The fund underperformed in June, due largely to being over-weight in DeemedRetractible issues, more particularly insurance DeemedRetractibles which severely underperformed – in fact, these issues performed indistinguishably from PerpetualDiscounts.
Markets in general performed poorly in June, with long-dated fixed-income investments (such as preferred shares) being hurt badly. This was due to speculation about the possible end of Quantitative Easing (whereby the Fed is injecting $85-billion/month into the US money supply), which – according to some – were confirmed by the June 19 FOMC statement and particularly Bernanke’s press conference afterwards. The market bottomed on June 24 and has been slowly recovering since then; various Fed officials made a concerted effort to calm the market on June 27.
ZPR, is a relatively new ETF comprised of FixedResets and Floating Rate issues, with a very high proportion of junk issues, which returned -1.77% for the month, and -3.07% over the past three months (according to my calculations from the fund’s NAV data and distribution data; our regulators are hard at work protecting you from performance data since the fund has been extant for less than a year), versus returns for the TXPL index of -2.00% and -3.24%, respectively. The fund has been able to attract assets of about $843.4-million in the six and a half months since inception, adding $18.0-million in June despite the market downturn (which by itself will have reduced assets by slightly over $16-million), and I feel that has had a great effect on the prices of its targetted preferreds and their close relations.
TXPR had returns over one- and three-months of -2.21% and -3.06%, respectively
Returns for the HIMIPref™ investment grade sub-indices for May were as follows:
June, 2013 Performance
Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close June 28, 2013, was 10.3261 after a distribution of 0.132348.
|Returns to June 28, 2013|
|Period||MAPF||BMO-CM “50” Index||TXPR
|CPD – according to Blackrock|
|Two Years (annualized)||+2.95%||+3.80%||+3.23%||N/A|
|Three Years (annualized)||+8.25%||+7.17%||+5.91%||+5.22%|
|Four Years (annualized)||+11.25%||+8.52%||+6.84%||N/A|
|Five Years (annualized)||+16.84%||+6.72%||+5.47%||+4.80%|
|Six Years (annualized)||+13.00%||+4.79%||+3.42%|
|Seven Years (annualized)||+11.86%||+4.05%|
|Eight Years (annualized)||+10.92%||+3.88%|
|Nine Years (annualized)||+10.80%||+4.17%|
|Ten Years (annualized)||+11.72%||+4.18%|
|Eleven Years (annualized)||+11.29%||+4.52%|
|Twelve Years (annualized)||+11.63%||+4.41%|
|MAPF returns assume reinvestment of distributions, and are shown after expenses but before fees.|
|CPD Returns are for the NAV and are after all fees and expenses.|
|* CPD does not directly report its two- or four-year returns.|
|Figures for Omega Preferred Equity (which are after all fees and expenses) for 1-, 3- and 12-months are -2.01%, -2.38% and +2.33%, respectively, according to Morningstar after all fees & expenses. Three year performance is +5.85%; five year is +5.54%|
|Figures for Jov Leon Frazer Preferred Equity Fund Class I Units (which are after all fees and expenses) for 1-, 3- and 12-months are -1.54%, -2.14% and +0.96% respectively, according to Morningstar. Three Year performance is +3.25%|
|Figures for Manulife Preferred Income Fund (formerly AIC Preferred Income Fund) (which are after all fees and expenses) for 1-, 3- and 12-months are -3.84%, -4.76% & +0.73%, respectively. Three Year performance is +3.91%|
|Figures for Horizons AlphaPro Preferred Share ETF (which are after all fees and expenses) for 1-, 3- and 12-months are -1.93%, -2.27% & +2.85%, respectively.|
|Figures for Altamira Preferred Equity Fund are -2.30% and -2.97% for one- and three- months, respectively.|
|The figure for BMO S&P/TSX Laddered Preferred Share Index ETF is -1.77% and -3.07% for one- and three-months. [calculation by JH]|
MAPF returns assume reinvestment of dividends, and are shown after expenses but before fees. Past performance is not a guarantee of future performance. You can lose money investing in Malachite Aggressive Preferred Fund or any other fund. For more information, see the fund’s main page. The fund is available either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited.
