Category: MAPF

The fund underperformed the indices in September, weighed down by its heavy weighting in FixedResets, particularly those with a low Issue Reset Spread.

The poor performance of the preferred share market is getting to be ridiculous and has started to attract press comment, such as Why you can’t trust the yields on preferred share ETFs and “‘Slaughter’ of preferred shares is alarming”, discussed on September 2.

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 has moved back again, to July month-end, 2010. This incredible period is illustrated in the following graph of cumulative total returns:

As may be seen, 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!

Aficionados will also appreciate the graph of 1-year and 2-year annualized returns:

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 has now escalated into blind panic. The yield of FixedResets has now decoupled from the five-year Canada rate:

This has led to a narrowing spread between PerpetualDiscounts and FixedResets … :

… which has put pressure on the price of PerpetualDiscounts, raising their spread to long corporate bonds to Credit Crunch proportions:

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 -6.55%, -15.86% and -26.63% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of -6.59%, -15.93% and -26.49% respectively. The fund has been able to attract assets of about $898.9-million $982.1-million since inception in November 2012; AUM declined by $83.2-million in September; given an index return of -6.55% a decrease of about $64.3-million was expected, so there was a very significant cash outflow over the month. I feel that the flows into and out of this fund are very important in determining the performance of its constituents. Those seeking shreds of solace amidst the wreckage may find some comfort in the fact that ZPR has changed its index provider; 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 -5.56%, -12.89% and -19.64% respectively with CPD performance within expectations.

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

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close September 30, 2015, was $7.8140 after a dividend distribution of 0.115947.

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 August, insurance DeemedRetractibles performed much worse than bank DeemedRetractibles as, again, the former issues behaved as if they do not believe my thesis that the NVCC rules will eventually be extended to insurers:

… and about the same as Unregulated Straight Perpetuals (a category which includes bank Straights that are explicitly NVCC-compliant).

Correlations were poor for bank DeemedRetractibles (0%, not shown) and insurance (-6%; not shown) but good enough for government work for unregulated/NVCC-compliant issues (15%).

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.

Significant positions were held in DeemedRetractible, SplitShare and NVCC non-compliant regulated FixedReset issues on June 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:

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.

Turnover declined a little in September, to about 5%.

There is extreme segmentation in the marketplace, with OSFI’s NVCC rule changes in February 2011 having had the effect of splitting the formerly relatively homogeneous Straight Perpetual class of preferreds into three parts:

• Unaffected Straight Perpetuals
• DeemedRetractibles explicitly subject to the rules (banks)
• DeemedRetractibles considered by me, but not (yet!) by the market, to be likely to be explicitly subject to the rules in the future (insurers and insurance holding companies)

This segmentation, and the extreme valuation differences between the segments, has cut down markedly on the opportunities for trading.

To make this more clear, it used to be that there were 70-odd Straight Perpetuals and I was more or less indifferent as to which ones I owned (subject, of course, to issuer concentration concerns and other risk management factors). Thus, if any one of these 70 were to go down in price by – say – $0.25, I would quite often have something in inventory that I’d be willing to swap for it. The segmentation means that I am no longer indifferent; in addition to checking the valuation of a potential buy to other Straights, I also have to check its peer group. This cuts down on the potential for trading.

And, of course, the same segmentation has the same effect on trading opportunities between FixedReset issues.

There is no real hope that this situation will be corrected in the near-term. OSFI has indicated that the long-promised “Draft Definition of Capital” for insurers will not be issued “for public consultation in late 2012 or early 2013”, as they fear that it might encourage speculation in the marketplace. It is not clear why OSFI is so afraid of informed speculation, since the constant speculation in the marketplace is currently less informed than it would be with a little bit of regulatory clarity.

As a result of this delay, I have extended the Deemed Maturity date for insurers and insurance holding companies by three years (to 2025-1-31), in the expectation that when OSFI finally does provide clarity, they will allow the same degree of lead-in time for these companies as they did for banks. This had a major effect on the durations of preferred shares subject to the change but, fortunately, not much on their calculated yields as most of these issues were either trading near par when the change was made or were trading at sufficient premium that a par call was expected on economic grounds. However, with the declines in the market over the past nine months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

Due to further footdragging by OSFI, I will be extending the DeemedMaturity date for insurance issues by another two years in the near future.

