Manager’s Commentary – Geoff Castle – December 2015
The Pender Corporate Bond Fund returned -1.6%* in December. Price declines were fairly broad-based across the Fund but particularly impacted longer-duration and lower-rated securities. Most of the price movement took place in the first two weeks of December when an unusually negative group of factors were at play. The major catalyst was Third Avenue’s December 9 announcement that it would suspend redemptions in its $778M distress-focused high yield bond fund. This event, occurring as it did at the height of tax-loss selling, was followed quickly by three other redemption suspension announcements by high yield funds. The result was a frenzy of liquidation activity across the high yield credit sector that pushed prices lower. Marks on our holdings, unfortunately, were not immune from this panic selling.
The historic December 16 move by the Federal Reserve to raise its short term interest rate target by 25 basis points, while affecting some other bond portfolios, coincided with the start of a modest rebound for our Fund which persisted through year-end. Leading the recovery was our basket of closed-end funds, which as a group, had a total return of +0.4% for the month. A number of these funds saw significant reductions in their discounts to net asset value after the Fed meeting. The discount in the Prudential Global Short Duration High Yield Fund, for example, reduced from a mid-month high of 17% to close out the year at 12% discount to daily-reported NAV. The discount in the Aberdeen Asia Pacific Income Fund reduced from 20% to 17% over the same period.
Notwithstanding the year-end unit value stabilization, for 2015 as a whole, the Fund returned a disappointing loss in excess of eight per cent. In the broadest terms, the source of the losses was the Fund’s early and untimely shift in weighting toward lower quality credits about one year ago that resulted in defaults and other significant markdowns through the last twelve months. Although the Fund was not alone in posting negative returns, the aggressive positioning contributed to returns that were below the average of the category. The C$ versions of the Fund were also impacted by its currency hedge of US dollar securities, which worked against us this year. The US dollar version of the Fund had a similar US$ terms loss in excess of eight per cent, but holders of this version did benefit from the 16% appreciation of the US dollar versus the Canadian dollar through 2015.
Focused on the End Client
Our thoughts at the beginning of 2016 are first with our end client, the somewhat risk-averse investor who wants to earn a reasonable cash return on savings. This client is willing to take on somewhat higher risk than a GIC investor, but this risk appetite is still moderate. As exciting as it may be to swing for the fences in the current environment, we see plenty of opportunities for very attractive “base hits” and our focus is on making these – lower risk, short-term wins from bonds where we have high confidence in cash payout. To this basic mix of lower risk “base hit” opportunities, we have retained some weight in longer-term heavily discounted securities. We retained positions where current prices appear to reflect extraordinarily high risk premiums compared to the real default risk we believe exists. Our overall goal is to provide returns in a range between that of an investment grade bond ladder and the high yield universe.
A Stable Core of Moderate Risk
We start 2016 with large positions in near term maturities of strong credits such as Twitter, HealthNet and Volkswagen. Twitter and HealthNet are just two of the bonds we own where the issuer’s working capital exceeds all debt outstanding. Although these issuers are consistently cash generative, which by itself should guarantee refinancing of debts, the ability to repay outstanding maturities from cash on hand justifies very strong confidence in these credits. Volkswagen clearly has some longer-term risk due to concerns about its recent emissions scandal, but the two 2016 maturities we own (February and October) are well covered by a recently reported 21 billion euro bridge loan facility and stand in front of 66 billion euros of equity at market value. The blended average yield of these core credits is 3.6% with average duration of 1.7 years. These core positions are liquid, are sufficiently insulated from credit risks, and yet provide a strong yield advantage vs. typical investment grade securities.
Heavily Discounted Securities Provide Upside
The commodity collapse we experienced over the past eighteen months came, in our view, from a collapse of fundamentally unstable demand from China. We are not holding our breath for the return of a commodity boom. However, that does not mean that certain securities issued by profitable commodity producers aren’t undervalued, or that near-term maturities covered by robust refinancing arrangements won’t be discharged as planned. We like the outlook for loans and bonds of Westmoreland Coal, Energy Fuels, and Paladin Energy, all of which generate sufficient cash flow to cover interest charges even within the current weak price environment. In these cases, the Bloomberg default risk for the term to maturity, (based on the DRSK model considering leverage, operating performance and equity valuation) is on average 5%, but the average yield to maturity of these securities exceeds 15%. Here we accept some uncertainty of outcome, but we are confident we are being adequately compensated for risks undertaken.
Capital Structure Abitrage – Exploiting Unique Situations
An important tool at our disposal is the selective use of long/short positions to exploit opportunities where we believe different securities of an issuer are mispriced relative to one another. Over the past couple of months we have entered into two such positions and look to add to these as opportunities present themselves. In November we acquired a long position in the rate reset preferred shares of Veresen Inc, offset with a short position in the unsecured bonds of the same issuer. Our thesis was that the extraordinary discount applied to the Veresen Series A preferred shares was not matched by the high price of Veresen’s unsecured debt. Our short position in the unsecured bonds can help protect us in the event that the company’s credit deteriorates. The net effect of this position is a substantially hedged 7.5% cash yield.
Another opportunity relates to Teck Resources. We are highly confident in Teck’s ability to repay its January 2017 maturity and have entered into a long position at this tenor. For longer maturities, the outlook for Teck is more uncertain and so we have entered into a long/short trade in which we are long the deeply discounted maturities at the long end of the curve, priced in the 40’s, while being short a 2018 maturity priced in the 70’s. With the long/short trade, we stand to profit either in the event that Teck defaults prior to 2018, or in the event that Teck is acquired and the bonds are redeemable at par.
We realize 2015 was not a profitable year for our investors. In 2015 we acted to return the risk profile to a more moderated position. We are now focused on the future and the good opportunities we see looking forward. The yield to maturity of the Fund was 6.24% as of December 31. Liquidity, temporarily elevated due to recent maturities and the close of term loan trades, is 23%. Fund average duration remains low at 1.6 years.
January 6, 2016
* F Class