Manager’s Commentary – Geoff Castle – May 2016
The Pender Corporate Bond Fund returned 2.1% in May. This good result, well ahead of our benchmarks, was driven by broad-based strength in the portfolio. Of particular impact was the gain in our holding of 2nd lien bonds of Sandridge Energy, which surged over 15% in the wake of that company’s pre-packaged Chapter 11 which was announced on May 18 and favoured holders of the security which we own. We also saw strength in 2nd lien bonds of Chesapeake Energy and Energy XXI, which rose 18% and 13% respectively. (Note: Towards the end of the month we trimmed our Chesapeake weight by 50%). Two event-driven positions (Rona preferred shares and Niska Gas Storage bonds) also rose on improved investor sentiment regarding acquisition-related workouts of those holdings. Fage Dairy bonds also improved on a credit upgrade from S&P.
Big Picture – Lots of Positives in Key Corporate Credit Markets
Overall, we see lots of things to be positive about in key corporate credit markets. In the United States we see strong economic improvement, led by housing. Investors in US housing, at current “cap rates,” stand to earn very high rental returns on purchased property, relative to the cost of mortgage debt. And US home renters appear to have the strongest economic incentives to purchase their homes in more than a decade. We are already seeing a significant pickup in prices and activity in US housing which, until recently, had only been slowly recovering from the crash of 2008. With strength in US housing should come improvements in the balance sheets of US regional banks, stronger credit growth, better employment and higher earnings across a broad variety of industries that have lagged the recovery for many years. We listen to what US Federal Reserve Chair, Janet Yellen, is saying about the strength of the US economy and, considering the facts, we agree. If you combine US domestic economic strength with an improvement in the supply/demand picture for oil and other commodities (mostly driven by reductions on the supply side which are the direct result of dramatically lower capital spending), there are many parts of the US high yield market that are either recovering or, in our view, about to recover. We do not believe that a Federal Reserve rate hike of 25 or even 50 basis points over the balance of 2016 will be enough to derail this positive momentum.
Looking at other markets, where we are admittedly less active, we also like what we are beginning to see in European and Emerging Market (EM) corporate credit. The European Central Bank’s entry into the corporate bond market as a “QE” buyer has started to significantly reduce corporate risk premiums there, and meanwhile Europe is starting to show the first private credit growth in almost eight years. In Emerging Markets, we see rebounds in many currencies that had been severely punished in the credit freeze, and this is a critical factor for EM credit, which is dominated by US dollar debt instruments.
In this context we see Canadian corporate credit as a laggard, albeit with a few notable bright spots. However we continue to maintain no portfolio exposure to Canadian banking and very little exposure to Canadian consumer demand companies. We believe these sectors are vulnerable in the event that we observe a reversal in the extremely buoyant conditions that currently exist in certain Canadian housing markets.
With the generally improving fundamental picture has also come a major portfolio allocation shift from a number of leading institutions towards high yield credit. Nowhere is this more evident than in the largest US bond manager, PIMCO, which recently announced a big increase in the allocation towards high yield securities in its flagship $80 billion Total Return Bond Fund. Effective June 13, 2016, that very influential portfolio’s maximum allocation to high yield will increase eightfold from 2.5% to 20%. This move is almost a mirror image reversal of the high yield liquidity crisis that began with the suspension of redemptions in the Third Avenue Focused Credit Fund back in December 2015. Where PIMCO leads, we believe many others will follow. And that dynamic augurs well for new issuance activity, prices and returns in high yield credit through the balance of this calendar year.
New US High Yield Holdings
Given the constructive market context, we have been working hard to find strong return opportunities with excellent valuation coverage. In the US market, we have recently initiated positions in Gibson Brands, a leading musical instrument company whose guitars have been the mainstay of Eddie Van Halen, the Beatles, Jimi Hendrix and Eric Clapton amongst others. Gibson became somewhat overextended on the recent purchase of the consumer electronics components business of Phillips Electronics, but we are comfortable that our bond position is well covered by collateral value at current prices. Recently we also invested in bonds of high-end cosmetics marketer, Elizabeth Arden, where we see a combination of operational turnaround and a reversal of currency headwinds supporting a rebound in the fortunes of that company.
Canadian Rate Reset Preferred Shares – Doing the Math
One area of the Canadian credit market where we are very enthusiastic is in the beaten up rate reset preferred shares of a number of issuers. In May, our basket of “pref” shares expanded from positions in Veresen, Atlantic Power and Dundee to also include new positions in Power Financial, Fairfax, Great West Life and Brookfield Renewables.
In each of these cases, we see extraordinary value. Not only are the current dividend yields of these preferred share issuers far higher in relation to unsecured debt yields than they have ever been, but the deep price discounts from par makes large capital gains possible if the market decides to compress preferred yields. Keep in mind that most longstanding preferred share issuers are used to seeing their tax-advantaged preferred shares trade with yields significantly below their bond yields. For some reason, the last year has seen this relationship break down, and issuers with corporate debt trading in the 1-3% yield range have preferreds that yield between 4-8%.
To explain the magnitude of the opportunity let’s use the example of Fairfax Series I preferred shares. [By the way, we are big fans of Fairfax as a credit, with its disciplined underwriting record, a significant capital surplus and a long history of compounding book value by over 20% p.a.] The Series I preferreds yield, at current prices and recently reset dividend, about 5.6%. On a tax-equivalent basis that is roughly the same as receiving a 7.3% bond coupon. However, longer dated Fairfax bonds actually only yield about 3.5% at present. If Fairfax Series I was to close even half of the tax-equivalent yield gap, the dividend rate would be…4.2%. In order for the yield on Series I to fall from 5.6% to 4.2%, to what price would the Series I shares need to rise? The answer is $21.33, which happens to be a 33% increase from the $16.00 price where we recently bought. If that yield compression were to happen within one year, a twelve month total return for this security of extremely good credit quality could be as high as 39%, counting the dividend.
Keep in mind, this opportunity really exists because the absolute price of the securities are so far below par. Normally, a yield compression rally in a near-to-par preferred issue would result in a par call and re-issue at lower coupon rate. But when prices have been driven down so far below par, issuers have no ability to spoil the capital gain party.
Can such a significant move really happen? Obviously time will be needed to reveal the answer. But we see enormous numbers of Canadian portfolios with heavy weightings in 1.3% GIC’s. For these folks, a move up to relatively safe 4% preferred dividend yield would represent a quadrupling in after-tax income. We have seen “GIC refugees” become emboldened before and the rallies they cause can be truly powerful.
The Fund yield to maturity at May 31 was 7.7% with current yield of 5.9% and average duration of maturity‐based instruments of 2.3 years. There is a 8.3% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 7.5% of the total portfolio at May 31.