MAPF Performance: February 2014

The fund outperformed the indices in January, helped by its holdings in insurance DeemedRetractibles but brought down a bit by it’s holdings of the PerpetualDiscounts CU.PR.F and CU.PR.G, which underperformed.

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I continue to believe that the decline in the preferred share market has been overdone; the following table shows the increase in yields since May 22 of some fixed income sectors:

Yield Changes
May 22, 2013
February 28, 2014
Sector Yield
May 22
February 28
Five-Year Canadas 1.38% 1.62% +24bp
Long Canadas 2.57% 2.94% +37bp
Long Corporates 4.15% 4.5% +35bp
Investment Grade
(Interest Equivalent)
3.51% 4.71% +120bp
Investment Grade
(Interest Equivalent)
6.34% 7.25% +91bp
The change in yield of PerpetualDiscounts is understated due a massive influx of issues from the PerpetualPremium sub-index over the period, which improved credit quality. When the four issues that comprised the PerpetualDiscount sub-index as of May 22, 2013 are evaluated as of February 28, 2014, the interest-equivalent yield is 7.68% and thus the change is +134bp.

ZPR, is an ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned XXX%, XXX% and XXX% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of +0.70%, +0.08% and -3.25% respectively. The fund has been able to attract assets of about $954.6-million since inception in November 2012; AUM increased by $23.6-million in February, of which only about $6.5-million is due to internal growth, indicating that money is still flowing into the fund. I feel that the flows into and out of this fund are very important in determining the performance of its constituents.

TXPR had returns over one- and three-months of +0.91% and +0.26%, respectively with CPD performance within expectations.

Returns for the HIMIPref™ investment grade sub-indices for February were as follows:

HIMIPref™ Indices
Performance to February, 2013
Sub-Index 1-Month 3-month
Ratchet N/A N/A
FixFloat -2.18% -8.25%
Floater +0.16% -4.35%
OpRet +0.50% +1.09%
SplitShare +1.26% +1.96%
Interest N/A N/A
PerpetualPremium +0.38% +1.30%
PerpetualDiscount +0.75% +2.22%
FixedReset +0.88% +0.55%
DeemedRetractible +1.41% +0.78%
FloatingReset -0.05% -1.01%

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close February 28, 2014, was $10.2067.

Returns to February 28, 2014
Period MAPF BMO-CM “50” Index TXPR
Total Return
CPD – according to Blackrock
One Month +2.20% +0.92% +0.91% +0.86%
Three Months +1.72% -0.30% +0.26% +0.15%
One Year -1.93% -0.83% -2.14% -2.50%
Two Years (annualized) +3.02% +2.02% +1.44% N/A
Three Years (annualized) +2.91% +3.58% +2.77% +2.25%
Four Years (annualized) +7.06% +5.55% +4.50% N/A
Five Years (annualized) +15.11% +9.64% +8.17% +7.49%
Six Years (annualized) +12.40% +4.76% +3.51%  
Seven Years (annualized) +11.09% +3.44%    
Eight Years (annualized) +10.52% +3.57%    
Nine Years (annualized) +9.97% +3.61%    
Ten Years (annualized) +9.90% +3.62%    
Eleven Years (annualized) +11.62% +4.17%    
Twelve Years (annualized) +10.70% +4.00%    
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 +0.77%, +0.41% and -0.34%, respectively, according to Morningstar after all fees & expenses. Three year performance is +3.18%; five year is +8.70%0
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 +0.48%, -0.38% and -2.73% respectively, according to Morningstar. Three Year performance is +1.06%; five-year is +5.69%
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 +0.79%, -1.11% & -7.22%, respectively. Three Year performance is +0.68%
Figures for Horizons AlphaPro Preferred Share ETF (which are after all fees and expenses) for 1-, 3- and 12-months are +0.81%, +0.12% & -0.38%, respectively. Three year performance is +3.71%
Figures for Altamira Preferred Equity Fund are +0.72%, -0.24% and -3.39% for one-, three- and twelve months, respectively.
The figure for BMO S&P/TSX Laddered Preferred Share Index ETF is +0.66%, -0.08% and -3.72% for one-, three- and twelve-months, respectively.
Figures for NexGen Canadian Preferred Share Tax Managed Fund are not available since our wise regulators are protecting you from inappropriate knowledge.

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, and in June, 2013, when the insurance-issued DeemedRetractibles behaved like PerpetualDiscounts in a sharply negative market.

