The Manager's Commentary - October 2010

Time for a Kit-Kat?

It would seem that the corporate bond market is ripe for a break from the new issuance pace we’ve seen year to date. Over the last two years, corporations have issued more bonds than any other prior two year period. However, it appears that the market could begin to push back on the acceptance of new issues. Importantly, from an investor’s perspective, the yield to maturity on investment grade bonds is lower than it has ever been and high yield is within 25 basis points of matching its all time low in yield.

Interestingly, the previous low in yields for both investment grade and high yieldwas experienced shortly after the Federal Reserve drove the Fed Funds Rate to 1% in June of 2003. While corporate bond yields began to tick up in 2005 and 2006, investors were still able to generate positive returns in those years due to the larger coupons they possess. As we don’t expect government bond yields to increase dramatically, we would expect the broad corporate bond universe to earn its coupon over the medium term.

The fly in the ointment, however, is that we are starting to see some dubious new issues come to market. Specifically, we have started to see some companies issue bonds to pay a dividend to their private equity owners. While some may be able to handle this additional debt, on the margin, it signals to us that the new issue market is getting a tad toppy and could lead, down the road, to an increase in the default rate.

Of course, one can choose, like us, to not participate in such issues and instead look for short duration opportunities in the secondary market. To be clear, the approximate US$ 8 trillion of corporate bonds and US$ 2 trillion of loans in North America provide us with ample supply to draw from. On the loan front, we are on the cusp of allocating cash to some specific opportunities. Loans, in our opinion, are one of the best corporate securities to ensure preservation of capital and, as well, provide a near perfect hedge against an increase in interest rates. We hope to share with you in the future, more specific details on the loans the fund purchases.

Matthew Shandro
October 31, 2010