October 6, 2015

Manager’s Commentary – Geoff Castle – September 2015

Written by Geoff Castle

Fund Repositioning

Upon assuming in-house management of the Pender Corporate Bond Fund in early September, we acted quickly to make a few important changes to the composition of the Fund. We sold a number of positions where we believed a high default risk existed within the term of our credit exposure. We also exited certain positions where the Fund held securities that were relatively junior within the issuer’s capital structure and where we were concerned that we had inadequate asset value coverage to our claim. And we added weight in securities possessing relatively high credit quality metrics. The net effect of these changes is a Fund with approximately 20% less issuer default risk, as calculated using the Bloomberg “DRSK” methodology, combined with a more senior overall capital position. The changes to positioning are now complete.

While we retain a much higher yield profile than the investment grade bond universe, we have returned to the more moderate risk positioning that characterized the Fund for much of its history. At month-end the Fund shows a current yield of 7.57% and duration of 2.33 years.

The moderated daily fund price volatility we experienced through the latter part of September, and the relatively stronger performance in a weak market period, is consistent with the changes made to the composition of the Fund. Although the track record of the repositioned Fund is short, it is instructive to note that the Fund had a modest decline of -0.70% in September versus a $CAD total return of -1.24% for the Bloomberg USD High Yield Corporate Bond Index*.

Market Conditions

We find ourselves at a very challenging point in the credit cycle, with generally rising defaults, widening spreads (particularly in the CCC band of credits) and significantly negative investment fund flows to high yield credit. We are careful about forecasting market conditions. However  the relatively stark divergence between government and sub-investment grade bond yields, the large discounts to net-asset-value that have emerged in corporate credit closed-end funds and the rather pessimistic investor sentiment readings towards high yield securities may signal that the trough of the cycle may be near at hand. While we remain cautious, we note that the statistical readings of these indicators are in the same neighborhood as major credit cycle bottoms of the past twenty years.

New Holdings

In the current uncertain environment, we have added weight in a group of securities that share the fundamental characteristics of strong investment grade credit, but have not yet been awarded such status by either Moody’s or S&P and trade consequently at a much higher yield.

Twitter Senior Convertible Notes due September 2019

The 0.25% Convertible Senior Notes of Twitter Inc. (TWTR) due September 2019 were purchased at a significant discount to par. Twitter, a company whose core social media platform is known to almost everyone, is a rapidly growing business with expanding cash generation. The company has negative net debt – its $3.5B cash pile dwarfs its $1.5B bonds outstanding. Moreover, Twitter’s $17B market capitalization provides an equity cushion in excess of 10x its financial obligations. According to the Bloomberg default risk calculation method, BB rated Twitter’s fundamental credit position is solidly within investment grade territory, with a 1-year default risk of less than 0.2%.

We acquired TWTR bonds between 87 and 88 cents per dollar of face value, which offers a 3.7% yield to maturity on a pristine credit. This is much higher than the yield of investment grade credits with similar default risk. AA- rated Xerox Corp, for instance, with 1 year default risk of 0.25% has 2019 bonds currently yielding 2.4%. Moreover, considerable speculation exists that TWTR may be acquired due to the poor recent performance of its stock. In the event Twitter were acquired, our bonds would be redeemable at our option at par, providing a 14% return to holders of the Convertible Notes at today’s price.

Healthnet Senior Unsecured Notes due June 2017

We recently acquired a position in the June 2017 bonds of California-based Healthnet Inc, a leading Health Management Organization (HMO). Healthnet is subject to a current acquisition bid from HMO industry player Centene Corp, which is pending shareholder approval on October 23, 2015 and regulatory approval subsequent to that event. As the contemplated takeover transaction is largely payable in stock and as the credit quality of the acquirer is similarly strong to that of Healthnet itself, we are indifferent to the outcome of the takeover bid.

Healthnet’s standalone credit profile is excellent. The company has a strong credit profile with low debt levels, stable operating income and strong coverage ratios. The issuer is publicly traded with a market cap of over $5B and total debt of $609M at June 30, 2015. Interest coverage exceeds 8x. While a BB rating from Standard and Poors, the company is rated BBB- by Egan Jones Rating Company. Bloomberg 1 year default risk probability is 0.0387%, which places the company fundamentally within the middle of the investment grade spectrum, comparable to “A” issuers such as Anthem Inc. Prospective acquirer Centene’s credit metrics are similarly strong with default risk probability (1 yr = 0.0515%) well within investment grade territory and recent EBIT interest coverage exceeding 15x.

High Yield Closed End Fund Basket

One unique opportunity that the current market dislocation has provided is the appearance of very large discounts to net asset value of credit oriented closed-end funds. Closed-end funds are like actively managed mutual funds, with the difference being that they trade on equity exchanges, based on market determined prices, rather than daily calculated net asset values. As a result of the fluctuations in prices compared to net asset value, closed-end funds will sometimes trade at a premium and other times trade at a discount to the underlying value of their securities. It is this potential for discount that has attracted many good investors to focus on this small sector of the market, not the least of which was Benjamin Graham, author of the value investors’ bible, The Intelligent Investor.

During September, we observed a number of credit focused closed-end funds with indicated yields in the range of 8-11% trading at discounts to daily-calculated net asset values of 16-18%. We acquired positions in shares of several of the larger ones with asset values between $300M and $1.7B. Our payoff scenario from these investments is two-fold. First, our aim is to earn at least half of the indicated yields even under abominable credit market conditions and, more likely, an amount closer to the indicated yields of 8-11%. Secondly, we aim to earn a strong price return as the funds eventually close the discount between the net asset value of actual holdings and the market price of the fund. If we recover even half of the discount to net asset value in the coming 12 months, it would contribute over 8% return on these positions.

On a personal note, I very much appreciate the strong support from the Fund’s major holders through this transition in management and we will work towards our goal of posting strong risk-adjusted returns in the months and years ahead.

Geoff Castle
1 October 2015

* 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.