The Manager's Commentary - January 2011
The first commentary of the year highlighted some specific investment opportunities that we are excited about. This month’s commentary will touch on some of the high level investment themes that will be on investors’ minds as they look to invest in corporate bonds in general, and the Pender Corporate Bond Fund specifically.
Macro Overview
The Federal Reserves’ policy goal of achieving stable prices is very well recognized. However, another policy goal of the Federal Reserves’ is the pursuit of maximum employment. While the unemployment rate is a lagging indicator of economic growth, we believe it will be the leading indicator on when the Fed increases the fed funds rate. The unemployment rate is still at an elevated level, despite some recent small improvements, and we suspect it will continue to remain elevated for some time.
Specifically, prior to the financial crisis, the unemployment rate was between 4 and 6%. However, unemployment in the US construction sector is currently above 20% compared to averaging in the high single digit range prior to the start of the financial crisis. With residential housing starts below 600 thousand annually compared to the peak of over 2 million in 2006, unemployment will be difficult to bring down unless one or more of the following three things happen: housing starts improve, industrial construction picks up or these displaced workers upgrade their skills and move into higher skilled jobs.
We see little chance of any one of these three triggers influencing the Fed to move interest rates aggressively higher over the next 18 months.
Credit Market Overview
2010 proved to be the second consecutive year of strong returns for the corporate bond market and as we embark on a new year we remain constructive on corporate bonds/loans albeit with lower return expectations. Despite absolute yields at close to historic lows, we believe credit will continue to benefit from accommodative monetary policy which should keep government bond yields relatively low for 2011.
Notwithstanding, both investment and non-investment grade corporate bonds are trading above par - the first time in four years. Therefore, while corporate bonds have reached their theoretical price limit (all bonds mature at par) we believe corporate bond indexes will return close to their coupon in 2011.
The average coupons for investment grade and non-investment grade bonds are 5.7% and 8.4% respectively. Compared to 10 year government bond yields less than 4% we think there will continue to be support for corporate bonds and other yield investments that provide more yield and/or capital gain potential than government bonds.
In addition, with default rates forecast to stay low (i.e. 2 percent), in large part supported by loose monetary policy, we don’t expect investors to retreat from the asset class due to deteriorating credit quality.
Investment Strategy
We will always be focused on event driven investment opportunities such as M&A and restructuring events where there is asset coverage and the aforementioned catalyst to realizing this value. Specifically, the level of cash on the balance sheets of S&P 500 companies is higher than it has ever been. At some point in the future, this approximately 2 trillion dollars, will, in our opinion, lead to increased joint venture/merger activity. We will be focused on locating businesses that can benefit from this.
While looking for investments with catalysts will always be a theme, particular attention is being paid to protecting the fund from a dramatic jump in government bond yields. This can be achieved by also focusing on keeping duration short, making select equity investments, and keeping a healthy cash position in the fund.
Matthew Shandro
January 31, 2011