Manager’s Commentary – Geoff Castle – August 2016

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The Pender Corporate Bond Fund had a strong month, returning 2.8% in August. The month saw strength from a variety of different credits as bonds purchased at discounts moved towards par. In general, we see market risk premiums continuing to normalize from the rather extreme risk aversion that existed earlier this year.

The beginning of September brings with it the one year anniversary of the current management team’s stewardship of the Fund and Pender’s coincident move to bring under in-house management all of the previously sub-advised Funds. In an interesting market (which included a tough sledding through credit bear market conditions for the first six months and better market conditions through the second six months) the dust has settled with a twelve month performance of 10.7%. We are pleased with this result as well as with some of the less visible changes to the Pender Corporate Bond Fund that include improved liquidity, the implementation of risk control processes (including position size and risk band limits) and a lower management expense ratio.

Our Focus on Value is Driving 2016 Returns

Beyond “coupon clipping,” which does deliver a sizeable portion of the return in the Fund, our performance this year has also benefited from the rising prices of bonds we own. Some price movers in August included:

  • Energy XXI second lien bonds which improved 21% as the company continues to make progress on its reorganization that should result in its re-emergence as a traded equity in late 2016 or early 2017;
  • Mexican furniture retailer Grupo Famsa 7¼% notes of June 2020 surged 11% on a positive ratings action from S&P as the business continued to deliver on its targets; and
  • Beazer Homes 7½% notes of September 2021 improved 5% on strengthening US housing markets and a ratings upgrade.

Each of the stories above is the successful culmination of detailed valuation work we have done on the companies. That work focuses on estimating the collateral value of the entities in liquidation and then compares the as-liquidated value of the bonds to the traded market value at the time of acquisition. Where we find a big discount, or “margin of safety,” on a valuation basis, we feel comfortable pressing the “buy” button, regardless of what rating agencies, ETF’s, or trend following algorithms might be doing. Eventually, the market tends to catch up with the valuation work and re-rates the bonds accordingly. Our daily practice of researching and evaluating company after company does not always get rewarded immediately; but, over time, this activity delivers good results. We consider our rather unique focus on the art of credit valuation to be an important edge in a market that is by no means short on investment “product.”

What Keeps Us Up at Night

When we go on the road to discuss what we are doing in the Fund, we are heartened still to be hearing the numerous questions about “tail risks” or what is “keeping us up at night.” While we do not want to blithely ignore any substantive risks building in the credit markets, we do observe that the best market conditions are those that exist when market participants exhibit a healthy degree of worry. That good condition, in our view, is still in place.

Nevertheless, we ourselves do have worries. Our principal worry, always, has to do with the ongoing development of default risk in companies held by the Fund. This requires constant vigilance. On a more general level, we also are concerned about keeping up with inflation. In a market populated with a surprising amount of corporate bonds yielding less than 2%, we are surprised more people do not also voice such a concern. Once you consider Canadian inflation that has been ranging between 1% and 2% and the fact that there are some fees and costs associated with investing, there are an awful lot of bonds being held in funds that don’t really protect the purchasing power of investors. With real interest rates (that is risk free interest rates net of inflation) being negative, we have moved to occupy spaces that have historically performed well in such circumstances (such as high spread credit, certain commodity sectors and a category we might call “special situations”). Had we not taken this stance, we may have ended up delivering an outcome to our clients that left them poorer in real terms than they were 12 months earlier. The risk of having client assets slowly dilute under the weight of persistent inflation — now THAT keeps us up at night.

Some New Positions

Every market has its darlings and its outcast souls. If we were to cast a character to play Mr. Market right now, we might envision an over-fed type pounding fists on a table demanding cash payouts, and demanding them now. The idea of limiting payouts to invest for future growth, a practice that seems particularly wise given the rapid pace of change we observe in many industries, is more out of style than we can ever remember. If 1999 was the peak of the “growth company” era, 2016 appears to rival that mania in investors thirst for cash “payouts.”

As credit investors we see the same dynamic unfolding as in equity markets. High payout utilities are coveted in credit portfolios despite tiny yields that stretch into the future as far as the eye can see, while true growth companies are burdened with extremely high cost of capital. Never mind that these growth companies are building the products of the future or are establishing infrastructure that will form the basis of strong cashflow growth two or three years from now. This is a market that values its bird in the hand far more than two, three or even ten in the bush.

Against the grain of this trend, we have recently initiated a position in the first lien 2022 notes of the wonderfully named Gogo Inc. Gogo is a half billion dollar revenue company engaged in the rather quickly growing business of delivering wifi connectivity on commercial airplanes via satellite. Faced with a large order backlog and a shortage of capital, Gogo struggled to raise $525 million this spring in a tight credit market and was required to price these notes with a 12½% coupon. We picked up some of these notes in the aftermarket at an attractive price and look forward to strong returns.

Another recent investment of note is in the 2¾% convertible bonds of Fluidigm Corp. Fluidigm makes products and supplies for laboratory research that allows for single cell analysis of various factors relating to cancer mechanisms or immunology. This business has stumbled recently on internal issues relating to multiple simultaneous product launches. However, the game-changing nature of Fluidigm’s technologies and its solid sales base above $100M suggests an underlying enterprise value far greater than its $200M outstanding convertible bond issue. Yet we found Fluidigm bonds recently trading at 63% of face value, a price which represents 14% yield to a 2021 put date. We are excited about Fluidigm and about the returns we believe we will eventually realize on this position.

Portfolio positioning

The Fund yield to maturity at August 31 was 7.5% with current yield of 6.1% and average duration of maturity‐based instruments of 2.1 years. There is a 8.5% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 3.3% of the total portfolio at August 31.

Geoff Castle
September 2, 2016

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* FTSE TMX Canada Bond Universe. Given the composition of the Fund at present this index, or other similar US high yield indices, are more reflective of the underlying pool of potential investments than the formal benchmark, the FTSE TMX Canada Bond Universe, with its significant weightings in Canadian and provincial government issues. The appropriate benchmark index for the Fund is currently under review.