Manager’s Commentary – Geoff Castle – March 2016
March was a positive month for the Pender Corporate Bond Fund, with the value of the portfolio rising 3.1%*. For the first quarter, which included a significant sell-off and rebound in high yield credit, the Fund’s return was 2.6%. Of particular note, the Fund’s maximum year-to-date draw down, into the lows of February 11, was limited to 2.5%. While that drawdown was approximately one third of the drawdown of the most popular high yield exchange-traded funds, our overall return for the quarter was ahead of these and other relevant benchmarks. A short period, for sure, but these results are in line with where we are aiming, which is to be a corporate fixed income portfolio with strong return potential and moderated volatility.
While returns were broad-based, key contributors this month included positions in US oil and gas producers Chesapeake Energy (with the March 15th maturity paying out as anticipated) and Energy XXI second lien bonds, our basket of closed-end funds, consumer finance holdings SpeedyCash and Enova International, and certain preferred share issues. Offsetting the generally positive tone were a few declines including weakness in the convertible bond of Gain Capital, where we do note that significant insider buying of equity occurred during the month.
Closing the Discount in Closed-End Funds
The first quarter of 2016 rewarded us for the work we did last year on credit oriented closed-end funds, which traded through H2 2015 at discounts to daily-indicated NAV in excess of 15%. Those unusual discounts caused us to initiate a basket buy in September. What has happened in the interim? Since September 30 we have seen a variety of good news items develop for the closed-end funds: discounts to NAV have declined, regular monthly distributions have been paid, some issuer buyback programs were initiated, and underlying NAV’s, which had all been falling, have generally stabilized and begun to rebound higher. Led by our largest September buy, which was the Aberdeen Asia Pacific Income Fund, which returned 15.8% over the past six months, that entire basket posted a return of 11% for the past six months — more than 22% annualized. That is not bad considering that high yield indices have generally been negative for this period. While we have now trimmed back about half our weight in these instruments, we still observe discounts in the range of 12-14% in our largest remaining closed-end fund holdings at the end of March.
Rate Reset Preferred Market
Another rather unpopular market segment we have spent time investigating is the Canadian rate reset preferred share market. Originally sold to investors on the premise that these securities would protect them from “inevitably rising rates,” resets were pummelled through 2014 and 2015 with prices falling from $25 par value to the low teens or even the single digit dollars. We believe the market has now overcompensated for the lower-than-expected reset dividend rates and, by and large, this asset class now represents more opportunity than risk. Over the last month we saw real strength in some of the issues we own, including Dundee Series D floaters, which gained in excess of 15%, and Veresen Series A preferreds which returned more than 20%. We continue to be active, unearthing good bargains in this sector.
New Core Holdings
At the heart of our Fund is a core of relatively short duration corporate bonds that we believe to have attractive risk/reward characteristics. In this category we made some significant additions in March. We added a position in the 2019 and 2020 zero coupon convertible bonds issued by Restoration Hardware. We like the low cost innovation that Restoration Hardware has brought to the higher end of the home furnishings market in North America and believe that, despite a slowdown in growth, the company is poised to compete effectively in this segment for many years to come. We view the recent yield blowout to more than 7% to be a function of the transition from equity-focused holders to credit-focused holders of these well-covered, but busted, convertible bonds.
During the month we also added to our position in short duration Corning bonds. The 2% yield on the November 2017 maturity is hardly exciting on an absolute basis, but for strong investment-grade credit maturing in less than two years, the bond represents excellent risk-adjusted return potential.
The Bargains of Third Avenue
Another area where we have added weight has been in one of the most distressed corners of the credit market, the oil and gas sector. While commodity prices have come down significantly, the degree to which entire capital structures have been repriced lower is quite remarkable. We believe the collapse of the Third Avenue Focused Credit Fund in late 2015, and the related panic of redemptions across the broader distressed credit sector created an attractive and asymmetric risk/reward environment for freshly deployed capital in this area.
Our analysis of a broad set of opportunities has thus far led us to make three investments in second lien bonds of three US-based energy companies: the 8% second lien notes of Chesapeake Energy, the 8¾% second lien notes of Sandridge Energy, and the 11% second lien notes of Energy XXI. We sold these same Energy XXI notes from the Fund back in September of 2015 at a level just above 60% of face value. We continued to follow developments with the company and believe that our repurchase of a significantly larger face value position in March at a cost of less than 12% of face value was done with enormous valuation coverage when considering the likely value of the company’s assets in liquidation.
Taking these three companies in combination, their total enterprise value was in excess of $40B in 2014. Our investment in the second liens is based on our belief that the assets of these companies is worth at least $2B in liquidation. To the extent that bankruptcy is avoided or that liquidation yields higher proceeds, we stand to make quite a strong return on our invested capital.
Our weight in this area is less than five per cent of the Fund’s cost basis. Although we believe the valuation to be compelling, we need to balance the strong potential return against the illiquidity of these instruments and their likely volatility that will come with tough headlines and sentiment changes as the restructuring of the companies proceeds. We would not be buyers of the equities of these issuers as we expect workouts to occur through the next couple of years which could cancel equity values.
The Fund yield to maturity at March 31 was 6.7% with current yield of 5.7% and average duration of maturity-based instruments of 2.4 years. There is a 3% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 13% of the total portfolio at March 31, although this level has declined somewhat in early April.
* F Class