Manager’s Commentary – Geoff Castle – October 2015

Written by Geoff Castle

The Pender Corporate Bond Fund returned 0.2%* in October. Performance was assisted by strong returns in a number of new holdings including the basket of credit closed end funds acquired in September, as well as Healthnet, Twitter and Volkswagen bonds. M&A involving Fund holdings Canexus Corp and Visant also created a positive impact. Unfortunately, significant offsets to performance included weakness in resource holdings including Westmoreland Coal, the Southern Pacific write down, as well as lower marks on consumer finance names including CNG Holdings.

During the month we wrote down the entire carrying value in the Fund’s Southern Pacific Resources Corp term loan, which had defaulted in the first half of 2015. The write down impacted the Fund’s valuation by -0.44%. The move to write down the position was proactive on our part. We made the call due to our expectation that we will receive little, if any, recovery based on our discussions with the company’s receiver, PwC Canada. The Bond Fund’s two other historic defaults are marked either at zero (in the case of Armtec Holdings) or at the low end of the receiver-indicated range of potential recoveries (GasFrac).

Materials and Energy

In the current context, we are inclined to be patient, even hopeful, with respect to our 20% weighting in credits of energy and material producers. That weight is down from the approximate 30% weight the Fund held on management transition in early September as a result of our exit from many junior credit positions that lacked equity buffers. While some commodity bonds, such as those of timber producer Tembec Inc, participated in October’s high yield market rebound, many positions including the coal names like Westmoreland, suffered continued weakness. We can’t know the future, but we do note that multi-year low commodity prices, high cost of capital, capacity rationalization and extreme investor pessimism – all of which we observe at the moment in the commodity sector – are usually indicators that present themselves at the bottom of cycles. Despite the discomfort and investor frustration associated with volatility in this sector, we remain patient with our reduced position. We find the risk/reward of the bond fund’s commodity positions attractive here. As an example, the 8.5% Energy Fuels June 2017 Convertible Debentures (where the issuer’s year-to-date EBITDA interest coverage is 8x and net working capital is greater than total debt) are currently priced to yield over 20% to a cash maturity less than 20 months away.

Closed End Funds – the High Yield Market on Sale

Last month, we observed large discounts of between 15-20% to daily indicated net asset value (NAV) emerging in some of the largest North American closed end credit funds. While closed end funds routinely trade at small discounts to NAV, a look at history shows such extreme discounts have generally appeared at points near market troughs. And history also demonstrates that the closed end credit funds often trade at premiums to NAV. For instance, looking over the twenty-nine year history of the Aberdeen Asia Pacific Income Fund, we observed eighteen years during which the fund traded at a premium to NAV at some point during the year (most recently in 2013). Our strategy was to acquire a basket of closed end funds trading at an average 17% discount to daily indicated NAVs. In October that basket has returned approximately 6% and yet still trades, on average at a discount in excess of 15% to NAV, with an indicated yield in excess of 8%.

Our thesis on this basket, a 15% bond fund weighting, is threefold. We believe we can benefit from the strong indicated current yield, from the recovery of the discount to NAV and also from an improvement in the NAVs. In addition to this “triple play” potential, these holdings have the potential to bring the added benefits of broad diversification and improve the price transparency and its liquidity.

Rate Reset Preferred Shares – An Unusual Discount

Recently we began to poke around in the wreckage of the Canadian rate reset preferred share market and have begun to uncover some attractive opportunities. As background, rate reset preferreds were typically issued at $25 par value by investment grade Canadian corporations, with dividend yields that reset every five years, according to a given spread over a benchmark (typically the 5 yr Government of Canada yield). Investors originally were attracted to the rate reset feature as it protected them against “inevitably rising rates.” Many years later, most investors no longer care about being protected against rising rates and instead have grown fearful over possible future post-reset dividend declines of their preferred shares. Many issues that were snapped up a few years ago at $25 are now languishing in the $15-$19 range yielding 6-9% on a current basis and 4-7% on a post-reset basis.

Many preferreds trade at tax-equivalent yields (post-reset) of more than twice that of the unsecured debt of the same issuers. The usual situation over the past three decades is that preferreds trade at a lower yield than the debt. However, today we find preferreds trading at a higher absolute yield post-reset than unsecured debt and a substantially higher tax-equivalent yield.

One position we added recently was in the Veresen Series A preferreds, where the September 2017 post-reset yield of approximately 6% compared favourably to the 2019 unsecured debt yield of 3.5%. On a tax-equivalent basis that dividend is 2.2x the unsecured yield. We believe our credit-hedged position in these preferreds could deliver strong returns, with the potential for underlying price appreciation. We continue to explore further similar opportunities in the rate reset preferred share market.

Other New Positions

Over the past weeks we have also added several new bond positions including some weight in “yield to deal” situations relating to Visant and Canexus, and outright new positions in obligations of AGT Food & Ingredients and Volkswagen. We continue to add weight in situations where above average yields can be obtained in securities with below-average fundamental risk on tight maturities.

Fund Position Today

We believe the bond fund, as repositioned, is an attractive alternative for the income-focused investor who seeks higher credit quality and better liquidity than the typical high yield portfolio. Our small size, flexible mandate and value orientation are key components in delivering this solution. At October 31, yield to maturity in the bond fund is 8.6%, current yield is 7.1% and duration is 2.05 years.

1 November 2015

* F Class