May 3, 2016

Manager’s Commentary – Geoff Castle – April 2016

Written by Geoff Castle

The Pender Corporate Bond Fund achieved a return of 4.8% in the month of April. This very good result was the consequence of strong capital appreciation in a number of holdings. The most notable move, a 144% gain in our position in second-lien bonds of Gulf of Mexico oil producer Energy XXI, accounted for just over one-third of the increase. However, the strong performance had many other components, as the Fund held positions in nine securities that posted double digit increases during the month, and several more that delivered more than 5%. Gains were broad based, with energy and materials leading the way, but strong returns from some rate reset preferred shares and consumer finance bonds also contributed, along with continuing strength in closed-end fund holdings.

Energy XXI – Pays Dividends for Valuation Work

The Fund’s biggest contributor to date in 2016, the two month tripling in value of the 11% second lien notes of Energy XXI, shows the benefit of doing good valuation work in a market when other big holders do not care about such trivia.

We had originally sold our inherited position of $900K face value Energy XXI (or “EXXI”) bonds in September at 60% of face on the belief that a reasonable workout for the bonds might be approximately 50% of face value. In the wake of the December collapse of the Third Avenue Focused Credit Fund, these bonds priced down to 30% of face. And in early February, the coup de grace was delivered to EXXI in the form of the bond’s removal from the Barclays High Yield Very Liquid Index. That index deletion caused the EXXI second liens to be automatically and unconsciously sold from index tracking funds, including the SPDR Barclays High Yield Bond Fund, better known by its ticker symbol “JNK.” On the sudden high volume disposition by the ETFs we saw this bond trade down as low as 10¢ on the dollar of face value. Re-sharpening our pencil, we quickly worked through updated models and determined a minimum mid-February stressed valuation of 46% of face value. With such a margin of safety, we could justify buying a much larger position than we had sold and the Fund bought $9.3 million face value of the EXXI 2nd liens at a price just above 11% of face value, with the Pender Value Fund also acquiring $9 million face value.

On April 14th EXXI filed for bankruptcy protection. We had considered this event highly probable in our analysis. Under the terms of the restructuring proposal presented, all subordinated debts were to be extinguished and our holding became the presumptive equity of the restructured company. It isn’t every day that one’s holding files for bankruptcy and your position gains 57%, but that is indeed what happened on April 14. Viewed as an unlevered equity, the valuation of the company’s 50,000 BOE (Barrel of Oil Equivalent) daily production and massive reserve base has come into much clearer focus in the market. Even at the month end price of 35.5% of face value, which is more than 3x our average cost, the company is still trading at less than 10% of its peak enterprise value achieved back in 2014. And, although we believe our holding is still undervalued, our portfolio weighting discipline has caused us to trim the position by about 25% over the past month.

Big Picture … Changes in the Market Environment

Beyond notes on individual names, a comment on the distinct change in the credit market environment in 2016 is warranted. We believe that the panic of mid-February marked an end to the snowballing bear market that existed in certain risk markets, including distressed energy and materials credit. That is not to say that every oil bond is a buy, but rather we see that market participants have begun to think more rationally about long-term asset values of commodity firms. Asset values are now being re-assessed based on clearing prices of commodities being at least equal to the current full costs of global middle-tier cost position. Our assessment of implied bond values (assuming workouts or asset liquidations) compared to market prices suggests that this positive re-rating, while already well underway for some issuers, is far from complete. Therefore we continue to take a very constructive stance towards low priced senior bonds of companies with competitive cost structures who are participating in the energy and materials sectors. We see the large sector underweights of several major “performance sensitive” bond portfolios in energy and materials, the scrambly, “gap-up” up nature of day-to-day trading in the larger issues, and the fact that the rally has flown in the face of a barrage of cautionary commentary in the popular press, as factors consistent with our view that the current trend of price appreciation in energy and materials credit may continue for some time.

While the comments above are made with specific reference to energy and materials bonds, we see rather similar dynamics unfolding in one or two other market sectors and we expect to make comments on some new positions in these sectors at the end of May.

A Word on Our Portfolio Risk Discipline

While the market environment may have changed, our commitment to maintain controls on credit risk and to ensure ample liquidity in the portfolio have not. We target 75% of the portfolio to meet key criteria regarding issuer credit quality and issue size (essentially one year Bloomberg default risk of less than 2% or rating equivalent, and issue size greater than $200 million) and that at least one third of that weight is either formal investment grade securities or securities whose Bloomberg default risk is aligned with the investment grade band. We consider earning a good return for our investors as our top priority, but we do so within the context of being committed to capital preservation and within the ever-present requirement to preserve ample fund liquidity.

Another aspect of managing portfolio risk is to aggressively write-down carrying values of positions where we believe custodian prices do not reflect real values. In this vein, during April we elected to write down the carrying value of Alberta-based Connacher Oil and Gas Term Loan B, which defaulted on an interest payment due at the end of March. This holding, continuing from prior management, remains marked by custodians in many funds at 50% of face value. We chose to write this security down to 40% of face, which in our estimate represents the minimum liquidation value of this position. The cost of this write down, approximately 0.1% of fund assets, is already included in the NAV and monthly performance figure noted above. In the absence of this charge, our monthly return would have been approximately 4.9%.

Optimizing Weightings … Moneyball and the Pender Corporate Bond Fund

One of the factors that we expect to continue to drive portfolio performance in 2016 has been our adoption of an algorithm-based rebalancing strategy that prompts weight adjustments towards areas where our models suggest that risk-adjusted returns will be highest. This strategy is not dissimilar in concept to the statistics-based techniques that some sports teams have adopted, popularized in the Michael Lewis book (and Brad Pitt movie), Moneyball. In the world of baseball, the key under-appreciated statistic was a player’s “on base” percentage. In basketball, successful teams have discovered the points efficiency of making more three point basket attempts. In investment funds, we believe the key is to ensure that prospective returns of each holding are estimated explicitly and that, within the constraints of each of the Fund’s three risk bands, weight is concentrated towards those holdings with the highest probability-adjusted one year return potential. Recent deletions of Rogers weight in favour of Volkswagen, and deletion of Chart Industries weight in favour of added weight in SpeedyCash are examples of profitable re-allocations within like-for-like risk bands that have been prompted by this approach.

Portfolio Positioning

The Fund yield to maturity at April 30 was 7.1% with current yield of 5.5% and average term to maturity of 2.6 years. There is a 7.0% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 6.7% of the total portfolio at April 30, although this level has risen somewhat in early May.

Geoff Castle
May 2, 2016

* F Class

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