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A Better Way in Fixed Income

November 24, 2017
Written by Geoff Castle

There is no longer an “easy button” in fixed income whereby investors can earn relatively high real returns from invested instruments guaranteed by the government. While most investors still construct their portfolio with a mix of “ballast” and “earners” (fixed income and equities), many no longer expect to earn meaningful returns from their fixed income allocation. However, we believe that it can be done. Moreover, we believe that there should be a healthy part of investor portfolios assigned to credit instruments that can protect their principal well, while adding to the overall return of their portfolio. Investors no longer have to depend on equity markets to carry the full weight of their return expectations.

In order to earn attractive fixed income returns, we believe investors need to embrace a process which carefully assesses credit and which takes advantage of a wide arsenal of tools and approaches to enhance returns.

In managing the Pender Corporate Bond Fund, we have been implementing these new “tools”.

The Old Way vs a Better Way

To us … what matters most is how credit risks are assessed and how a fund manages its operations to optimize risk-adjusted returns. And in those core, critical functions, we like to think we are working towards a better way.” Pender Corporate Bond Fund PM Commentary, September 2017

Bond Ladder vs Dynamic Rebalancing

Many are familiar with the concept of bond ladders. On a five year ladder, one fifth of a portfolio is bought at the five year tenor every year and the Portfolio Manager leaves them alone until maturity.

The problem with a passive bond ladder is that prices change. Watching the price of a bond over the course of a year, one may see it move from, say, 100 to 105 and then maybe back to 100 again. Through regular rebalancing, our team makes the holdings in the Fund compete for weight, selling the expensive and adding to the cheap. We rebalance within risk bands so as not to change the overall risk positioning of the Fund as we trade. We believe there is considerable value to be gained from a well-managed, dynamic rebalancing process.

Ratings-Based Credit Analysis vs Fundamental Credit Evaluation

Many managers and advisors will define fund risk by ratings and only by ratings. Upgrades and downgrades of creditworthiness are left to Moody’s and S&P. Following this approach, managers are, essentially, outsourcing to conflicted rating agencies the hard work of credit, which is to figure out the likelihood of default and loss given default.

We do something different. We do fundamental credit valuation and liquidation value analysis and supplement that with the use of default risk models (Pender Corporate Bond Fund PM Commentary, April 2017). We look at ratings, but only as an indication of what market participants may do if they change, rather than as a tool in our core process of evaluating a credit position.

Mandate Straightjacket vs Dynamic Risk Allocation

Many mandates at large firms are extremely tightly defined. What if an area of the credit market is unattractive? What if the market has become overly risk averse, or conversely, too accepting of risk? Clients of ‘mandate straightjacketed’ funds are often faced with having to either switch funds or accept lower returns in cyclically unattractive mandates.

We approach the credit markets as being tiered into three general risk categories: high-quality most liquid, moderate risk, and distressed or ‘special opportunities’. Our weighting in each of these risk bands adjusts to become more risk-accepting in wider credit spread environments, and more conservative in low-spread environments. Therefore, we can adjust our mix based on whether market conditions favour return-seeking behaviour or capital-protecting behavior, while still being attuned to individual, attractive situations.

Buy “the Index” vs Trading Against Indexers

The market now provides a large number of passively managed index funds and ETF’s that automatically acquire pieces of the largest bond issues, as defined by issue size.

Of course, the index has rules. Bonds must maintain defined ratings to remain within the index. A downgrade can lead to a forced sale by index trackers. An upgrade can lead to a forced buy. Certain classes of bonds, such as convertibles, are left out of many indices. And if a company buys back its own bonds in the open market (a great sign to our way of thinking) it may decrease the size of the issue and result in its removal from an index.

We also see indices change when new issues come to market. Every big new issue delivers an echo-effect of forced selling of the pre-existing index components.

In our case we actively trade against the index. So for instance, in 2016 we acquired our position in Energy XXI 2nd lien bonds (How active management can take advantage of passive instruments in the credit markets) after the bond was downgraded and kicked out of the index with a forced sale at 11c on the dollar. Our analysis showed that the value attributable to these bonds was more than four times the traded price. The Fund was indeed able to realize that value over the next twelve months. We took advantage of the opportunity to be on the other side of a trade of a counterparty who was not thinking about value…only rating.

Understanding ETF and index rules is important to us. At the time of writing we are witnessing multiple large Maple Bond issues (issuance of C$ bonds by foreign domiciled issuers). There have been $1 Billion or $750 Million issues coming out of Apple, Pepsi and McDonald’s. There was never a Canadian bond index that included McDonald’s, Pepsi and Apple. But it will be hard to keep issues this large out of the indices and we believe that if they are added there will be managers or funds that are compelled to buy regardless of the prevailing prices. So by acquiring a position early, we are really trading against a potential future index rebalance.

Small Pool of Issuers vs Addressing the Full Universe

Some managers follow a comparatively small group of companies. Particularly if they depend on the sell side for ideas they can fall into a pattern of owning only those bonds that local brokers may bid or offer.

The problem with this approach is lack of choice. Sometimes Bombardier and Videotron bonds are attractive credit holdings. Sometimes they are not.

We have set up the Fund and our research process to address the full universe of CAD and USD corporate credits. Not only do we have our in-house bond team, we also leverage the Pender equity team in areas where they cover a company with traded debt. Moreover, we also have access to a network of experienced sector-specific credit analysts who work for us on a subscription basis and are available to us whenever needed. In total, we have access to more than 80 analysts, all specialists. When we are studying an area that is new to us, this gives us the ability to take advantage of the experience of someone who has over a decade working in that sector. This allows us to do high quality research and to cover a broader number of potential issues.

Manage for Payout vs Manage for Value

The old way is to think about how much money the client wants at the end of the month and to manage the fund to provide a payout.

We believe it is much better to manage the Fund for value. This sometimes means we have to tell our clients that we can’t pay out as much this month. But the big payout ideas are not necessarily the best value ideas. Let’s preserve the capital first and then let’s think about what we can earn.

Does it Work?

Past returns are not the same as forward looking returns. However, we believe the track record of the Fund is beginning to speak for itself. Review performance and read more about the Pender Corporate Bond Fund.

November 24, 2017

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