Manager’s Commentary – Geoff Castle – October 2016
The Pender Corporate Bond Fund returned 2.9% in October, a very good result. Driving the strong performance during the month were a couple of key events: first was Sandridge Energy’s October 7 emergence from bankruptcy and simultaneous equity relisting on the New York Stock Exchange, which delivered a bump of approximately 20% to our position in Sandridge debt securities; and second, the decision by Lowe’s Companies to tender for all of the outstanding Rona preferred shares at a sharp premium to the prevailing market price. These events, in concert with broad based strength in our higher yielding, short duration holdings, helped the Fund perform strongly in what was otherwise a very weak month in bond markets.
Security-Specific Homework Pays Off
Earlier this year, we invested in the second lien bonds of Sandridge Energy in anticipation of that company’s bankruptcy filing. Our original analysis of the asset value of Sandridge indicated that the work-out value in Sandridge was far higher than the bond price (approximately 25c per face value dollar at the time). On October 7, our original bond stake was replaced by new equity and the stock began trading 20% above its prior equivalent price in bond terms, which was more than 100% above the valuation of our original cost base. We have since trimmed some weight, but still see Sandridge common shares at a material discount to peers in the mid-continental oil and gas exploration and production business. Our intent is not to hold equity positions long-term, but we recognize the potential lift that forthcoming analyst initiations and quarterly reporting can give to Sandridge shares.
We acquired Rona preferred shares after considerable analysis of Lowe’s potential actions in the wake of a failed $20 tender offer for Rona preferred shares at the time of the equity acquisition. We viewed even a $25 par offer for the pref’s as a very modest extra consideration by Lowe’s in the context of the larger deal. Moreover, given that Lowe’s appeared to being laying off all the Canadian personnel who had responsibility for dealing with its Canadian securities listings, and understanding that Lowe’s likely had no use for a Canadian listing in accessing capital markets, we felt that Rona preferred shares would likely be subject to a new, higher tender. As such, we saw Rona preferreds below $20 being a true “free lunch” type of investment. In the event there was no tender offer, Rona pref’s were still yielding more than any of Lowe’s fixed rate securities, but the prospect of a higher tender represented a zero cost call option. Ultimately, that zero cost call option turned out to be worth $4 per preferred share.
Short Duration Pays Off
For most of the past decade, long dated investment grade securities have been a good investment. However, at very low rates, long dated securities can become highly sensitive to even small movements in yields. October’s rate back-up demonstrated that point clearly as the US 30 year Treasury bond fell more than 5% as its yield expanded from 2.32% to 2.58%. Imagine losing two years’ worth of expected returns in just one month holding a US government bond! That just happened. And herein lies the problem with investment grade bonds these days. Yields are so low that, even if rates do not move permanently higher, drawdowns well in excess of an entire year of returns can occur very quickly. Even the relatively short-dated Government of Canada 5 year bond gave up more than 1% of its value in the first two weeks of October. That’s a big drawdown for a security which yielded less than 0.6% per annum on October 1.
Our approach has been to avoid the duration trap by focussing on nearer term maturities of credits with strong valuation coverage. Our exposure is primarily to the credit of individual companies. Our duration exposure, given the Fund’s term to maturity of approximately two years in our defined maturity holdings, is about as small as we can reasonably make it.
As we shave some weight from strong performers like Sandridge and Rona, we continue to find interesting risk/reward opportunities to redeploy capital. Significant new positions this month include the 7.375% 2019 notes of LMI Aerospace Inc. LMI, which makes a number of non-mechanical components for commercial aircraft. LMI is an interesting deleveraging story. The company’s expanding market share within Boeing and other key commercial aircraft platforms, combined with solid underlying OEM order growth, support its growing cash flows from operations.
Also in October we also added weight to our holding in credit of Quantum Corp 4½% convertible bonds of 2017. Quantum, which develops data storage solutions, recently arranged a bank line to support a complete repayment of this bond in November 2017. Notwithstanding the clear path to liquidity for this obligation, we were still able to add to our position below 96% of face value, implying a yield to one year maturity of more than 8%.
During the month we also picked up some exposure to very short-term refinance credit opportunities including the June 2017 maturities of Just Energy and TransGlobe Energy Corp, both of which are issuers with refinancing activities already underway that are anticipated to close before year-end. Both of these issues yield 6%, which is a great level for what is, in effect, money market paper.
The Fund yield to maturity at October 31 was 7.5% with current yield of 5.9% and average duration of maturity‐based instruments of 2.3 years. There is a 5.3% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 4.0% of the total portfolio at October 31.
* FTSE TMX Canada Bond Universe. Given the composition of the Fund at present this index, or other similar US high yield indices, are more reflective of the underlying pool of potential investments than the formal benchmark, the FTSE TMX Canada Bond Universe, with its significant weightings in Canadian and provincial government issues. The appropriate benchmark index for the Fund is currently under review.