Manager’s Commentary – Geoff Castle – July 2016

Written by Geoff Castle

The Pender Corporate Bond Fund returned 1.5% in July. This month was characterized by a change in leadership by sector as commodity credit was quite weak with the pullback in crude oil prices while consumer oriented companies and US housing related issuers did relatively well. Within our Fund these latter sectors carried the weight as we experienced strong gains in credits of homebuilder Beazer Homes and furniture retailer Restoration Hardware. Our weighting in Canadian preferred shares and closed-end credit funds also made significant contributions in July.

Market Risk/Return Pendulum Moves Back Towards Average

A key consideration when investing in corporate credit markets is determining what stage in the credit cycle we are occupying at the current time. Admittedly, reading this cycle is as much an art as it is a science, but, as other markets have, the credit markets have some statistical signals that give fairly helpful clues.

A couple of the more useful signals in credit are: a) the difference in yield (or “spread”) between the US high yield index and US Treasuries, and b) the ratio of the yield to maturity of that index and the US 10 year yield. In the very worried credit market of February 2016, the high yield market had a spread of 8.9% above Treasuries and the ratio of yield of the high yield index to 10 Year Treasury yields was 5.9 times. After five months of recovery, we now observe a spread to Treasuries of approximately 5.5% and the ratio between the two indices has fallen to 4.6 times.

So how do we sit currently compared to the historic range? The short answer is somewhere in the middle, perhaps a little closer to the “fear” reading than to the “greed” indicator. If you look at recent “tops” in the credit market, spreads and yield multiples were much lower. In June 2007, for instance, the high yield index had a spread of 2.5% over Treasuries and a ratio to 10 year Treasury yields of only 1.5 times. More recently, the credit market topped out in June 2014 with a spread of 3.5% over Treasuries and a ratio of 2.3 times.

Our outcome, of course, depends on the results of the particular credits we own and we work hard to find better than average risk/reward. But we should not ignore the general level of risk pricing in the market. As it stands today, the extraordinary rebound we have seen over the past six months has likely run its course. On the other hand, we believe a number of mis-priced credits still exist and we expect that the coming 12 months can deliver an attractive level of returns, consistent with the headline yield-to-maturity of the Fund.

New and Increased Positions

In recent weeks we have established a couple of new positions in credits with relatively low default risk, yet which possess attractive risk-adjusted yields. These include a 2019 maturity of Titan Machinery, a well-positioned agricultural machinery dealer which distributes (on an exclusive basis) equipment of the number two US equipment brand, Case New Holland, across the Midwest farm belt. Titan’s strong cash balance, its consistent level of service-oriented cash flow, solid inventory position and significant undrawn credit facility capacity are all strong credit positives that will help this business withstand the current headwinds in the agricultural machinery business. Notwithstanding the fact that this relatively short term credit exposure is three times covered by cash and current assets the bond has a yield in excess of 10% to maturity.

We also added recently to our holding of a 2019 maturity of EnerNOC Inc. EnerNOC is in the rather profitable business of aggregating electrical generation “capacity” from large power users in the United States. Essentially this business reduces the need for additional high cost power plant investments by co-ordinating occasional power draw decreases from its base of large industrial power-user customers in order to reduce peak power demands in various regional power grids. The money saved by the grid operator is shared with EnerNOC which generates approximately $50M in EBITDA annually from capacity management. This “capacity” business has been a proven mainstay of EnerNOC for over 10 years and, while relatively low growth in the US, continues to expand internationally.

EnerNOC’s current problem is that the company has spent aggressively to develop a complementary software business that helps their large power-using customers more effectively manage their power consumption. While, on a standstill basis the software business makes money, aggressive marketing and product development spending have burned through all of the company’s recent cash generation and then some. For this reason, one finds the EnerNOC 2¼% convertible bonds of 2019 priced below 74% of face value to yield over 13%. We see this profitability issue as well within EnerNOC’s control and believe the value of the capacity management business and the company’s $100M cash balance provides very deep valuation coverage of this relatively small $127M obligation.

Two Areas We Avoid

With such attractive, well-covered yields available in short-term corporate credit, it does make us wonder why any reasonably nimble investor would bother owning any positions in micro-yielding or negative yielding long-term government bonds. We believe the only logical buyers of these securities are central banks who are engaging in quantitative easing exercises, not as investors, but in order to push nervous private capital into risk bearing assets and to suppress longer term interest rates. If you are a private agent, pursuing portfolio growth, buying a negative yield in fiat currency long bonds of countries with histories of substantial inflation seems completely irrational to us.

In the past few days, we have been witness to the problems that owning long-dated micro-yield securities can cause. In the wake of a reduction of bond buying by the Bank of Japan, 20 year Japanese Government Bond yield rose from a mere 0.10% to a still-tiny 0.30%. That small move in yields, due to the long duration, resulted in a price decline in those bonds of 3.4% within a two day period. To have a drawdown equal to more than thirty years of expected returns occur over the course of a long weekend strikes us as one of the worst risk-reward payoffs available. This is just one example of micro-yielding “safe” securities which we put in the category of “return-free risk” and avoid.

Another area where we avoid is the world of Canadian non-prime mortgages. To be clear, we own no Canadian mortgages of any kind, but grant that low loan-to-value or CMHC-backstopped obligations have fairly limited risk accompanying their very low returns. However, being familiar with the considerable ease at which Canadians are able to originate CMHC-backed mortgages, and being mindful of the rather unprecedented levels of residential real estate valuations in some major Canadian cities, we doubt that the various peddlers of “non-conforming” mortgage product are properly advertising the risks of capital impairment of these securities. We are aware that despite the pervasive money-laundering, frauds and rampant speculation, some people have made money in subordinated real-estate-backed securities in recent years. However the future is not always the same as the past and it would not surprise us if investors in non-prime, subordinated Canadian mortgage securities lose a lot of capital in the coming years.

Portfolio positioning

The Fund yield to maturity at July 31 was 7.5% with current yield of 5.9% and average duration of maturity‐based instruments of 2.5 years. There is an 8% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 5.5% of the total portfolio at July 31.

Geoff Castle
August 3, 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.