PrefBlog

Well, there’s no sense trying to put a gloss on it: the fund had a horrible month in September.

The fund’s Net Asset Value per Unit as of the close September 30 was $10.2709 after a dividend distribution of $0.151168.

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.

The fund’s poor return for the month is basically due to the following:

The precipituous decline in YLO preferreds may in turn be attributed to their September 28 Press Release (discussed on PrefBlog) in which they announced, among other things:

• Elimination of the common dividend
• Stringent new rules for their sharply reduced bank credit line

Reaction from the rating agencies was mixed: DBRS went into hysterics, slashing the preferred rating four notches to Pfd-4(low); S&P merely yawned, maintaining their rating at P-4(high) and stating that they’d be looking forward to the next quarterly report with more interest than usual.

The price of the common and the preferreds, which had been sharply declining, promptly cratered.

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I don’t get it. The company still has about $1.5-billion in revenue and estimated free cash flow in excess of $200-million per year. Yes, of course both these figures are going to decline somewhat in the future, and yes, you at the back of the room, I know you haven’t looked at the Yellow Pages in three years, but the question is – how fast?

In the August edition of PrefLetter I made a spreadsheet available at http://www.prefblog.com/xls/YellowMediaProjection.xls which attempted to quantify the effects on cash-flow and debt of various user-specified assumptions regarding the rate of print revenue decline and digital substitution; you have to make some assumptions that I consider quite extreme before you start getting seriously scared. The baseline assumptions – which I consider a little on the gloomy side, if anything – indicate that the targetted Debt:EBITDA ratio falls to 2:1 in about six years. Interestingly, reflecting the elimination of common dividends in the spreadsheet and applying these savings to debt reduction reduces the time for this target to be met to three years.

Is this a guarantee? No, of course, not. Ain’t nothing guaranteed. But my point is that awfully severe assumptions have to be made in order to show a bankrupt company and it is my judgement that these awfully severe assumptions have a low probability.

I had an illuminating conversation over dinner with another investment manager recently. We don’t really talk about investments much, but this time I was bemoaning the horror of the YLO carnage, while he said with satisfaction that he’d just sold his last YLO bonds at forty cents on the dollar. So I said (his paraphrased comments in brackets) something like … “Look, when I look at the company’s financials and apply a 15% annual rate of decline in print revenue forever (‘Could be more.’) and assume a 50% digital substitution rate (‘Could be less.’) at a 40% profit margin (‘Could be less.’), I just don’t understand the hysteria.”

But his comments illustrate, boys and girls, how investment management is usually done. You can project bankruptcy for any company in the world by making your assumptions severe enough – there’s no skill in that. Investment management involves making judgements about the future while at all times remembering that you might be wrong – which is why the fund will no longer top up its YLO holdings (the new credit agreement carries with it a partial loss of access to capital markets). Whatever your “gut reaction”, it can be justified. When I look at YLO, I see a company that is in decline, certainly, but I also see it spinning off cash like crazy in the meantime – much like one of those gold mines that is the latest Big Investment Idea around now – and becoming a smaller digital media company. The company has always made more sense as private equity rather than a public company; and at current prices I wouldn’t be surprised if Google, Microsoft and Yahoo! weren’t wondering if it would be cheaper to buy than build.

We have seen something like this before: in September 2002 the fund underperformed by a stunning 8.01%. Why? Much the same reason – the fund held Bombardier preferreds, which were engulfed by a wave of market sentiment very similar qualitatively to the sentiment which now surrounds Yellow Media. The relative price drop of the BBD preferreds was smaller, but the fund’s holdings were larger.

In the end, BBD recovered and the fund eventually exited its position with a small profit. I can’t, of course, guarantee that the same thing will happen in this episode – but I can’t, at this point, see why not. In the meantime, we will remember one of the ways in which the liquidity premium can be captured:

The spread on corporate bonds over the liquid risk-free rate (for example, government bonds) represents compensation for several different factors:

A Expected default losses
B Unexpected default risk, such as default and recovery rate risk
C Mark-to-market risk, such as the risk of a fall in the market price of the bond
D Liquidity risk, such as the risk of not finding a ready buyer at the theoretical market price.

Investors concerned with the realisable value of their investment in the short-term require compensation for all these risks.

However, investors who can hold bonds to maturity need compensation only for A and B. Such investors can enjoy the premiums for C and D, and we refer to these collectively as a ‘liquidity premium’

Right now we’re seeing mark-to-market risk with a vengeance!

Sometimes everything works … sometimes the trading works, but sectoral shifts overwhelm the increment … 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’. 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.

Significant positions were held in DeemedRetractible and FixedReset issues on August 31; all of the former and most of the latter currently have their yields calculated with the presumption that they will be called by the issuers at par prior to 2022-1-31. This presents another complication in the calculation of sustainable yield. The fund also holds a position in a SplitShare (BNA.PR.C) and an OperatingRetractible Scrap (YLO.PR.B) which also have their yields calculated with the expectation of a maturity at par, a somewhat dubious assumption in the latter case.

