Manager’s Commentary – Geoff Castle – June 2016
The Pender Corporate Bond Fund returned 1.5% in June. This period was relatively turbulent in credit markets and our daily NAV was a bit bumpier than we would have liked, with the days immediately preceding and following the “Brexit” referendum providing some drama. With that said, the overall result was acceptable and we emerge from the month with optimism towards forward looking returns over the balance of the year.
A Few Successes
Although fairly broad-based, one third of the Fund’s monthly return resulted, fortuitously, from a rise to par of our holding of Elizabeth Arden bonds which we had purchased less than one month ago at a price of less than 75% of par value. On June 16, Revlon Inc. announced it was acquiring Arden in a friendly takeover and we now anticipate participating in the take-out of our bonds at the transaction-driven price of over 103% of face value. We file that one under the heading of good things happening to cheap securities. We also had some success in another distressed energy holding, Stone Energy Corp, where our (too small!) position rose more than 60% in the month of June.
Value and Risk
We paid attention to the June 24 one-day move related to the Brexit vote which resulted in a drawdown for the fund of approximately one per cent, which was fully recovered in the ensuing week of trading. Although our move on that day was less severe than that of the large high yield ETFs, we are sensitive to the effect that volatility has on end unit holders. The primary way we manage risk is by seeking deep underlying valuation support of in the credit securities we buy. While this has proven very effective this year in some choppy markets, we do accept the potential for some volatility in order to take advantage of the great opportunities that we see at present.
There are plenty of areas we see attractive risk/reward opportunities in credit markets. One of the most interesting ideas right now is in a long-term favorite area, discounted credit-oriented closed-end funds. In recent weeks, the improvement in underlying NAVs of several closed-end funds has significantly outpaced traded values on the exchanges. Thus we see some funds (for example the Legg Mason BW Global Income Fund) hitting fresh highs in underlying NAVs and yet discounts to NAV are actually widening to crisis-type levels of more than 16%. Usually, discounts expand with falling prices and contract in with rising prices. This growing discount in a rising market is very bullish for our closed-end holdings and we have increased weightings in this area towards our maximum 10% allocation.
Another very attractive area within the Fund over the next few months will be the likely emergence from bankruptcy proceedings of key distressed oil and gas holdings, Energy XXI and Sandridge. We have done the math on the implied equity valuations of our positions compared to the current trading value of similar oil and gas equities in the market. We believe that these companies, as distressed bonds, are trading at less than half of the “read-across” valuation of their closest equity peer group. Although the timeline is uncertain, it is very possible that these positions will be trading as equities before the end of 2016. And, obviously, closing even a portion of this large liquidity-driven discount would be very beneficial to the Fund’s value.
A Note on Tax
One of the important benefits of the repositioning that the fund went through last year was a crystallization of a number of loss pools available from securities sold below original cost. Those transactions created a substantial hidden asset for this fund, at least from the point of view of taxable investors, which is $21 million in tax-losses. Going forward, this loss pool is available to offset any potential tax that might arise from situations like Energy XXI where our return is capital gain. Realistically, the tax loss pool will likely be enough to offset capital gains for several years to come. Combining the benefits of our loss pools with the healthy mix of dividend income we receive from the fund’s weighting in preferred shares and closed-end funds, the fund is positioned very well to deliver a much lower taxable income percentage than most other income oriented funds. Non-registered investors should take notice.
The Fund yield to maturity at June 30 was 7.9% with current yield of 6.0% and average duration of maturity‐based instruments of 2.6 years. There is a 8.9% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 2.1% of the total portfolio at June 30.
July 4, 2016