Manager’s Commentary – Geoff Castle – February 2016

Written by Geoff Castle

The Pender Corporate Bond Fund returned 0.4% in February, with that rather unremarkable result belying the considerable mid-month volatility that took place. After a steep drop in the first ten days, the Fund rallied more than two percent over the back portion of the month. As exciting as that may seem, many high yield funds with more aggressive risk profiles experienced swings of three times that amplitude. We intend to occupy what we believe to be a client-friendly niche of attractive income yield with moderated volatility. While our track record post-transition is short, we can point to February as evidence that we have made progress toward that goal.

In our case, the biggest contributor to mid-month volatility was our position in the March 2016 bond of Chesapeake Energy. A rumour of imminent bankruptcy filing, which turned out to be baseless, caused our very short tenor position to be marked down significantly for a few days. We were able to take advantage of this volatility through the purchase of other, more sensitive securities of Chesapeake, which in this case was the 6.625% bond of 2020. In its February 24 earnings release, Chesapeake management revealed that the company has repurchased in the open market about half of March 2016 bond issue, and the company established its unequivocal intent to pay out our maturity at par this month with its cash on hand and ample available credit facility. As a result of this trading against the grain the return on our Chesapeake position has been significantly higher than we originally expected.

In February, we also took advantage of extraordinarily weak market conditions to establish positions in a number of new holdings at attractive prices. We acquired stakes in short-term and long-term bonds of copper producer Freeport-McMoRan, a busted convertible bond issued by Chart Industries (a US-based gas compression specialist), and a long maturity of Kinross Gold. We also initiated temporary “deal arbitrage” positions in bonds of Capstone Infrastructure and preferred shares of Rona Inc in relation to pending takeovers.

Strategy Notes

We don’t know what the future will bring, but we certainly do observe a remarkable change in tone in high yield credit markets since mid-February. On a particularly dark day late in 2015, one of our Wall Street brokers told me that his firm’s trading floor whiteboard had a list of sixty-seven major client orders, sixty-five of which were “sells.” In early March, we have seen the frustration in the market quickly turn from “lack of bids” to “lack of offers” as certain low-priced bonds have gapped up on strong investor interest. At these price levels, it seems possible that the rally can continue for a while.

The combination of very low prices and a renewed bid in the market (with its implicit promise of the re-opening of a financing window that had been slammed shut) has made us somewhat less risk averse, and we have been initiating positions in a number of low-priced securities of larger, better quality resource issuers. Beginning a couple of months ago with a purchase of a long-dated Teck Resources bond priced in the 40s, we have selectively added positions in Kinross Gold in the low 60s and Freeport-McMoRan in the 60s. Originally issued at quite low fixed rates, we believe these long-dated bonds have traded down more as a result of uncompetitive coupons, than concerns about low recoveries in the event of default. The result is a security with less principal risk than the other pari passu bonds of these issuers, with the trade-off being a slightly lower yield than nearer-term issues priced in the 80’s and 90’s. As with any low priced bonds, with these positions we enjoy the optionality related to the ability to put the bonds to the issuers at par on change of control. And the as-purchased yields of these securities, in the range of 10-15%, appear to us to be both sustainable and attractive. With the financing window perhaps opening, we also believe these bonds to be likely targets of issuer buybacks as their repurchase would be a very cost-effective way to reduce headline leverage ratios.

We are following with interest developments in the market for Collateralized Loan Obligations or CLO’s. These securities, which are Wall Street created term loan bundles, have come under significant pressure recently, particularly within the lower rated tranches as losses and defaults have mounted. We see no particular opportunity in the constituent loans at the moment, but we are watching for long opportunities to emerge as well as for the reaction of banks and central banks to this problem, which has infected several important balance sheets.

Fund Positioning

At month-end, the Fund sits with ample liquidity. Cash and bonds maturing in less than one year stand at 39% of total holdings. Yield to maturity in the Fund is 7.7%. Current yield is somewhat lower at 5.9% as our weighted average security price is somewhat below par. Average duration is approximately 2.2 years. Over two thirds of the Fund matures in less than three years.

Geoff Castle
March 2, 2016