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Pender Corporate Bond Fund – Manager’s Commentary – February 2017

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The Pender Corporate Bond Fund returned 0.8% in February. We view this  return as reasonable for the period, given the lower credit spread environment, combined with our own more cautious risk positioning. Our February returns were roughly evenly split between interest accrual and capital appreciation. On the capital side of things, positive moves by our positions in the discounted bonds of Grupo Famsa, Jakk’s Pacific Holdings and Restoration Hardware were offset, to a degree, by a decline in Global Brokerage Inc. notes (formerly FXCM), as that company was impacted by regulatory action.

February saw a change in the direction of some key long-term government interest rates, with both longer-dated US Treasuries and Government of Canada bonds trading to slightly lower yields. Credit markets were a little stronger as the major high yield indices continued to tighten their spreads to US Treasuries. In general, we view North American credit markets as now having moved towards the expensive side of the range. In response, we have begun to add more high quality credit to the portfolio mix, while maintaining relatively short duration.

Adjusting the Mix for Lower Credit Risk
One of the main changes in the Fund composition in 2017 has been the re-introduction of a reasonably large weight in very low risk credits. Recently added weight in bonds issued by McDonalds, Alliance Data Systems, Walt Disney, General Motors, Twitter and Verisign has contributed to a more defensive positioning. All these issuers have multi-billion equity market capitalizations below our extremely well covered credit positions. Across the Fund, securities of issuers with a Bloomberg 1 year default risk of less than 0.5% now constitute more than 50% of the Fund, up from the 25% weighting we held for most of last year.

The downside of higher credit quality is lower expected return, and we may be foregoing some short term earning opportunities with this stodgier stance. Ignoring any expected gains from workout or equity securities held by the fund, yield to maturity has dropped to 6.1%, down from a level of 7.5%-8.5% where we were positioned for most of the past 18 months. The shift in emphasis is intentional as we transition from a “grow and protect” orientation towards “protect and grow.”

The upside in reduced risk positioning is the potential to revert to a more risk accepting stance at a future point when spreads are wider and when we believe the odds for outsized returns are once again heavily in our favour. This may happen on a company-by-company basis, or it may be a market-wide event. However, we are building our reserves of dry powder to capitalize on opportunities as they arise. When you have ample cash and near-cash securities, volatility is your friend.

Where We Are Taking Risk – Shifting the Sector Mix
One area of the market that has seen significant disturbance over the last few quarters has been smaller pharmaceutical companies and biotechnology. While Valeant’s troubles have been well chronicled, there has been a much broader retreat. From concerns about actions to combat price gouging, to worries about the impact of the repeal of the US Affordable Care Act, the sector has been under significant stress over the past two years. And once the hits to company valuation start coming, the market has a way of creating an avalanche of pain. What we see now is a number of companies which were valued at more than a billion dollars in 2014-2015 now trading with an enterprise value of less than a quarter of this level.

We recently added small weights in the credit positions of Orexigen Therapeutics, which markets a novel weight loss drug, and Novavax Inc, which is relatively far along in developing vaccines for preventing respiratory illnesses that are linked to significant levels of morbidity in the United States and around the world. Once balance sheet cash is taken into consideration, we believe there to be much less capital risk in the debt of these issuers than is implied by credit prices, which places the notes of these issuers at less than half of par. The outcome in these cases is uncertain, which is why these positions are rather small in the context of the Fund, but we see plenty of scenarios for materially higher workout.

As commodity-related credit has gained materially over the past year, we view our investments in depressed life sciences issuers as attractive replacements for distressed oil bonds that have performed so well within the higher risk band of the Fund. Energy and materials, a big driver of returns in 2016 for the Fund, now represents just over 10% of our assets.

Portfolio Positioning
The Fund yield to maturity at February 28 was 6.1% with current yield of 4.9% and average duration of maturity‐based instruments of 2.3 years. There is a 6.3% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 5.2% of the total portfolio at February 28.
 
Geoff Castle
March 2, 2017

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