MAPF Performance: October, 2015

The fund underperformed the indices in October, as several of the insurance sector low-spread FixedResets held gave up their relative out-performance over the prior two months.

When I wrote eMail To A Client towards the end of July, one had to go back to January, 2011, to find a starting point that would give you a positive return through the holding period. As of the end of September, the required starting point moved back again, to July month-end, 2010. Readers will be happy to learn that, according to the TXPR index, one now sees positive returns for the period August 2010 to October 2015.

The current 62-month total cumulative return of basically zero was only exceeded during the Credit Crunch – and even then, the figure was only negative for seven months, from October 2008 to April 2009 inclusive. The discussion in eMail To A Client still applies … but more so, now!

So why is this happening? I believe that a sudden realization that low Canada yields would be reflected in dividends of FixedResets, that started with the reset of TRP.PR.A announced in early December, 2014, turned into unreasonable fear in the spring of 2015 and escalated into blind panic. The yield of FixedResets has decoupled from the five-year Canada rate (note that this chart was prepared prior to the monster rally of the second half of October):

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This has led to a narrowing spread between PerpetualDiscounts and FixedResets (note that this chart was prepared prior to the monster rally of the second half of October) … :

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n.b.: the spread here is “interest-equivalent”

… which has put pressure on the price of PerpetualDiscounts, raising their spread to long corporate bonds to Credit Crunch proportions (note that this chart was prepared prior to the monster rally of the second half of October):

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n.b.: the spread here is “interest equivalent”

So there you have it in a nutshell! Regrettably, I am unable to predict either the timing or the degree of the correction that must happen at some point.

ZPR, is an ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned -%, -% and -% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of +7.28%, -4.75% and -21.19% respectively. The fund has been able to attract assets of about $1,043-million since inception in November 2012; AUM increased by $144.1-million in September; given an index return of +7.28% an increase of about $65-million was expected, so there was a very significant cash inflow over the month. I feel that the flows into and out of this fund are very important in determining the performance of its constituents. ZPR changed its index provider effective October 2015; I believe that this may have been at least partially motivated by a desire to de-emphasize the horrific performance of the past three years by using an index with a very recent inception date; and that this may be taken – with a grain of salt – as an indication that the BMO Brain Trust thinks FixedResets are at a bottom.

TXPR had returns over one-, three- and twelve-months of +5.74%, -3.95% and -15.45% respectively with CPD performance within expectations.

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

HIMIPref™ Indices
Performance to August, 2015
Sub-Index 1-Month 3-month
Ratchet N/A N/A
FixFloat N/A N/A
Floater +5.68% -13.49%
OpRet N/A N/A
SplitShare -1.56% -2.05%
Interest N/A N/A
PerpetualPremium +1.01% -0.14%
PerpetualDiscount +2.72% -1.60%
FixedReset +4.89% -7.35%
DeemedRetractible +1.35% -0.22%
FloatingReset +5.04% -4.21%

It will be noted that the highest sectoral return observed, +4.89%, is less than the performance achieved by the TXPR index! This is due to October’s outperformance by junk issues, which was illustrated in the post Low-Spread FixedResets: October 2015.

Additionally, the poor October performance by the fund’s large holdings of low-spread insurance-related FixedResets has been fingered as the cause for underperformance in October. This is due to the reversion of these issues to ‘normal’ for low-spread issues not subject to OSFI regulation over a three month period, as shown in the table below:

Ticker October Performance Three-Month Performance Regressed Three-Month Performance
GWO.PR.N -1.01% -13.34% -15.85%
PWF.PR.P -1.29% -14.77% -14.15%
MFC.PR.F -0.85% -15.98% -15.23%
SLF.PR.G +0.13% -7.64% -15.23%
The ‘Regressed Three-Month Performance’ is the performance predicted by the regression line in the last chart of the post Low-Spread FixedResets: October 2015

All that being said, however, there is reason to believe these lower-spread issues are currently cheap. We can look at the Implied Volatility calculation for the MFC FixedResets, with MFC.PR.F shown at its actual bid of 14.02, and a counter-factual price of 15.17, which is where it would be if it had achieved an October return of 7.28%, equal to that of the TXPL index. This results in the following chart:

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So, this very significant change in price looks entirely reasonable according to the pattern displayed by the other MFC FixedResets. We will just have to wait and see how it turns out!

