The Manager's Commentary - December 2011
“It’s the End of the World as We Know It (And I Feel Fine)” – R.E.M.
Catchy tune released in 1987, which was 25 years ahead of its time. 2012 not only marks the start of REM’s retirement but the year in which the pre-Christopher Columbus inhabitants of the Mesoamerica region (Mexico to Costa Rica) believe the world will come to an end. Of course, Christian and Jewish faiths could interpret this as the perfection of God’s creation of the World … and “feeling fine”.
The Mayan’s specifically determined Dec. 21, 2012 as the end of the world. Maybe these people of 300 to 900 A.D. saw the looming wall of debt coming due in Europe (sovereign and bank) and the stack of national elections around the world culminating with the implosion of the world. Whether or not you believe in the predictive powers of the Mayans, one thing is for sure, there will be lots of macro events to keep the broader markets spinning in 2012.
We believe this should set up well for the relative predictability of corporate bonds. In our opinion, with interest rates at essentially all-time lows, the key will be to isolate credit risk while avoiding the interest rate risk of longer duration bonds.
The interest rate risk can be best highlighted by the graphs below. The first graph shows the yield on 10 year Treasuries over the past 10 years; the second for 30 year Treasuries. Interestingly, 10 year Treasuries are currently yielding less than in December 2008 when the financial crisis was at its nadir. And while the same cannot be said of 30 year Treasuries, they have been hanging around the 3% psychological “middle part of the abyss” level that was last visited in late 2008.
Source: Bloomberg
To avoid the eventual pain of a back up in rates, it will be important to stay short in duration and focus on investing in corporate bonds where there is a catalyst to having the bond or loan called or tendered before maturity. In our opinion, being nimble and open minded to value will be very important for corporate bond investors over the next few years.
One such example is the 6 percent convertible bond of Wi-Lan that was issued in August, 2011 and which the fund purchased in early November.
This $230 million convertible was issued to finance the prospective purchase of Mosaid. If, however (and this is the interesting part), the purchase of Mosaid was unsuccessful, Wi-Lan would have to redeem these bonds at par plus accrued interest. We bought these bonds after Wi-Lan determined that they would no longer pursue the purchase of Mosaid.
This bond will generate a 6 percent return when are redeemed at the end of January. While this investment is an example of an extremely short term bond, it merits highlighting because of its certain repayment and well above average return for investments of similar duration. Furthermore, targeting bonds that will be redeemed due to a merger or acquisition will always be one area we target for investment opportunities.
Another area where we believe opportunities will present themselves is the loan market. As can be seen from the graph below, more loans are now priced below par than at the beginning of 2010.
There are two notable reasons why this is the case. First, prior to 2008 the majority (60%) of loans were purchased by CLO's (Collateralized Loan Obligations). Many of these funds were created to specifically purchase corporate loans. However, over the last few years their participation has been dropping. They now represent less than 50% of the buying.
The second, and maybe more influential reason loan prices have drifted lower, is the Federal Reserve communicating that interest rates will stay low until the middle of 2013. Because loans are floating rate instruments, lower short term interest rates equate to lower coupons and most fixed income funds prefer to maximize income. In fact loans are the most senior security in a company's capital structure; so are safer than the bonds and equity below them. The contrarians in us say that the combination of less buying from CLO's and an extended low interest rate environment will present opportunities in the loan market.
Matt Shandro
December 31, 2011