A problem that has bedevilled the market over the past two years has been the OSFI decision not to grandfather Straight Perpetuals as Tier 1 bank capital, and their continued foot-dragging regarding a decision on insurer Straight Perpetuals has segmented the market to the point where trading has become much more difficult. The fund occasionally finds an attractive opportunity to trade between GWO issues, which have a good range of annual coupons (but in which trading is now hampered by the fact that the low-coupon issues are trading near par and are callable at par in the near term), but is “stuck” in the MFC and SLF issues, which have a much narrower range of coupon, while the IAG DeemedRetractibles are quite illiquid. Until the market became so grossly segmented, this was not so much of a problem – but now banks are not available to swap into (because they are so expensive) and non-regulated companies are likewise deprecated (because they are not DeemedRetractibles; they should not participate in the increase in value that will follow the OSFI decision I anticipate and, in addition, are analyzed as perpetuals). The fund’s portfolio is, in effect ‘locked in’ to the MFC & SLF issues due to projected gains from a future OSFI decision, to the detriment of trading gains particularly in May, 2013, when the three lowest-coupon SLF DeemedRetractibles (SLF.PR.C, SLF.PR.D and SLF.PR.E) were the worst performing DeemedRetractibles in the sub-index!
I have pointed out in the past that the market continues to treat regulated insurance issues (SLF, GWO) in much the same way unregulated issues (PWF) but there is a much more dramatic illustration of this than usual for the month of June.
As can be seen from the above two charts, DeemedRetractibles issued by insurers behaved much more like Straight Perpetuals than like Bank DeemedRetractibles. Another point worth noting is that the four bank issues which are, or can be, recognized by OSFI as having a NVCC clause (since they can be converted into common without consent by the holders) behaved more like Bank DeemedRetractibles than like the Straight Perpetuals they are.
As the fund holds a high proportion of insurer-issued DeemedRetractibles, fund performance was hurt by this phenomenon.
A side effect of the downdraft was the return of measurable Implied Volatility:
|Implied Volatility of
Two Series of Issues
June 28, 2013
|Issuer||Pure Yield||Implied Volatility|
Those of you who have been paying attention will remember that in a “normal” market (which we have not seen in well over a year) the slope of this line is related to the implied volatility of yields in Black-Scholes theory, as discussed in the January, 2010, edition of PrefLetter. As has been previously noted, very high levels of Implied Volatility (in the 40% range) imply a very strong expectation of directionality in future prices – i.e, an expectation that all issues will be redeemed at par. The decline in Implied Volatility – which is still at very high levels – implies more uncertainty regarding this prediction.
Sometimes everything works … sometimes it’s 50-50 … sometimes nothing works. The fund seeks to earn incremental return by selling liquidity (that is, taking the other side of trades that other market participants are strongly motivated to execute), which can also be referred to as ‘trading noise’ – although for quite some time, noise trading has taken a distant second place to the sectoral play on insurance DeemedRetractibles. There were a lot of strongly motivated market participants during the Panic of 2007, generating a lot of noise! Unfortunately, the conditions of the Panic may never be repeated in my lifetime … but the fund will simply attempt to make trades when swaps seem profitable, without worrying about the level of monthly turnover.
There’s plenty of room for new money left in the fund. I have shown in recent issues of PrefLetter that market pricing for FixedResets is demonstrably stupid and I have lots of confidence – backed up by my bond portfolio management experience in the markets for Canadas and Treasuries, and equity trading on the NYSE & TSX – that there is enough demand for liquidity in any market to make the effort of providing it worthwhile (although the definition of “worthwhile” in terms of basis points of outperformance changes considerably from market to market!) I will continue to exert utmost efforts to outperform but it should be borne in mind that there will almost inevitably be periods of underperformance in the future.
The yields available on high quality preferred shares remain elevated, which is reflected in the current estimate of sustainable income.
|Calculation of MAPF Sustainable Income Per Unit|
|NAVPU is shown after quarterly distributions of dividend income and annual distribution of capital gains.
Portfolio YTW includes cash (or margin borrowing), with an assumed interest rate of 0.00%
The Leverage Divisor indicates the level of cash in the account: if the portfolio is 1% in cash, the Leverage Divisor will be 0.99
Securities YTW divides “Portfolio YTW” by the “Leverage Divisor” to show the average YTW on the securities held; this assumes that the cash is invested in (or raised from) all securities held, in proportion to their holdings.
The Capital Gains Multiplier adjusts for the effects of Capital Gains Dividends. On 2009-12-31, there was a capital gains distribution of $1.989262 which is assumed for this purpose to have been reinvested at the final price of $10.5662. Thus, a holder of one unit pre-distribution would have held 1.1883 units post-distribution; the CG Multiplier reflects this to make the time-series comparable. Note that Dividend Distributions are not assumed to be reinvested.