However, if the entire portfolio except for the PerpetualDiscounts were to be sold and reinvested in these issues, the yield of the portfolio would be the 5.84% shown in the MAPF Portfolio Composition: September 2011 analysis (which is greater than the 5.35% index yield on September 30). Given such reinvestment, the sustainable yield would be $10.2709 * 0.0584 = $0.5998 a decrease from the $11.1492 * 0.0580 = $0.6467 reported in August.

Different assumptions lead to different results from the calculation, but the overall positive trend is apparent. I’m very pleased with the 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 constant 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 was virutually non-existent in September, at about 1%.

I lay a lot of the blame for lack of turnover on OSFI, and will illustrate my argument with a graph of the price difference between CM.PR.J and GWO.PR.I, which pay the same annual dividend; the differences in structure of the instruments are negligible, other than the fact that, of course, the issuer is different. However, while the market appears to have incorporated OSFI’s advisory on Non-Viability Contingent Capital to banks, it does not appear to have extrapolated this advisory to insurers and insurance holding companies, which is something I expect to happen in the relatively near future.

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It will be recalled that OSFI has announced that CM.PR.J (and all other issues of its ilk) will not be eligible for inclusion in Tier 1 Capital to any degree whatsoever after 2022-1-31; that this implies the company will cease to regard it as “cheap equity” and instead consider it “expensive debt”, and that therefore redemption at par is anticipated by 2022 at the latest. My expectation, given the laudable objective of harmonizing insurance and banking regulation to the extent possible, is that this precept will apply, sooner or later, to GWO.PR.I and all other regulated financial issues which do not have an NVCC clause. See my definition of “DeemedRetractibles” for more discussion of this matter.

As I remarked in the September PrefLetter:

Most obvious is the very high price spread between the two issues, but it is also apparent that there is a high degree of volatility in this spread; this spread cannot be explained by fundamental factors, it is a market artifact arising from random fluctuations in supply and demand.

One might think, therefore, that my fund8 would have been frantically trading throughout the year, seeking to exploit these transient pricing differences – that is, after all, what my proprietary valuation software, HIMIPref™, is designed to indicate. This has not been the case and in fact, trading has been significantly lower than usual since the OFSI-derived activity in the first quarter.

The reason for this is the high degree of stratification in the market; while the difference in prices has fluctuated in a very wide range (a variance of about $1.00), taking advantage of these fluctuations implies giving up a great deal of valuation (since the assumption is that two issues are directly comparable). In order to take advantage of the low difference in price (in hopes of making $1 on the trade when the difference is high) it is necessary to sell GWO.PR.I and buy CM.PR.J, giving up $2 in “permanent valuation”.

The software is designed to correct for factors such as this; while one factor assumes that the price difference will return to zero (given that the issues are virtually identical in terms of characteristics), another factor assumes that the price difference will return to its average of about $2.50. In this case, though, the predicted effect from the first factor overwhelms the contribution from the second; GWO.PR.I is always calculated to be cheap relative to CM.PR.J; and the portfolio’s position in the former is maintained. In other words, there would be considerable risk in executing the swap since the probability of losing $2 (if the price difference returns to zero) outweighs the probability of gaining $1 (if the price difference returns to its upper limit).

As I remarked in the February, 2010, edition of this newsletter, the preferred share market has, to a certain extent, become OSFI’s casino, with valuation far more dependent upon potential regulatory decisions and their timing than it should be, with consequent loss of market efficiency – and the trading profits of investors similar to Hymas Investment Management, who seek to eke out excess returns by supplying that efficiency.

Trades were, as ever, triggered by a desire to exploit transient mispricing in the preferred share market (which may be thought of as “selling liquidity”), rather than any particular view being taken on market direction, sectoral performance or credit anticipation.

We can only hope that OSFI makes an announcement regarding the status of Straight Preferreds issued by insurers and insurance holding companies at some point in the near future, one war or the other.

Be that as it may, 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:

The increase in Pfd-4(low) holdings at the expense of Pfd-3 is due to the downgrade of YLO.

Liquidity Distribution is:

The increase in the proportion of issues with an Average Daily Trading Value less than $50,000 is mainly due to the migration of CCS.PR.C and ELF.PR.G. The decrease in those with more than $300,000 is mainly due to the migration of SLF.PR.E, MFC.PR.C and BNS.PR.X.

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) or those who subscribe for $150,000+. 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) as of August 31, 2010, and published in the September, 2010, 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 higher
• MAPF Yield is higher
• Weightings in
  • MAPF is much more exposed to DeemedRetractibles
  • MAPF is much less exposed to Operating Retractibles
  • MAPF is slightly more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF weighting in FixedResets is much lower