In February, insurance DeemedRetractibles outperformed bank DeemedRetractibles:

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… and Straight Perpetuals:

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A side effect of the downdraft has been the return of measurable Implied Volatility (all Implied Volatility calculations use bids from February 28):

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Implied Volatility of
Three Series of Straight Perpetuals
February 2014
Issuer Pure Yield Implied Volatility
GWO 4.57%(-0.43) 22% (+5)
PWF 4.25%(-0.62) 25% (+5)
BNS 0.01% (0) 40% (0)
Bracketted figures are changes since January month-end

The Implied Volatility of GWO Straight Perpetual (ignoring their Deemed Maturity) has increased over the month, indicating a steepening of the theoretical slope, implying that lower-coupon issues have outperformed the higher-coupon issues; this is shown in the following chart:

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There is little discernible difference between GWO and PWF, as shown when we show the GWO data with the best fit derived for PWF

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In the September, 2013, edition of PrefLetter, I extended the theory of Implied Volatility to FixedResets – relating the option feature of the Issue Reset Spreads to a theoretical non-callable Market Spread.

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Implied Volatility of
Two Series of FixedResets
February 28, 2014
Issuer Market Reset Spread
Implied Volatility
BPO 85bp (-4) 40% (0)
FFH 338 (-8) 0.1% (-10)
Bracketted figures are changes since January month-end

These are very interesting results: The BPO issues are trading as if calls are a certainty, while FFH issues are trading as if calls are not at all likely.

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, at which point the calculation may be considered virtually meaningless) imply a very strong expectation of directionality in future prices – i.e, an expectation that all issues will be redeemed at par.

It is significant that the preferred share market knows no moderation. I suggest that a good baseline estimate for Volatility over a three year period is 15% but the observed figure is generally higher in a rising market and lower in a declining one … with, of course, a period of adjustment in between, which I suspect we are currently experiencing.

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; something that dismays me, particularly given that the market does not yet agree with me regarding the insurance issues! 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 PrefLetter that market pricing for FixedResets is very often irrational 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
Month NAVPU Portfolio
June, 2007 9.3114 5.16% 1.03 5.01% 1.3240 0.3524
September 9.1489 5.35% 0.98 5.46% 1.3240 0.3773
December, 2007 9.0070 5.53% 0.942 5.87% 1.3240 0.3993
March, 2008 8.8512 6.17% 1.047 5.89% 1.3240 0.3938
June 8.3419 6.034% 0.952 6.338% 1.3240 $0.3993
September 8.1886 7.108% 0.969 7.335% 1.3240 $0.4537
December, 2008 8.0464 9.24% 1.008 9.166% 1.3240 $0.5571
March 2009 $8.8317 8.60% 0.995 8.802% 1.3240 $0.5872
June 10.9846 7.05% 0.999 7.057% 1.3240 $0.5855
September 12.3462 6.03% 0.998 6.042% 1.3240 $0.5634
December 2009 10.5662 5.74% 0.981 5.851% 1.1141 $0.5549
March 2010 10.2497 6.03% 0.992 6.079% 1.1141 $0.5593
June 10.5770 5.96% 0.996 5.984% 1.1141 $0.5681
September 11.3901 5.43% 0.980 5.540% 1.1141 $0.5664
December 2010 10.7659 5.37% 0.993 5.408% 1.0298 $0.5654
March, 2011 11.0560 6.00% 0.994 5.964% 1.0298 $0.6403
June 11.1194 5.87% 1.018 5.976% 1.0298 $0.6453
September 10.2709 6.10%
1.001 6.106% 1.0298 $0.6090
December, 2011 10.0793 5.63%
1.031 5.805% 1.0000 $0.5851
March, 2012 10.3944 5.13%
0.996 5.109% 1.0000 $0.5310
June 10.2151 5.32%
1.012 5.384% 1.0000 $0.5500
September 10.6703 4.61%
0.997 4.624% 1.0000 $0.4934
December, 2012 10.8307 4.24% 0.989 4.287% 1.0000 $0.4643
March, 2013 10.9033 3.87% 0.996 3.886% 1.0000 $0.4237
June 10.3261 4.81% 0.998 4.80% 1.0000 $0.4957
September 10.0296 5.62% 0.996 5.643% 1.0000 $0.5660
December, 2013 9.8717 6.02% 1.008 5.972% 1.0000 $0.5895
February, 2014 10.2067 5.69% 0.994 5.724% 1.0000 $0.5842
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, SplitShare and FixedReset issues on February 28; 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) or on a different date (SplitShares). 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 only a small position in 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 1.62% for the February 28 calculation) to estimate dividends after reset for FixedResets.

Most funds report Current Yield. For instance, ZPR reports a “Portfolio Yield” of 4.90% as of February 21, 2014 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 5.15% as of February 28, but I will neither report that with any degree of prominence nor take any great pleasure in the fact that it’s a little 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:

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The difference is because the bond’s yield calculation includes the amortization of the discount; therefore, so does the Sustainable Income estimate.

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 has generally been 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.

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