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close October 30, 2015, was $8.0903.

Returns to October 30, 2015
Period MAPF BMO-CM “50” Index TXPR
Total Return
CPD – according to Blackrock
One Month +3.54% +5.22% +5.74% N/A
Three Months -8.57% -4.50% -3.95% N/A
One Year %-19.02 -15.34% -15.45% -15.64%
Two Years (annualized) -5.83% -5.95% -5.29% N/A
Three Years (annualized) -4.32% -3.91% -3.97% -4.31%
Four Years (annualized) -0.66% -1.47% -1.58% N/A
Five Years (annualized) -0.06% +0.07% -0.40% -0.83%
Six Years (annualized) +3.21% +2.30% +1.57%  
Seven Years (annualized) +10.62% +4.38% +3.53%  
Eight Years (annualized) +8.44% +2.15% +1.33%  
Nine Years (annualized) +7.10% +1.34%    
Ten Years (annualized) +7.02% +1.71%    
Eleven Years (annualized) +6.97% 1.91%    
Twelve Years (annualized) +7.65% +2.21%    
Thirteen Years (annualized) +8.99% +2.60%    
Fourteen Years (annualized) 8.23% +2.66%    
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.
Figures for National Bank Preferred Equity Income Fund (formerly Omega Preferred Equity) (which are after all fees and expenses) for 1-, 3- and 12-months are +3.58%, -3.04% and -11.69%, respectively, according to Morningstar after all fees & expenses. Three year performance is -2.18%; five year is +0.75%
Figures for Manulife Preferred Income Class Adv [into which was merged Manulife Preferred Income Fund (formerly AIC Preferred Income Fund)] (which are after all fees and expenses) for 1-, 3- and 12-months are +5.53%, -4.27% & -15.87, respectively. It will be noted that AIC Preferred Income Fund was in existence prior to August, 2009, but long term performance figures have been suppressed.
Figures for Horizons Active Preferred Share ETF (which are after all fees and expenses) for 1-, 3- and 12-months are +5.15%, -3.36% & -12.88%, respectively. Three year performance is -2.59%
Figures for National Bank Preferred Equity Fund (formerly Altamira Preferred Equity Fund) are +4.98%, -3.60% and -14.29% for one-, three- and twelve months, respectively. Three year performance is -4.37%
The figure for BMO S&P/TSX Laddered Preferred Share Index ETF is +7.03%, -4.89% and -21.45% for one-, three- and twelve-months, respectively. Two year performance is -9.14%.
Figures for NexGen Canadian Preferred Share Tax Managed Fund (Dividend Tax Credit Class, the best performing) are -%, -% and -% for one-, three- and twelve-months, respectively.
Figures for BMO Preferred Share Fund are -3.74% and -14.20% for the past three- and twelve-months, respectively.
Figures for PowerShares Canadian Preferred Share Index Class, Series Fare +4.83%, -3.32% and -15.64% for the past one, three and twelve months, respectively. The three-year figure is -5.23%
Figures for the First Asset Preferred Share Investment Trust (PSF.UN) are +6.36%, -6.80% and -20.57% for the past one, three and twelve months, respectively. The two-, three-, four- and five-year figures are -9.35%, -7.07%, -4.54% and -3.58%, respectively.

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 four 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. Until the market became so grossly segmented, there were many comparables for any given issue – 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 was, in effect ‘locked in’ to the low coupon DeemedRetractibles due to projected long-term 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. Nowadays, the fund is ‘locked-in’ to the low-spread FixedResets from these companies: GWO.PR.N, MFC.PR.F, and SLF.PR.G.

