Manager’s Commentary – Geoff Castle – November 2016
The Pender Corporate Bond Fund returned 0.8% in November. This was a reasonably good result, given the state of the bond market in general. During the month, yields on longer-dated bonds rose significantly, continuing a price correction that began in the mid-summer. The 10 year US Treasury bond declined in price more than 5% during the month of November, with many corporate issues faring worse. Our benchmark, the FTSE TMX Canada Bond Universe, had a total return of -2.1% for the month.
Within the portfolio, we saw gains in our position in Energy XXI 2nd lien bonds as that issue made progress towards the re-listing of its reorganized equity. US consumer finance credits SpeedyCash and Enova International also advanced due to the now-likely cancellation of the Obama administration’s regulatory initiatives in this sector. We also saw strength in our US convertible notes of KeyW Holdings and Gain Capital as equity market gains positively affected the option values embedded within these bonds. Offsetting this growth, to a degree, was weakness in a long-dated Kinross Gold bond, a post-election decline in prices of Grupo Famsa notes as companies with Mexican exposure were impacted, and a modest decline in the value of our Sandridge Energy equities.
President Trump – Too Early to Tell
The somewhat surprising election of Donald Trump to the Presidency of the United States seemed to be a catalyst for sharp moves in a number of markets. But it may be too early to conclude that the United States government will suddenly begin to act in any coordinated macro-economic direction. For every economic stimulus idea presented during the campaign (like wall building or highway building) there were other ideas (like medical insurance removal or mass deportations) which, if enacted, might reduce economic activity. And there appears to be a fair chance of differences emerging between what the campaign themes were and what the US government actually does under Trump’s leadership. Suffice it to say, our view on how a Trump Presidency may change fundamentals in the business of most of our holdings is generally a non-view. In particular, we are hesitant to suggest that any kind of permanent change in the bond market (such as a new secular trend towards rising rates) should logically follow from the election. However, we do view the current period as containing a little more than the usual amount of uncertainty. Our focus remains on determining strong valuation coverage of the bonds we hold. These are times that call for a margin of safety.
Short Duration Pays Off Again
As followers of our Fund will be aware, this Fund is run with a relatively short effective duration. Term to maturity of instruments with a defined maturity is less than 2.5 years. With risk-free interest rates at generational lows and with real interest rates (that is interest rates less inflation) being negative, we believe it is quite possible that rates might rise, materially, over an extended period. And even if the rise is not permanent, the large percentage drawdown at the longer tenors versus the tiny anticipated returns do not make long-term high grade securities worth the trouble. There is plenty to do in shorter term, well-covered bonds that exist outside the investment grade spectrum.
Lately, our stance has helped us dodge significant drawdowns. Since the end of July, the yield on a 30 year US Treasury bond has risen from roughly 2.1% to 3.1%. It doesn’t sound like much, but in capital value, the loss from holding that “risk free” bond is about 17%. Long-dated corporate credit has actually done a little better, particularly if the spreads started wide, but the drawdowns there have still been noticeable. These price impacts of rising rates are no longer theoretical calculations at the back of a finance textbook, but actual facts printed on investment statements. We encourage all investors to understand where they sit on the duration spectrum and position themselves where they feel most comfortable.
This month, we trimmed a few winners, such as Energy XXI, where our position has gained over 370% from its purchase at 11c on the dollar to trade at more than 50c. We also sold a portion of our holdings of KeyW Holdings and Quantum Corp on strength.
New holdings include a stake in the 4½% 2018 convertible notes of Layne Christensen (LAYN), an American company engaged in diversified drilling activities in water management, energy and construction. LAYN has a long history of profitable operations, despite recent headwinds. We like the company’s recent return to positive cash generation and its healthy cash balance, which exceeds the value of this, its nearest maturity bond. Trading just above 90% of face value, this bond yields more than 8% to November 2018. Owning a convertible, we also enjoy a free option on equity appreciation should LAYN’s stock price approach $22, a level that LAYN shares traded at in ten of the past twelve years.
During the month we also added a position in the 5¼% 2019 convertible notes of Moduslink Global Solutions (MLNK). MLNK is in the supply chain management business, with an emphasis on software applications. This is another situation where the company’s cash balance exceeds all debts outstanding and we observe encouraging debt repurchasing activity on the part of the company. We acquired our position at a price discounted to approximately 85% of face value, a level from which a yield of more than 12% to maturity is available.
The Fund yield to maturity at November 30 was 7.3% with current yield of 5.8% and average duration of maturity‐based instruments of 2.0 years. There is a 5% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 8% of the total portfolio at Nov 30.