Manager’s Commentary – Geoff Castle – September 2016

Written by Geoff Castle

The Pender Corporate Bond Fund returned 0.5% in September which was a positive, if unexciting, result. For the quarter, which included strong returns in July and August, the Fund returned 4.8%. During the month, the Fund saw strong gains from holdings in a number of “busted” convertible bonds, including that of Titan Machinery, where the company announced a significant debt repurchase, and Twitter Inc, whose bonds rallied on takeover speculation. These gains were offset, to a degree, by weakness in a few of the Fund’s lower rated securities that arose as risk-off sentiment picked up in September. We continue to believe that this latter group of securities has both compelling valuation coverage and strong appreciation potential.

Counting the Bricks of the Wall of Worry

What are the sources of risk in our Fund? We often get asked this. In corporate credit, particularly in cases like ours where the bonds we are holding are trading at wide spreads to Treasuries, what matters most to our returns is risk that may arise in some individual businesses. We do read what the Fed has to say, but our time is better spent at the company level. And at this level, we are comfortable with the business risks we have taken on.

Each security within the Fund is stress tested at company liquidation value levels and asset prices that occur at the low end of historical ranges. This is where we can influence our fate. We determine the multiple of valuation coverage that we receive on bonds at various yield-to-maturity levels. What we do not control is changes in perceptions of business risk amongst investors. That certainly can and does move prices in the short run. But we have chosen to accept a degree of volatility as the price of longer-term good results.

Right now, the general degree of risk aversion we see is still above average. That is good for long-run returns. What is our evidence for investors being on the risk averse side? We see this in the questions we receive about the Fund, which are risk focused versus reward oriented nine-times out of ten. We see it in the wide disparity of trading multiples between cyclical businesses (which in general are at historic lows with credit at wide spreads) compared to well-known stable companies (where we see record high equity multiples and tiny credit spreads). We also see this “flight to safety” bias demonstrated clearly in the American Association of Individual Investors US investor sentiment survey. On a four week moving average basis, AAII “bullish” readings are now at the lowest level in that index’s 29 year history. It is never easy to be on the other side of sentiment. However in this business, like no other, fortune favours the bold.

Twitter – Cashing in on a Cream Puff of Credit

A little over one year ago, we added a significant position in the 0.25% 2019 convertible notes of Twitter Inc. Indeed, for much of the past year these notes have been this Fund’s single largest position. We bought Twitter for three reasons. First, due to the company’s massive net cash position, strong operating cash flow, and large equity market capitalization, Twitter, at least in credit terms, was the closest we could find to a fireproof house. The second reason was that, notwithstanding the safety of the company’s financial position, the notes still provided a reasonably healthy 3.7% yield to 2019, which was probably due to the company’s curiously low BB credit rating.

But there was a third factor that also drew us to the Twitter 2019’s, which was the notes’ heavy discount from par, trading at 87 cents on the dollar on purchase. We had no crystal ball, but we knew the company was a widely rumoured acquisition target, which might give us the opportunity to earn our three years of discount all at once, in the form of our right to “put” these notes to the company at 100 on a change of control. It seemed to us that Twitter’s unique two-way newswire, which occasionally morphs into a global “town square” during times of crisis or excitement, might be considered a trophy asset amongst global media properties.

Over the last few weeks, as rumours of bids by Disney, Salesforce.com and Alphabet, have surfaced, our Twitter notes have rallied sharply. In recent days, we have been able to trim the position within a few points of par, netting a gain of more than 10% from our year-ago purchase. This has been a real-time example of our taking advantage of one of the “cream puffs” of credit, which are situations where very attractive upside exists with only a tiny risk of capital impairment.

New Positions

In September we initiated a position in a discounted convertible note of Tesla Motors, the 1¼% notes of 2021. Now discounted to 84% of face value, the notes all-in yield is between 5-6%. We like Telsa’s positioning in the growing electric vehicle industry, with a strong customer value proposition related to its technology leadership and popular consumer brand.

We believe that Tesla, which boasts a market capitalization of over $30B, cash balance of $3.2B and debts of only $2.6B, is a very remote bankruptcy risk. Viewed in terms of Bloomberg default risk, Tesla is currently evaluated at approximately 0.31% one year default risk, which places this credit in a range similar to that of investment grade issuers in the auto industry such as BMW and Toyota. Tesla’s default risk is actually much lower than investment grade rated Volkswagen which had a one year default risk of 0.54% at month-end. In our view, the company’s attractiveness as a potential acquisition target may provide further credit support in the event that the company’s equity value were to decrease.

Also in September we purchased a stake in the June 2017 maturity of Just Energy, which are attractive on a greater than 6% yield-to-call basis, with calls expected to refund our investment before year-end.

A final new position was initiated in the November 2017 maturity of data storage company Quantum Corp. Trading down below 91% of face value with just over one year until maturity, we see huge opportunity in a well-collateralized risk, in a business that we already know by virtue of our equity positions in several of Pender’s other funds. The yield-to-maturity on an as-purchased basis was approximately 14%.

During the month we exited our investment in Chesapeake second lien 2022 bonds after their rally from 48% to face value to 98% of face. We also sold our position in shorter term notes of Freeport McMoran. In these instances cash was re-deployed to more attractive opportunities.

Portfolio Positioning

The Fund yield-to-maturity at September 30 was 8.4% with current yield of 5.9% and average term to maturity of maturity‐based instruments of 2.2 years. There is a 7% weight in distressed securities purchased for workout value whose notional yield is not included in the foregoing calculation. Cash represented 5.3% of the total portfolio at September 30.

Geoff Castle
October 6, 2016

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* 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.