In October, insurance DeemedRetractibles outperformed bank DeemedRetractibles:

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… but underperformed Unregulated Straight Perpetuals…

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Correlations were poor for bank DeemedRetractibles (4%, not shown) and insurance (-5%; not shown) but pretty good for unregulated/NVCC-compliant issues (38%).

A lingering effect of the downdraft of 2013 has been the return of measurable Implied Volatility but given my recent updates in recent daily market reports, I will not discuss them further in this post.

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.

What has happened over the past year has been – obviously, now! – a very significant re-pricing of the FixedReset market. My analytical software, HIMIPref™ assumes that the market is always right when it comes to pricing asset classes; it seeks to pick off the individual issues that stray too far from the normal price. Two years ago, FixedResets were yielding so little that the system didn’t see much value even in buying the mispriced ones – the weighting of FixedResets in the September, 2013, MAPF Portfolio Composition was only 8%. However, as the market drifted lower, the cheap outliers gradually became more and more attractive, and the weighting increased from 23.4% in the September, 2014, MAPF Portfolio Composition to its current figure of 70.2% in the September, 2015, MAPF Portfolio Composition. So … too early! But who would have thought that the market would be astonished in December, 2014, that the GOC-5 yields that have been so low for years could possibly have had an effect on dividends? Regrettably, when the entire market is blind, so are quantitative systems. Still, while relative performance has been poor lately, it hasn’t been disastrous … although some clients might feel that absolute performance has been quite disastrous enough, thank you very much.

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
March, 2014 10.2233 5.55% 0.998 5.561% 1.0000 $0.5685
June 10.5877 5.09% 0.998 5.100% 1.0000 $0.5395
September 10.4601 5.28% 0.997 5.296% 1.0000 $0.5540
December, 2014 10.5701 4.83% 1.009 4.787% 1.0000 $0.5060
March, 2015 9.9573 4.99% 1.001 4.985% 1.0000 $0.4964
June, 2015 9.4181 5.55% 1.002 5.539% 1.0000 $0.5217
September, 2015 7.8140 6.98% 0.999 6.987% 1.0000 $0.5460
October, 2015 8.0903 6.84% 1.002 6.826% 1.0000 $0.5522
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.

The same reasoning is also applied to FixedResets from these issuers, other than explicitly defined NVCC from banks.

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.
Calculations of resettable instruments are performed assuming constant contemporary GOC-5 and 3-Month Bill rates. For September 30, 2015, yields of 0.78% and 0.40%, respectively, were assumed; base rates in October, 2015, were 0.80% and 0.36%, respectively.

Significant positions were held in DeemedRetractible, SplitShare and NVCC non-compliant regulated FixedReset issues on September 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) or on a different date (SplitShares) This presents another complication in the calculation of sustainable yield, which also assumes that redemption proceeds will be reinvested at the same rate.

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 to estimate dividends after reset for FixedResets. The assumption regarding the five-year Canada rate has become more important as the proportion of low-spread FixedResets in the portfolio has increased.
iii) Making the assumption that deeply discounted NVCC non-compliant issues from both banks and insurers, both Straight and FixedResets will be redeemed at par on their DeemedMaturity date as discussed above.

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.

Most funds report Current Yield. For instance, ZPR reports a “Dividend Yield” of 4.5% as of August 29, 2014, but this is the Current Yield, a meaningless number. The Current Yield of MAPF was 4.89% as of August 29, 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 discuss it in the context of portfolio reporting is misleading.

However, BMO has taken a significant step forward in that they are no longer reporting the “Portfolio Yield” directly on their website; the information is taken from the “Enhanced Fund Profile” which is available only as a PDF link. CPD doesn’t report this metric on the CPD fact sheet or on their website. I may have one less thing to mock the fundcos about!

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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