Manager’s Commentary – Geoff Castle – December 2016
The Pender Corporate Bond Fund returned 2.2% in December and 23.7% for the full year 2016. This was a very good result, well ahead of our benchmark and, frankly, ahead of our own expectations. During the year, we came upon a large number of opportunities where the price of the bond was much lower than our estimation of the workout value, even given default. Once purchased, a large number of these opportunities worked out well, with some doing so extremely quickly. As a result, the returns the Fund generated in 2016 were about three-quarters capital appreciation and one-quarter coupon-based income.
We see prospects for 2017 as more evenly balanced between potential for capital appreciation and income, although we continue to seek out new price discounted opportunities. And while the number of capital gain opportunities available in credit markets is somewhat smaller than last year, we are cautiously optimistic about a number of discounted positions that we already hold.
To comment on December’s results specifically, the Fund’s performance was driven by gains in a number of discounted securities. Strong returns came from our positions in convertible bonds of demand-side management innovator EnerNoc Inc, biotech research equipment maker Fluidigm Corp, Veresen Series “A” preferred shares and workout debt securities of Brazilian telecoms operator, Oi S.A. Offsetting these gains to a degree was weakness in our holdings of debt in Grupo Famsa and Energy Fuels Inc.
We are not able to specifically forecast the future. However, we do follow price relationships in a lot of markets. Sometimes we see price relationships that are highly unusual compared to history. Statistically speaking, we watch out for two- or three- standard deviation events. In these cases current values are in the range of less than 5% of historic observations. And, in certain markets that tend to revert to average levels, spotting this kind of deviation can help highlight an opportunity or a key risk. Going into 2017, we do see a few of these anomalies.
The most important anomaly we see is in developed market government bonds, where yields are still unusually far below inflation expectations…and this situation is quite pronounced in our home Canadian market. We are therefore strong avoiders of Canadian government credit based on the premise that the unusually negative Canadian real interest rate (that is interest rate less inflation) is unlikely to last. We have also tended to avoid tight spread Canadian investment grade bonds, because yields here appear to be too low.
To be constructive in an environment of potentially rising rates, we do like high quality floating rate instruments. In Canada, we continue to favour the rate reset preferred shares of low default risk issuers such as Fairfax Financial, Power Corporation and Thomson Reuters amongst others. An inflationary, rising rate environment can also be a tailwind for commodity producers. In this area we hold discounted bonds of Canadian issuers such as Sherritt International, Silver Standard Resources and Gran Colombian Gold, amongst others.
Another market where we see unusual pricing is in the US dollar convertible bond market. Essentially, this market, which was so overstuffed with questionable issuance back in 2013 and 2014, has descended to levels where the theoretical value of the call option embedded in convertible bonds is not fairly reflected. For a number of close-to-the-money convertible bonds, the embedded option value is far less than the price we would pay for the combination of a regular bond and a call option if purchased separately. For this reason we hold positions in several US convertible issues such as KeyW, Quantum Corp and PRA Group.
One market relationship that is still relatively ‘normal’ but has moved considerably in the past year has been the US high yield market as compared to the US investment grade market. Back in February 2016, the spread between the BAML high yield index and US treasuries was about 850 bps. Since that time yields in the high yield universe have come down and the yields on investment grade bonds have actually risen as the Yellen Fed has raised rates and future rate expectations. The high yield index spread (currently about 415 bps) is now about average, or even slightly on the low side of history.
In this converging spread market, we have seen a few US higher grade credits become more attractive and we have added a little weight. The recent new positions in 3-4 year tenors of Disney and General Motors result from this shift. We also added weight to the group of credits that “should be” investment grade based on balance sheet and cash flow measures (and, consequently these credits show extremely low default risk). Our positions in credit of Alliance Data Systems and Versign Inc, are examples here.
A final market that is starting to look “stretched” is the US dollar. We do not directly play in currency markets due to our hedged currency position. However, foreign exchange rates do impact credit quality around the world because so many global issuers have debts in US dollars. The trend here is still positive from the point of view of the US dollar, but the value ratio of “US dollar vs. currency X” is near extreme levels for a great number of currencies, not just in terms of price, but also in terms of purchasing power. As such, we would not be surprised by a reversal in trend this year. Such a turnaround would likely be very good news for our credits that are sensitive to US dollar exchange rates, including Grupo Famsa, Oi S.A. and a few deeply discounted closed end fund positions we hold which themselves have significant positions in emerging markets issuers.
The Market’s Song Remains the Same
The changing elements of the credit market environment we mention above are the exceptions. In general, the market circumstances we are in are the same as they were last year. Credit investors still care more about headline coupon than they do about underlying valuation coverage. They continue to rely heavily on rating agency grades that do not fairly reflect the risk-reward equation of bonds and other credit instruments. They are happy to lock in “guaranteed” returns, even if the level of return is below the level of prevailing inflation. They are drawn to high yield indexes, even if the indexes are constructed on the basis of quantity of debt outstanding instead of ability to repay. Based on these continuing inefficiencies in credit markets, we believe our goal of delivering above average returns again in 2017 is achievable.
The Fund yield to maturity at Dec 31 was 8.4% with current yield of 5.8% and average duration of maturity‐based instruments of 2.1 years. There is a 4.6% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 4.9% of the total portfolio at Dec 31.