Sustainable Income is the resultant estimate of the fund’s dividend income per current unit, before fees and expenses. Note that a “current unit” includes reinvestment of prior capital gains; a unitholder would have had the calculated sustainable income with only, say, 0.9 units in the past which, with reinvestment of capital gains, would become 1.0 current units.
|DeemedRetractibles are comprised of all Straight Perpetuals (both PerpetualDiscount and PerpetualPremium) issued by BMO, BNS, CM, ELF, GWO, HSB, IAG, MFC, NA, RY, SLF and TD, which are not exchangable into common at the option of the company (definition refined in May, 2011). These issues are analyzed as if their prospectuses included a requirement to redeem at par on or prior to 2022-1-31 (banks) or 2025-1-31 (insurers and insurance holding companies), in addition to the call schedule explicitly defined. See OSFI Does Not Grandfather Extant Tier 1 Capital, CM.PR.D, CM.PR.E, CM.PR.G: Seeking NVCC Status and the January, February, March and June, 2011, editions of PrefLetter for the rationale behind this analysis.|
|Yields for September, 2011, to January, 2012, were calculated by imposing a cap of 10% on the yields of YLO issues held, in order to avoid their extremely high calculated yields distorting the calculation and to reflect the uncertainty in the marketplace that these yields will be realized. From February to September 2012, yields on these issues have been set to zero. All YLO issues held were sold in October 2012.|
Significant positions were held in DeemedRetractible and FixedReset issues on April 30; all of these currently have their yields calculated with the presumption that they will be called by the issuers at par prior to 2022-1-31 (banks) or 2025-1-31 (insurers and insurance holding companies). This presents another complication in the calculation of sustainable yield. The fund also holds positions in various SplitShare issues which also have their yields calculated with the expectation of a maturity at par.
I no longer show calculations that assume the conversion of the entire portfolio into PerpetualDiscounts, as the fund has no holdings of these issues.
I will also note that the sustainable yield calculated above is not directly comparable with any yield calculation currently reported by any other preferred share fund as far as I am aware. The Sustainable Yield depends on:
i) Calculating Yield-to-Worst for each instrument and using this yield for reporting purposes;
ii) Using the contemporary value of Five-Year Canadas (set at 1.31% for the May 31 calculation) to estimate dividends after reset for FixedResets.
Most funds report Current Yield. For instance, ZPR reports a “Portfolio Yield” of 4.83% as of June 28, 2013 and notes:
Portfolio yield is calculated as the most recent income received by the ETF in the form of dividends interest and other income annualized based on the payment frequently divided by the current market value of ETFs investments.
In other words – it’s the Current Yield, a meaningless number. The Current Yield of MAPF is 5.25%, but I will neither report that with any degree of prominence nor take any great pleasure in the fact that it’s higher than the ZPR number. It’s meaningless; to accord it any prominence in portfolio reporting is misleading.
It should be noted that the concept of this Sustainable Income calculation was developed when the fund’s holdings were overwhelmingly PerpetualDiscounts – see, for instance, the bottom of the market in November 2008. It is easy to understand that for a PerpetualDiscount, the technique of multiplying yield by price will indeed result in the coupon – a PerpetualDiscount paying $1 annually will show a Sustainable Income of $1, regardless of whether the price is $24 or $17.
Things are not quite so neat when maturity dates and maturity prices that are different from the current price are thrown into the mix. If we take a notional Straight Perpetual paying $5 annually, the price is $100 when the yield is 5% (all this ignores option effects). As the yield increases to 6%, the price declines to 83.33; and 83.33 x 6% is the same $5. Good enough.
But a ten year bond, priced at 100 when the yield is equal to its coupon of 5%, will decline in price to 92.56; and 92.56 x 6% is 5.55; thus, the calculated Sustainable Income has increased as the price has declined as shown in the graph:
The difference is because the bond’s yield calculation includes the amortization of the discount; therefore, so does the Sustainable Income estimate.
Thus, the decline in the MAPF Sustainable Income from $0.5500 per unit in June, 2012, to $0.4957 per unit in June, 2013, should be looked at as a simple consequence of the fund’s holdings; virtually all of which have their yields calculated in a manner closer to bonds than to Perpetual Annuities.
Different assumptions lead to different results from the calculation, but the overall positive trend is apparent. I’m very pleased with the long-term results! It will be noted that if there was no trading in the portfolio, one would expect the sustainable yield to be constant (before fees and expenses). The success of the fund’s trading is showing up in
- the very good performance against the index
- the long term increases in sustainable income per unit
As has been noted, the fund has maintained a credit quality equal to or better than the index; outperformance is due to exploitation of trading anomalies.
Again, there are no predictions for the future! The fund will continue to trade between issues in an attempt to exploit market gaps in liquidity, in an effort to outperform the index and keep the sustainable income per unit – however calculated! – growing.