Sectoral distribution of the MAPF portfolio on September 30 was as follows:

The “total” reflects the un-leveraged total portfolio (i.e., cash is included in the portfolio calculations and is deemed to have a duration and yield of 0.00.). MAPF will often have relatively large cash balances, both credit and debit, to facilitate trading. Figures presented in the table have been rounded to the indicated precision.

Credit distribution is:

Liquidity Distribution is:

MAPF is, of course, Malachite Aggressive Preferred Fund, a “unit trust” managed by Hymas Investment Management Inc. Further information and links to performance, audited financials and subscription information are available the fund’s web page. The fund may be purchased either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited. A “unit trust” is like a regular mutual fund, but is sold by offering memorandum rather than prospectus. This is cheaper, but means subscription is restricted to “accredited investors” (as defined by the Ontario Securities Commission). Fund past performances are not a guarantee of future performance. You can lose money investing in MAPF or any other fund.

A similar portfolio composition analysis has been performed on the Claymore Preferred Share ETF (symbol CPD) (and other funds) as of August 31, 2012, and published in the October (mainly methodology), November (most funds), and December (ZPR) 2012, PrefLetter. While direct comparisons are difficult due to the introduction of the DeemedRetractible class of preferred share (see above) it is fair to say:

• MAPF credit quality is better
• MAPF liquidity is a bit lower
• MAPF Yield is higher
• Weightings
  • MAPF is less exposed to Straight Perpetuals (including DeemedRetractibles)
  • MAPF is less exposed to Operating Retractibles
  • MAPF is more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF is overweighted in FixedResets

The fund underperformed the indices in August, weighed down by its heavy weighting in FixedResets, particularly those with a low Issue Reset Spread which performed poorly.

The poor performance of the preferred share market is getting to be ridiculous and has started to attract press comment, such as Why you can’t trust the yields on preferred share ETFs and “‘Slaughter’ of preferred shares is alarming”, discussed on September 2.

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 August, the required starting point has moved back another month, to December month-end, 2010. This incredible period is illustrated in the following graph of cumulative total returns:

As may be seen, the current 56-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!

ZPR, is an ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned -4.91%, -13.37% and -22.10% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of -4.95%, -13.40% and -21.93% respectively. The fund has been able to attract assets of about $982.1-million since inception in November 2012; AUM declined by $21.9-million in August; given an index return of -4.95% a decrease of about $49.7-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 … although for this month it appears that buying from this ETF was swamped by other sellers!

TXPR had returns over one-, three- and twelve-months of -3.82%, -10.63% and -15.44% respectively with CPD performance within expectations.

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

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close August 31, 2015, was $8.4914.

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 August, insurance DeemedRetractibles performed worse than bank DeemedRetractibles:

… and about the same as Unregulated Straight Perpetuals (a category which includes bank Straights that are explicitly NVCC-compliant).

Correlations were not very good for bank DeemedRetractibles (11%), rotten for insurance (6%; not shown) and lousy for unregulated/NVCC-compliant issues (2%; not shown).

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.

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.

Significant positions were held in DeemedRetractible, SplitShare and NVCC non-compliant regulated FixedReset issues on June 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:

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.

Turnover increased a little in August, to about 10%.

There is extreme segmentation in the marketplace, with OSFI’s NVCC rule changes in February 2011 having had the effect of splitting the formerly relatively homogeneous Straight Perpetual class of preferreds into three parts:

• Unaffected Straight Perpetuals
• DeemedRetractibles explicitly subject to the rules (banks)
• DeemedRetractibles considered by me, but not (yet!) by the market, to be likely to be explicitly subject to the rules in the future (insurers and insurance holding companies)

This segmentation, and the extreme valuation differences between the segments, has cut down markedly on the opportunities for trading.

