July 7, 2017

Manager’s Commentary – Geoff Castle – June 2017

Written by Geoff Castle

The Pender Corporate Bond Fund returned 0.3% in June, a reasonably good result given generally weak performance of credit markets. Helping this performance was our position in the convertible notes of EnerNOC Inc, which jumped more than 9% on the announcement of its agreement to be acquired. Our positions in Canadian rate-reset preferred shares also rallied strongly on upward movement in the Canadian 5-year bond yield. Offsetting this move was weakness in some securities with exposure to commodities.

A key event this month was the very aggressive message coming from the Bank of Canada indicating that, for the first time in two years, it was considering raising its benchmark overnight lending rate from current levels of 0.5%. The relatively rate-insensitive positioning we have adopted helped protect the Fund from some volatility that arrived in the wake of this news.

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EnerNOC – A Case Study in Credit Valuation

During June, the portfolio benefitted from the takeover announcement of EnerNOC Inc, one of the fund’s larger positions. We acquired EnerNOC 2.25% convertible debentures in 2016 at an average cost of 76% of face value. At the point of purchase we believed that this company, a leader in electricity demand-side response, was misunderstood by investors. On a reported basis, the strong profitability in its core business was obscured by significant losses in its startup software division. Considering the value of the two divisions separately, we estimated the fair value of EnerNOC’s profitable division, combined with its cash balance, to be far in excess of the company’s total debt.

The announced purchase of Enernoc by Italian utility group, Enel SpA, validated this belief, as the full deal valuation was approximately 3x total debt of $130M. It is one thing to talk about a margin of safety, but this deal really demonstrated how well covered our credit position was. On the deal, the debentures traded from a low 90’s mark up towards a $100 par value. We expect to put our position to the company at par on the deal close, sometime in Q3.

Bank of Canada Tightening Cycle

For just the second time since the crisis of 2008-09, the Bank of Canada appears to be embarking on a program of raising short-term interest rates. In June, two speeches by Bank of Canada Governor, Stephen Poloz, and his deputy, Carolyn Wilkins, made fairly strong cases for rate hikes.

It is clear that the Bank of Canada is concerned about speculation and imbalances in the Canadian residential real estate market. In the detailed Financial System Review the Bank published in June, there was extensive documentation of negative investor cash flows in the Canadian residential real estate market as well as discussion regarding the large amount of private debts Canadians have accumulated alongside our housing boom. We view the Bank of Canada’s moves here to be deliberate efforts to reign in runaway housing speculation and its concurrent debt buildup.

While we can’t expect to precisely predict the Bank of Canada’s actions, we certainly are aware of areas vulnerable to rate hikes across the Canadian economy. We believe the most exposed areas relate to real estate and certain consumer lending activity, and so we avoid these areas within the context of the Canadian market.

New Positions and Activity

During the month we added to our position in George Weston Ltd through the acquisition of a position of the company’s Series C preferred shares, currently paying a 5.2% dividend. We like Weston, the owner of Loblaws and select other assets, and consider the issuer to be one of the best Canadian credits. The company’s 1 year Bloomberg default risk of 0.02% is amongst the lowest of Canadian public companies. On a tax-equivalent basis, these preferred shares pay the same as a straight bond with a yield of 6.9%. However, even the longest dated Weston bonds have a yield just over 4.0%. Where the credit risk is nearly identical, we gladly take a higher equivalent yield.

In June we also added a position in the 5.5% of 2023 notes of California-based Plantronics Inc., the leading player in audio headsets for the call centre industry. Plantronics is a very solid credit, with a strong cash position and carrying net debt of less than 1x EBITDA. The company’s 1 year default probability is 0.03% at June 30. We believe these notes are likely to be called in May 2018 or May 2019 making the 4% yield to those events very attractive for such a short effective tenor.

On the somewhat more aggressive front, we also initiated a position in the 2019 1st lien bonds of loyalty program operator Aimia Inc. Aimia, the operator of the popular Aeroplan airline rewards program, has recently received lots of attention as Air Canada announced its intention to terminate that business relationship in 2020. While there is much uncertainty about the long-term future of Aimia, we are confident that the cash and securities reserves, non-core assets and short-term continuing profitability of Aimia are more than enough support for this senior secured obligation which is also first in the company’s maturity schedule. The bonds closed the month of June yielding close to 10%. Should a downgrade of Aimia’s credit rating occur following the company’s next earnings report, we note that the bond’s covenants provide for higher interest coupons depending on the severity of the ratings downgrade.

Happy Canada Day

By the time you read this, Canada’s 150th celebration of Confederation will have come and gone. Most years, we tend to think of this holiday as a good excuse for a party. But, this year in particular, we pause to appreciate what we have in Canada. Let us not take our country for granted.

Portfolio Positioning

The Fund yield to maturity at June 30 was 4.6% with current yield of 3.9% and average duration of maturity‐based instruments of 2.5 years. There is a 7.7% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash, temporarily elevated due to some liquidity events, represented 10.7% of the total portfolio at June 30.

Geoff Castle
July 6, 2017                                                            

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