Hitting the Sweet Spot: Low default risk and short duration are keys to attractive risk/reward in the current corporate credit market

November 16, 2016
Written by PenderFund

There are two different scenarios that we consider when we try to mitigate the effects of risk in the Pender Corporate Bond Fund. The two chief risks in the bond market – credit risk and duration risk

  1. Credit risk is the risk that the company that is being lent money is unable to repay the obligation, and further, in the event of default, the risk that the sale of the business and its assets is insufficient to repay the obligation.
  2. Duration risk is the risk that the price of a bond goes down, based on an increase in its yield to maturity.

1. How we address Credit Risk

We do several things in our Fund, that relatively few active managers do and no passive funds do, which are specifically focused on reducing units of credit risk per unit of expected return.

  • We employ default risk probability models. Primarily this means our use of Bloomberg “DRSK” but we also look at other objective credit risk signals such as Altman Z score, as well as credit default swap spreads where that makes sense. Risk probability models look at the measurable inputs of credit risk, including:
    • How much working capital (cash, inventory and accounts receivable, net of short term payables) does a company have?
    • How much value does the stock market assign to the equity of the company (which is of course subordinate to the bonds we own)?
    • What is the level of cash flow currently being generated by the company?
    • How much debt does the company have, relative to its assets and shareholder equity?
  • We find that credit ratings have shortcomings which have been well-documented and include conflicts of interest and being late to identify changes in a trend (up or down). We use default risk models because we believe they are a better predictor of defaults and of losses given default, than credit ratings.
  • We model each holding on a valuation basis to ensure that in the event of default our collateral value exceeds the price we pay for a bond.
  • Finally, we follow company reporting and newsflow carefully to ensure we are early to spot negative trends. We have a financial forecast for each holding. When we see actual results deviate from our expectations in a negative way, we are prepared and able to act quickly.

2. How we address Duration Risk

At a time when long term interest rates are near an all-time low, we believe that duration risk is exceptionally high right now. Here is what we do to mitigate the effects of risk.

  • We run one of the shortest average effective durations of any bond fund in Canada. With average duration in the portfolio between 2.0-2.5 years, we have very little exposure to the big price swings that occur out on the long end of the “curve.”
  • We also own several securities with floating rates or rate reset provisions. At October 31, 2016 the Fund has an 11% weight in securities with a floating or reset component to the cash income we receive.
  • Long duration has a huge effect on the price swing from a rate rise. For instance, if the current 2 year US Treasury bond yield increased by 1%, its price would decline by about 1.4%. But if the current 30 year US Treasury bond yield increased by 1%, its price would decline by about 17%!

3. How do these efforts work in practice? How successful has the Fund been in demonstrating effective risk management?

2016 has been a good year to stress test our performance under both a duration risk event and a credit risk event.

  • We have almost no risk from duration.
  • Our Fund does have some credit risk. We have to take some credit risk in order to earn returns and we believe that the risks we have taken have been worthwhile. With a YTD return of more than 8x our largest drawdown, we think our risk/reward equation has been very satisfactory and very competitive with any other fund in the income space. Note that the average return of the group of high yield ETFs is only 2x their largest drawdown YTD.
Geoff Castle, Portfolio Manager, Pender Corporate Bond Fund
November 14, 2016

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