To make this more clear, it used to be that there were 70-odd Straight Perpetuals and I was more or less indifferent as to which ones I owned (subject, of course, to issuer concentration concerns and other risk management factors). Thus, if any one of these 70 were to go down in price by – say – $0.25, I would quite often have something in inventory that I’d be willing to swap for it. The segmentation means that I am no longer indifferent; in addition to checking the valuation of a potential buy to other Straights, I also have to check its peer group. This cuts down on the potential for trading.

And, of course, the same segmentation has the same effect on trading opportunities between FixedReset issues.

There is no real hope that this situation will be corrected in the near-term. OSFI has indicated that the long-promised “Draft Definition of Capital” for insurers will not be issued “for public consultation in late 2012 or early 2013”, as they fear that it might encourage speculation in the marketplace. It is not clear why OSFI is so afraid of informed speculation, since the constant speculation in the marketplace is currently less informed than it would be with a little bit of regulatory clarity.

As a result of this delay, I have extended the Deemed Maturity date for insurers and insurance holding companies by three years (to 2025-1-31), in the expectation that when OSFI finally does provide clarity, they will allow the same degree of lead-in time for these companies as they did for banks. This had a major effect on the durations of preferred shares subject to the change but, fortunately, not much on their calculated yields as most of these issues were either trading near par when the change was made or were trading at sufficient premium that a par call was expected on economic grounds. However, with the declines in the market over the past nine months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

Due to further footdragging by OSFI, I will be extending the DeemedMaturity date for insurance issues by another two years in the near future.

Sectoral distribution of the MAPF portfolio on August 31 was as follows:

The “total” reflects the un-leveraged total portfolio (i.e., cash is included in the portfolio calculations and is deemed to have a duration and yield of 0.00.). MAPF will often have relatively large cash balances, both credit and debit, to facilitate trading. Figures presented in the table have been rounded to the indicated precision.

The increase in “Scraps” and decrease in “FixedResets” is largely due to the migration of ENB issues in the portfolio between the two classifications due to the DBRS downgrade of ENB preferred shares to junk.

Credit distribution is:

Liquidity Distribution is:

MAPF is, of course, Malachite Aggressive Preferred Fund, a “unit trust” managed by Hymas Investment Management Inc. Further information and links to performance, audited financials and subscription information are available the fund’s web page. The fund may be purchased either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited. A “unit trust” is like a regular mutual fund, but is sold by offering memorandum rather than prospectus. This is cheaper, but means subscription is restricted to “accredited investors” (as defined by the Ontario Securities Commission). Fund past performances are not a guarantee of future performance. You can lose money investing in MAPF or any other fund.

A similar portfolio composition analysis has been performed on the Claymore Preferred Share ETF (symbol CPD) (and other funds) as of August 31, 2012, and published in the October (mainly methodology), November (most funds), and December (ZPR) 2012, PrefLetter. While direct comparisons are difficult due to the introduction of the DeemedRetractible class of preferred share (see above) it is fair to say:

• MAPF credit quality is better
• MAPF liquidity is a bit lower
• MAPF Yield is higher
• Weightings
  • MAPF is less exposed to Straight Perpetuals (including DeemedRetractibles)
  • MAPF is less exposed to Operating Retractibles
  • MAPF is more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF is overweighted in FixedResets

Malachite Aggressive Preferred Fund has published its:

• 15H1 Semi-Annual Financial Statements (unaudited)
• June Month-end statement of holdings (unaudited)
• 15H1 Statement of transactions (unaudited)

All materials are accessable via the fund’s main web-page.

The fund underperformed the TXPR index in July (results for the BMO-CM “50” index are not yet available), weighed down by its heavy weighting in FixedResets, particularly those with a low Issue Reset Spread.

ZPR, is an ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned -XX%, -XX% and -XX% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of -5.31%, -9.07% and -17.26% respectively. The fund has been able to attract assets of about $1,004-million since inception in November 2012; AUM increased by $16.4-million in June; given an index return of -5.31% a decrease of about $52-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 … although for this month it appears that buying from this ETF was swamped by other sellers!

TXPR had returns over one-, three- and twelve-months of -4.10%, -7.53% and -11.47% respectively with CPD performance within expectations.

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

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close July 31, 2015, was $8.9795.

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 May, insurance DeemedRetractibles performed worse than bank DeemedRetractibles:

… and slightly worse than Unregulated Straight Perpetuals.

