November 5, 2020

Pender Fixed Income – Manager’s Commentary – October 2020

Written by Geoff Castle

The Pender Corporate Bond Fund experienced a modest loss of -0.3% in October, ending a series of strong months that saw the Fund substantially recover from its March drawdown. The decline occurred within the context of surging market volatility, as worsening COVID-19 pandemic conditions and worries about the upcoming US elections weighed on investor confidence. Towards the end of the period, we also saw a noticeable uptick in government bond yields.

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Weaker issues included our position in the bonds of fuel refiner Par Pacific Holdings, which traded lower as the timeframe for a recovery in travel to Hawaii was extended by the renewed viral wave. We consider Par’s business to be durable enough to make it comfortably to the other side of even an extended pandemic. However, a delay in “back-to-normal” does impact such positions. Another weaker issue in October was Intercept Pharma, which has struggled in garnering FDA approval for an extension in the prescriptible conditions for its Ocaliva liver therapy. Notwithstanding this uncertainty, we believe the value of Ocaliva, given its already approved indications, far exceeds the total of all Intercept debts. As such, we consider the 17% yield to maturity in Intercept’s 2023 convertible notes to be a bargain.

Offsetting the decliners, to a substantial degree, were a number of issues responding positively to diverse catalysts. SunPower, America’s leading provider of solar power solutions to residences and commercial entities, continued to strengthen amidst an improving outlook for solar investment, pulling our 2023 convertible notes above par. Husky Energy’s preferred shares rallied upon the announcement of a pending merger with Cenovus. Additionally, our position in long-dated Mattel bonds surged over par on a recovery in the Barbie franchise, giving us occasion to exit a position acquired in 2018 at prices in the 70s.

Light a Single Candle or Curse the Darkness? The Choice is Yours
These are troubling times. As a US election may be poised to ignite weeks of fractious political uncertainty, a global pandemic rages. With every passing day, the back-to-normal we all hope for seems to get no closer and we find ourselves wondering if “normal” will ever truly return. Given these challenges, is it really surprising that investors are skittish?

We cannot by ourselves dispel the cloud of worry. We can, however, enumerate a number of strengths in the market picture that may be under-appreciated by savers who cower in cash. Yes, there are headline risks in abundance. But under the surface there are a raft of positive factors that we believe will support credit and other risk assets going forward. Let us count these strengths.

The Risks are Known: When we compare this current moment to the beginning of the pandemic, so many of the unknowns surrounding COVID-19 have come into much clearer focus. Masks and distancing create inconvenience, but these practices, when adhered to, seem to work. We know much more about who is vulnerable to the virus and how to protect them. Hospital outcomes have improved. And a vaccine, howsoever imperfect, appears likely to arrive sometime in 2021. Whether further recovery comes by leaps, or by grindingly slow progress, the uncertainties of recovery from COVID-19 become smaller every day.

The Hedges are On: Given the widely known risks associated with the upcoming US election, and given the recent uptick in measures such as the CBOE put-to-call ratio, we surmise that some of the market’s recent volatility has resulted from hedging activity. But for every hedge put on, eventually a hedge must be taken off. There is really no central record of temporary de-risking and position hedging on at any one moment, but we can attest that in the last six weeks we have personally observed much more risk-off behaviour than usual. Given the hedgers have to cover, we are buyers of this wall of worry.

Our Bogey is Zero: Well it’s not exactly zero, but a 5-year Government of Canada bond, for instance, yields about 0.4%. As we look to other markets that have ended up with risk-free rates below the zero-lower-bound, we see a history of fairly striking spread compression. Given high yield credit spreads around their historic 5% range, there does appear to be continued scope for tighter spreads. And tighter spreads are good news for credit and other risk capital markets.

The Fed is Engaged: Unlike the circumstances that existed in March, the engagement of the Federal Reserve and other central banks is not open to question. The Fed is engaged and has the tools to manage a spike in risk premia with its unlimited firepower. There are indeed problems that a central bank can’t fix, but a nominal price collapse in domestic markets is not one of them.

We could list other factors that give us optimism amidst the current gloom. The rise of modern monetary theory as a boost to fiscal spending expectations is one. Another is the almost inevitably favorable comparative results that will arrive once we begin annualizing Q2 2020 numbers. There are many factors that encourage us to take sensibly considered credit risks in this environment. Will you light this single candle of optimism or will you choose to curse the darkness? The choice is yours.

New Positions
In October we added a position in the convertible notes of network security leader Palo Alto Networks. We like the long-term growth profile of Palo Alto as it rolls out cloud-based security offerings to supplement the company’s strong leadership in the enterprise space. With a net cash balance sheet, and 1-year default probability we estimate at less than 0.1%, we like the risk reward of the company’s convertible debt structure.

Also in October, we introduced a position in the secured debt of Mallinkrodt Pharmaceuticals, which filed a voluntary Chapter 11 petition on October 14 in conjunction with a variety of state litigation proceedings with respect to opioid claims. We like the 1st lien positions in the Mallinkrodt structure, which will remain current under the company’s plan and may be subject to make whole redemption.

Fund Positioning
The Pender Corporate Bond Fund yield to maturity at October 31 was 5.9% with current yield of 5.0% and average duration of maturity‐based instruments of 2.9 years. There is a 3.0% weight in distressed securities held for workout value whose notional yield is not included in the foregoing calculation. Cash represented 5.1% of the total portfolio at October 31.

Geoff Castle
November 5, 2020