Fixed Income – Manager’s Commentary – March 2022

Written by Geoff Castle

The Pender Corporate Bond Fund returned -0.4%[1] in March. While we never celebrate losses, it is worth noting that the Fund’s monthly loss was less than a third of that of the high yield index for the same period and over two percentage points above the Canadian bond universe. In short, it was a volatile month and we emerged without many scars.

In order to beat the average, it is important to do things that few others are doing, and March underscored the importance of that principle. Our Fund’s resilience was supported by gains in Country Garden Holdings Company Limited (HKG: 2007) bonds as Chinese state-backed financial institutions came to the defense of better capitalized property developers such as Country Garden, relieving a panic that had taken bond prices, in some cases, below 50¢ on the dollar. Our investment in Federal National Mortgage Association (OTCPK: FNMA) and Federal Home Loan Mortgage Corporation (OTCPK: FMCC) preferred shares also rose amid signs of the forthcoming emergence of these Government-Sponsored Entities (GSEs) from the conservatorship that arrived along with dividend suspension back in 2008. Finally, our position in the deeply discounted bonds of Plantronics, Inc. (NYSE: POLY) rallied from the low 80s to above par as that company agreed to be acquired by American hardware behemoth HP Inc. (NYSE: HPQ).

Notwithstanding the positive developments noted above, the broader bond market continued to struggle in the face of high inflation and a hawkish Federal Reserve. Our position in 2027 notes issued by BCE Inc. (TSX: BCE), as an example, fell in price by more than 3% in March, amongst several lines that were red in the period. We aren’t particularly worried about Bell Canada as an entity and consider the movement in bond prices merely to have shifted the Fund’s return profile toward the future from the current period.

A New View on Safety – Looking for Solid Footings Amid Turbulence

The past months of turbulence in fixed income markets have had a significant impact on investors’ mindsets. Where an allocation to bonds was traditionally seen as a place of calm that moderated the sometimes volatile swings in equities, recently bonds themselves have been a source of trouble. New questions emerge as the familiar, benevolent tailwind of gently falling risk-free rates is replaced by the prospect of a Treasury yield chart that moves up and to the right, presenting investors with lurching volatility. In such an environment, where do investors look for safety?

We see safety in accordance with three criteria, a safe investment should be able to provide: (1) real value, after inflation; (2) substantial insulation against potential loss; and (3) an ample degree of liquidity. Let us discuss these three elements in turn.

Holding real value is an important aspect of investment safety in 2022. While cash maintains nominal value, inflation reduces purchasing power and effectively results in real losses for cash. Even government bonds and GICs in the current environment offer a high probability of negative real returns, given yields well below inflation. We consider two prime methods of ensuring real return:

  • One way is to own an asset of sufficient scarcity that a decrease in the purchasing power of money translates fairly directly to an increase in price of the asset. And, while most fixed income securities do not provide this feature, many do. Here we consider real return bonds, Treasury inflation-protected securities (TIPS) and certain convertible securities tied to scarce business assets.
  • The other way to ensure real return is to own an asset with a yield comfortably above the rate of inflation. The higher the yield, as adjusted for default probability, the safer the bond is, in our view. Given the recent back up in yields, the bond market has actually begun to price in an increasingly positive real return for corporate credit. But delivering that return requires careful attention to issuers and the drivers of potential default.

Insulation against potential loss of capital is the second dimension of safety. It is one thing to own a security priced to deliver a high yield, and another thing to successfully realize the yield and return of principal. Insulation against loss is the result of backing by business assets that are worth unquestionably more than an entity’s liabilities. In this regard, safety doesn’t stem from a rating but from a valuation. And the degree of safety? Well that directly reports to the amount of excess value that covers a bond.

While sometimes a public market valuation can indicate a sizeable buffer against loss, it is also important to underscore here the importance of independent valuation. A market cap can provide a clue towards the fair value that underpins a credit valuation, but we feel more confident when our independent analysis supports the idea that a company has many times its debt in fairly valued business assets.

Liquidity is the third and final aspect of safety. It is fine to have assets that are secured by value and which have real return characteristics, but if they cannot be sold in a pinch, how can investors truly have confidence in their safety? We consider a number of factors in assessing liquidity. Issue size is important, as is a history of trading and the magnitude of spread between bid and offer. However, there are also elements of form of security, and the population of other owners that contribute to our understanding of a security’s liquidity. It is hard to put a finger on the exact boundary between “most liquid” and “less liquid” but when liquidity is not there it is very much evident.

Safety isn’t everything for investors, and it is certainly different from growth, which some people also need. But we believe it is useful for investors to understand the new dimensions of safety in a world now awash in risk. Our formula is simple: Safety = Real Value + Insulation Against Loss + Liquidity.

Fund Activity

Amongst new positions in the Fund this month, we added a position in US local telecommunications provider Lumen Technologies, Inc. (NYSE: LUMN). Lumen’s utility-like business generates, in our view, a solid and sustainable level of cashflow and we consider the company’s secured 4% notes of 2027 to offer solid risk/reward.

In March, we also added significantly to our position in bonds of Treehouse Foods, Inc. (NYSE: THS), which had fallen as low as 82¢ on the dollar in the face of input-inflation headwinds. Treehouse assets are critical and useful in North America’s food processing business and we consider the yield in excess of 7% on the 2028 notes to be very attractive in the context of 1 year default probability we estimate at less than 0.2%.

Fund Positioning

The Pender Corporate Bond Fund yield to maturity at March 31 was 6.1% with current yield of 4.9% and average duration of maturity‐based instruments of 3.5 years. There is a 2.5% weight in distressed securities held for workout value whose notional yield is not included in the foregoing calculation. Cash represented 2.6% of the total portfolio at March 31, 2022.

Geoff Castle
April 7, 2022

[1] All Pender performance data points are for Class F of the Fund. Other classes are available. Fees and performance may differ in those other classes.