Correlations were OK for banks (26%), good for insurance (59%) but not very good for unregulated issues (14%; not shown).

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.

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.

The 29bp drop in GOC-5 did not help the sustainable yield calculation!

Significant positions were held in DeemedRetractible, SplitShare and NVCC non-compliant regulated FixedReset issues on June 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:

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.

Turnover remained low in July at about 6%.

There is extreme segmentation in the marketplace, with OSFI’s NVCC rule changes in February 2011 having had the effect of splitting the formerly relatively homogeneous Straight Perpetual class of preferreds into three parts:

• Unaffected Straight Perpetuals
• DeemedRetractibles explicitly subject to the rules (banks)
• DeemedRetractibles considered by me, but not (yet!) by the market, to be likely to be explicitly subject to the rules in the future (insurers and insurance holding companies)

This segmentation, and the extreme valuation differences between the segments, has cut down markedly on the opportunities for trading.

To make this more clear, it used to be that there were 70-odd Straight Perpetuals and I was more or less indifferent as to which ones I owned (subject, of course, to issuer concentration concerns and other risk management factors). Thus, if any one of these 70 were to go down in price by – say – $0.25, I would quite often have something in inventory that I’d be willing to swap for it. The segmentation means that I am no longer indifferent; in addition to checking the valuation of a potential buy to other Straights, I also have to check its peer group. This cuts down on the potential for trading.

And, of course, the same segmentation has the same effect on trading opportunities between FixedReset issues.

There is no real hope that this situation will be corrected in the near-term. OSFI has indicated that the long-promised “Draft Definition of Capital” for insurers will not be issued “for public consultation in late 2012 or early 2013”, as they fear that it might encourage speculation in the marketplace. It is not clear why OSFI is so afraid of informed speculation, since the constant speculation in the marketplace is currently less informed than it would be with a little bit of regulatory clarity.

As a result of this delay, I have extended the Deemed Maturity date for insurers and insurance holding companies by three years (to 2025-1-31), in the expectation that when OSFI finally does provide clarity, they will allow the same degree of lead-in time for these companies as they did for banks. This had a major effect on the durations of preferred shares subject to the change but, fortunately, not much on their calculated yields as most of these issues were either trading near par when the change was made or were trading at sufficient premium that a par call was expected on economic grounds. However, with the declines in the market over the past nine months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

Due to further footdragging by OSFI, I will be extending the DeemedMaturity date for insurance issues by another two years in the near future.

Sectoral distribution of the MAPF portfolio on June 30 was as follows:

The “total” reflects the un-leveraged total portfolio (i.e., cash is included in the portfolio calculations and is deemed to have a duration and yield of 0.00.). MAPF will often have relatively large cash balances, both credit and debit, to facilitate trading. Figures presented in the table have been rounded to the indicated precision.

Credit distribution is:

Liquidity Distribution is:

MAPF is, of course, Malachite Aggressive Preferred Fund, a “unit trust” managed by Hymas Investment Management Inc. Further information and links to performance, audited financials and subscription information are available the fund’s web page. The fund may be purchased either directly from Hymas Investment Management or through a brokerage account at Odlum Brown Limited. A “unit trust” is like a regular mutual fund, but is sold by offering memorandum rather than prospectus. This is cheaper, but means subscription is restricted to “accredited investors” (as defined by the Ontario Securities Commission). Fund past performances are not a guarantee of future performance. You can lose money investing in MAPF or any other fund.

A similar portfolio composition analysis has been performed on the Claymore Preferred Share ETF (symbol CPD) (and other funds) as of August 31, 2012, and published in the October (mainly methodology), November (most funds), and December (ZPR) 2012, PrefLetter. While direct comparisons are difficult due to the introduction of the DeemedRetractible class of preferred share (see above) it is fair to say:

• MAPF credit quality is better
• MAPF liquidity is a bit lower
• MAPF Yield is higher
• Weightings
  • MAPF is less exposed to Straight Perpetuals (including DeemedRetractibles)
  • MAPF is less exposed to Operating Retractibles
  • MAPF is more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF is overweighted in FixedResets