PrefBlog

The market continued its post-July-16 recovery in August, with the PerpetualDiscount index up 3.91% for the month, with only four of the twenty trading days showing a negative total return.

The fund, with its heavy weighting in PerpetualDiscounts (see MAPF Portfolio Composition, August 2008), had a superb return as a result of both the market’s overall move and very frequent trading. The fund unit price increased 5.86% before fees but after expenses.

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 yields available on high quality preferred shares remain elevated, which is reflected in the current estimate of sustainable income.

It is very gratifying to see the sharp increase in expected income per unit – if there was no trading in the fund, this would be a constant number.

I must point out, however, that the expected income is a little skewed this month due to the extraordinarily high yields calculated for WFS.PR.A (purchased during July) and BNA.PR.C (purchased in August). At month-end, these positions comprised 19.4% of the portfolio and were valued with an average yield of 8.40% (as a dividend!). Sadly, these yields cannot be expected to last forever, due to the embedded options in the structures – so, while the calculation shown is accurate as far as it goes, as a long-term indicator it is expected to decline upon redemption, when the proceeds reinvested in securities that will not necessarily yield 8.40%.

If these two issues had been sold at market value at the end of August and the proceeds reinvested proportionately in the existing portfolio, the “Securities Average YTW” in the table above would have fallen about fifty basis points (0.50%) to approximately 6.25%; this would result in an estimate of “Sustainable Income” of $0.5391; less than is reported, but still a substantial increase from previous figures. It is hoped, of course, that the market will shortly recognize the merits of the two issues and bid up their prices until the yield is – according to me! – more reasonable, which should allow the fund to take a good-sized capital gain when swapping it for another issue with upside potential.

Note that if the yields on these two securities with a limited life had been less than that on the perpetuals, I would not suggest that the calculation be revised upward! It is in the natural order of things that retractible issues should yield less than perpetuals; it is much more reasonable to suppose that funds received at maturity would be reinvested in similar, lower yielding securities than to suppose (as the actual, unadjusted calculation would assume) that similarly higher-yielding securities will be available in the future.

I should emphasize, however, that the fund does not explicitly seek to maximize this number. Yield on the portfolio will be given up when it is possible to exchange it for something else that is attractive: credit quality, say, or retractibility. Over the very long term, however, it is the prime objective of fixed income management to maximize the income received from a given amount of capital.

As was the case in July, the fund was able to improve its performance by heavy trading, particularly within the CM issues. The performance report for July highlighted some advantageous swaps within the CM credit, ending the month with a position in CM.PR.P. This month, I’ll show what happened to the position in CM.PR.P over the month of August – as always, remember that this table is a best efforts attempt to show the flow of trading; details will be released in the transactions summary on the fund’s web page in due course.

As may be seen in the table above, there was considerable chaos in the upward movement of the CM issues, which allowed opportunistic trading between the issues. These trades did not, in and of themselves, change the portfolio’s credit risk or have a material effect on any element of the portfolio’s overall risk profile. Opportunistic trading is what MAPF is all about!

All in all, it was a very good month for the fund – in fact, it was the third-highest one-month return since the fund’s inception at the end of March 2001. While the depredations of the year – or even of the summer – have not yet been fully erased, the fund has a performance far in excess of its benchmark for periods of a year or greater and projected sustainable income per unit continues to grow. On August 29 the PerpetualDiscount index had a weighted average bid-yield-to-worst of 6.11%, equivalent to 8.55% interest at the standard 1.4x conversion factor, while long corporates were yielding about 6.2%. This yield spread of 235bp is very high by historical standards and is rich compensation for volatility endured.

There was a substantial amount of trading in August, as the resurgence in prices of PerpetualDiscounts in a confused market brought many opportunities to the Fund. Turnover was close to 100% for the month, but a high proportion of these trades were intra-issuer (trades between the CM issues were particularly frequent) and most others were intra-sector (PerpetualDiscounts rose at different rates).

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

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 SplitShares is due to purchases of BNA.PR.C net of a small sale of WFS.PR.A. Assiduous readers will recall that I consider exposure to BNA to be equivalent, for credit risk control purposes, to exposure to BAM. These readers will not be surprised, therefore, to learn that the purchase of BNA.PR.C was not only funded by a sale of BAM.PR.N, but that this trade reversed swaps undertaken last February.

As may be seen, the February-August swap was immensely profitable: there would have been a loss of $3.02 on the BNA.PR.C had it been held, about 14.6% of the February trading price. Instead, the BAM.PR.N lost $1.63, about 8.5% of the February trading price. The outperformance of BAM.PR.N by 6.1% is massive and leaves an old bond guy like me just shaking his head.

There will be those who will shout that it would have been better to have held cash during this period and lost nothing; but that would be market timing. I cannot predict the overall direction of the market, nor have I ever met anybody who can. The way to make money is to outperform the market whether it goes up or down; in time the rewards will be tangible.

As of month-end, the trade back into BNA.PR.C has not borne fruit – but given the substantial yield pick-up (over 2 points!) I consider it to be only a matter of time before the BNA.PR.C experiences a substantial price increase.

Credit distribution is:

The fund does not set any targets for overall credit quality; trades are executed one by one. Variances in overall credit will be constant as opportunistic trades are executed.

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. 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) and 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 CPD as of May month end; it should be noted that the underlying TXPR index has been rebalanced and I have not yet fully analyzed the changes. While the changes affect the allocation to the different sectors, I do not believe the credit or liquidity metrics will have changed much.

• MAPF credit quality is superior
• MAPF liquidity is somewhat lower
• MAPF Yield is higher
• But … MAPF is more exposed to PerpetualDiscounts
• MAPF is less exposed to Fixed-Resets