Manager’s Commentary – Geoff Castle – January 2017
The Pender Corporate Bond Fund returned 1.3% in January. This was a good, if unspectacular, result. Driving our returns in January was the increase in price of a number of discounted bonds, combined with our earning regular interest coupons. The proportion of returns was split roughly evenly between these two factors.
During the month benchmark bond yields did not move meaningfully, ending a string of months in which investment grade yields rose strongly and highly rated bonds fell in price. In January, this dynamic was replaced with more of a sideways market. We made no material adjustments to our relatively short duration positioning, a stance that keeps us fairly insulated from the price effect of rising (or falling) interest rates.
Don’t Just Panic – Sit There!
We did take notice of some of the extraordinary events of January 2017. After all, it is not every day that a sitting US President fires his Attorney General or has to defend allegations that his election was aided by foreign subterfuge. Clearly the last election has ushered in a lot of uncertainty and, for all we know, recent events may eventually lead to a constitutional crisis in the United States. While the political situation is unusual, we still view Congress, including most Republicans, as being committed to the most important elements of the US Constitution, and therefore we do not panic. Our high-liquidity strategy gives us plenty of options in exiting positions were the situation to change for the worse, but we are not overly concerned about US-based investments at this time.
We echo a similar sentiment with respect to the movement in the longer dated government bond yields. Our positioning is simple. We are holding short duration corporate credit. However, we would discourage our investors from interpreting this positioning as a “call” that rates are destined to move rapidly higher. It is possible that rates could go higher. But there are many other reasons why we find short duration credit attractive, including the very important fact that a maturity tends to act as a catalyst for an unfairly discounted debt security. We want to get paid for recognizing value sooner rather than later, and short duration credit is a great vehicle for getting that done.
Attractive New Positions
Over the past two months, we initiated a position in convertible notes of Jakks Pacific Inc, a Los Angeles- based manufacturer and distributor of toys. Although recent results have been somewhat disappointing for Jakks, we see opportunity in the deep working capital reserves and the long history of operating profitability of this business. Further, recent debt repurchase activity on the part of Jakks, coupled with significant insider equity buys give us confidence that this credit is well covered, despite attractive double-digit yields.
Another recent position we added was a weighting in two series’ of bonds issued by Texas-based loyalty program manager, Alliance Data Systems Corp. Consistently profitable, Alliance has a strong growth profile and limited leverage with net debt of less than 2x cash flow. Bloomberg’s 1 year default risk for Alliance is approximately 0.05%, placing the company’s default risk profile deep in investment grade territory. However, as this $13 billion market cap company remains unrated by either S&P or Moody’s, the company’s bonds yield over 5% at three- and four-year maturities. We believe that yield is far higher than the company ought to pay, given its very strong credit profile.
Adjustments in the Risk Bands of the Fund
As our longer term holders are aware, we run this portfolio in three discrete risk bands, or “buckets.” The lowest risk band must meet our stress test assumptions of single-day liquidity. Our medium risk band must meet our stress test assumptions of two-day liquidity. And, while our higher risk band has no particular liquidity test requirement, we do ensure that no position in that band represents more than 3% of our cost basis.
After a rip-roaring 2016, during which high yield credit spreads declined from more than 850 basis points above US Treasury yields to just below 400 basis points recently, we decided to adjust the risk band weightings in the Fund in a more conservative direction. From a mix of 25% – 50% – 25% weights in the Fund, going lowest to highest risk bands, we adjusted the bands to a 30% – 50% – 20% weighting, building up the concentration of low default risk, highly liquid bonds. Moreover, we tightened our criteria for inclusion in the higher quality bands. Taking our minimum threshold down to a 0.4% 1 year default risk in the upper band and a 1.5% default risk in the middle band. In short, we have tightened our risk toleration in two separate areas to give the Fund a more moderated risk position.
The Fund yield to maturity at January 31 was 8.0% with current yield of 5.4% and average duration of maturity‐based instruments of 2.2 years. There is a 6.6% weight in distressed securities purchased for workout value whose notional yield is adjusted in the foregoing calculation. Cash represented 5.2% of the total portfolio at January 31.