of April. We have pared down our exposures to these trades but continue to see good value at current levels.