PrefBlog

The market experienced a wild ride in July, with the PerpetualDiscount index down 8.85% for the month at nadir on July 16, subsequently recovering to a loss of “only” 3.34% as the bargain-hunters swooped in on some very juicy yields. See Best & Worst Performers, which shows results for both parts of the month as well as the whole, and Index Performance, July 2008 for comparison with other subindices and the two exchange-traded funds.

The fund, with its heavy weighting in PerpetualDiscounts (see MAPF Portfolio Composition, July 2008), was not immune to the carnage and declined 2.31% on the month, 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. While it is disappointing to see the net asset value per unit decline, it is the expected income per unit that will determine the long term performance of the fund as the market stabilizes.

I must point out, however, that the expected income is a little skewed this month due to the extraordinarily high yield available on WFS.PR.A, which was purchased in quantity during July. At month-end, this position was valued to have a yield of 9.50% (as a dividend!), but the security matures in three years time – so, while the calculation shown is accurate as far as it goes, as a long-term indicator it is expected to decline in three years when WFS.PR.A is redeemed and the proceeds reinvested in a security that will not necessarily yield 9.50%.

If WFS.PR.A had been sold at market value at the end of July and the proceeds reinvested proportionately in the existing portfolio, the “Securities Average YTW” in the table above would have fallen about thirty basis points (0.30%) to approximately 6.66%; this would result in an estimate of “Sustainable Income” of $0.5428; 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 WFS.PR.A and bid up the price 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.

So, despite the poor price performance in July, we must remember that we are fixed-income investors. The expected annual income per unit (these are shown gross of fees and expenses) continues to show an upward path … and it is the income that makes the asset class worthwhile.

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.

The fund’s heavy weighting in the underperforming PerpetualDiscounts hurt performance for the month; within that group, a relatively large exposure to CM issues was another negative factor. The fund was able to mitigate the effects of these two allocations by frequent trading within these two groups; trading was very heavy during the month, representing approximately 100% of portfolio value.

As may be seen in the table above, there was considerable chaos in the downward movement of the CM issues, which was mitigated by 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!

Overall, the market has normalized somewhat since the end of June. The extremely strange – and theoretically unsupportable – relationship that existed a month ago between prices and yields has basically reversed itself – although there remain small pockets of strangeness and always will! Theory will always reassert itself in the long run; it is simply unfortunated that in June I was caught in the underperforming end of the strangeness and hence could not execute trades to exploit the disparities.

And for the future? In the first few days of August, the market has moved higher, with PerpetualDiscounts up 0.72% in the first few days. The average yield on PerpetualDiscounts at month-end was 6.32% (as dividends), equivalent to interest income of 8.85% at the standard equivalency factor of 1.4x. This in turn represents a spread of 270bp over long corporates – and, as has been previously mentioned, the previous 10-year high was 250bp – so, some might say, we are still well within the area of a 10-year buying opportunity!

While it will take the credit crunch a great deal of time to unwind – and while I continue to disdain market timing, these elevated yields should gradually attract bond investors, which will help prices recover. But … keep your eyes on the income! I continue to apply and refine my processes for finding opportunities, such as the CM swaps shown above, to execute swaps with a favourable risk/return profile.

My next article for Canadian Moneysaver will discuss the events of the last two months in more detail and, once the black-out period has expired, will be republished here.

There was a substantial amount of trading in July, as the collapse 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 fell 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 WFS.PR.A, discussed below.

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.

The increase in the proportion of Pfd-2(low) issues held is due to purchases of WFS.PR.A:

As of month-end, the move into WFS.PR.A has not borne fruit – but given the substantial yield pick-up (over 3 points!) I consider it to be only a matter of time before the WFS.PR.A experiences a substantial price increase. As of July 24, it had asset coverage of 1.6+:1, according to Mulvihill; comparable issues (insofar as anything is comparable; as the name implies, World Financial Split has a portfolio with considerably more geographic diversification than most split share corporations) are trading to yield 5.5%-5.8%. If WFS.PR.A were to trade to yield a more reasonable (to me!) 6%, the price would be about $9.85, an increase of almost 10% from the the July month-end value. Frankly, it seems like a pretty good bet, particularly given the decrease in interest-rate risk when trading from perpetuals to a split-share maturing in just under three years!

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 comparable
• MAPF Yield is higher
• But … MAPF is more exposed to PerpetualDiscounts
• MAPF is less exposed to Fixed-Resets