Manager’s Commentary – Geoff Castle – April 2017
The Pender Corporate Bond Fund returned 0.3% in April. Although certain credits gained, others were weaker in the month and the net effect of winners and losers was this very modest total. Winners included demand-side management energy leader Enernoc Inc, where our convertible bonds rose in value by five points and foreign exchange broker Global Brokerage, where we saw an uptick in valuation. On the weaker side, Sherritt bonds were a few points lower on uncertainty surrounding the company’s bid to restructure its financial commitments in the Ambatovy nickel plant. Preferred shares also were slightly weaker in the month. In the end, our total return for April was approximately the level of underlying coupons.
During the month government bond yields fell slightly, with both Canadian and US sovereign yields retreating by about 0.1% at the 5 year tenor. Credit spreads were largely unchanged. The Bank of America Merrill Lynch US High Yield Index spread to Treasuries tightened modestly, to approximately 3.8%, towards the lower end of the recent historic range.
As a general strategy, we have been focused this year in growing the weight in the higher credit quality band of the portfolio. That work continued in April as we added significant weight in the 2022 notes of Halyard Health, a $2 billion provider of operating room consumable supplies and equipment. With a Bloomberg one-year default risk of 0.06%, and over $1.8 billion in equity valuation sitting below its $250 million bond obligation, we believe the 4.9% yield to be highly attractive risk/reward. We think Halyard’s much publicized recent lawsuit related to surgical gowns is likely to see a reduction in the plaintiff award on appeal, but even if no improvement in that judgement is made we are still very comfortable with our credit position.
In a similar vein the Fund added to its holdings of McDonald’s bonds, moving that very good quality credit to the top five exposures in the Fund from an issuer perspective. We also added convertible notes of PRA Group, where we believe there is very strong credit value coverage of the 2020 convertible notes. In the Canadian preferred share market, we added weight in issues from very strong Canadian credits Thomson Reuters and George Weston. Over half of the Fund is now invested in securities of issuers with a one-year default risk of 0.3% or less.
Default Risk Models – Our Early Warning System
The recent blow-up in Canadian sub-prime mortgage company Home Capital Group serves as a good example of the benefits of maintaining a real-time credit monitoring system as we do here at Pender, which uses daily changes in issuer default risk probability as a key input.
For reasons that we outline below, our credit mandate has a zero percent weight in the Canadian mortgage market, and we had no exposure to Home Capital Group in particular. But, had we been invested, we would certainly have noticed the four-fold increase in Bloomberg one-year default risk for Home Capital during the month of April. This rise in default risk was evident well ahead of the company’s spectacular meltdown on April 26. We note the current 1 year default risk on Home Capital is now in excess of 10%. As so often happens, the credit downgrades which arrived from rating agencies on April 27 came a little too late to be useful information. We continue to encourage investors to reduce their dependence on ratings-based risk models and adopt real-time, objective risk assessments and models.
Our Take on Home Capital and Canadian Mortgage Financial Markets
The Fund is not invested in bonds or other securities issued by Canadian housing finance companies, Canadian banks, mortgage pools or other Canadian residential real estate issuers. Perhaps, one day, when we are convinced that the underlying asset class has some good value, we might. But lots of things have to change in the market first. We see the recent stress of Home Capital Group as a first step towards a long-overdue market correction.
The main problem with the sector, as we view it, is residential real estate valuation. It appears unsustainable that homes which might rent for, say 1-2% of capital value (that is, net rent after taxes and costs divided by appraised property value) are being purchased by sub-prime buyers who are financing such purchases with mortgages that cost 3-5%. This “negative carry” requires investor landlords to continue to fund their property ownership through monthly cash subsidies. We understand “they aren’t making more land,” but that fact alone should not compel anyone to pay a higher cashflow out than a property can return in terms of rental income. Eventually a new set of prices and rates will arrive to make the math investor friendly again.
We have other concerns, as well, with respect to Canada’s housing and mortgage market. We are concerned about the relatively short duration mortgages that the lowest tier of Canadian borrowers have taken on. The worst pool of borrowers is, ironically, the most immediately vulnerable to changes in the credit environment. In addition, we see the clear policy direction from the Government of Canada as being one of withdrawing, bit by bit, the sovereign credit guarantee in key areas of the mortgage market. We believe the ONLY reason why home prices have moved demonstrably higher in Canada than they are in the United States has to do with this government backstop which has been provided largely through insurance and guarantees of the Canadian Mortgage and Housing Corporation (CMHC), but also to a degree through the Canadian Deposit Insurance Corporation (CDIC).
We are still avoiding any exposure to this sector. When an industry starts to enter distressed territory, our experience has been it does not pay to be the first to swoop in to pick up “bargains.” If the dislocation in Canadian housing and mortgages is even half as severe as we believe it may become, there will be plenty of time to find well covered, attractive distressed credits. For now, we watch.
The Fund yield to maturity at April 30 was 5.8% with current yield of 4.8% and average duration of maturity‐based instruments of 2.5 years. There is a 7.7% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 3.0% of the total portfolio at April 30.
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