PrefBlog

The fund underperformed the indices in January due to its heavy weighting in FixedResets, particularly low-spread issues, which performed very poorly. A rebound in February allowed some of the poor relative performance to be recovered.

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. The debacle of the last two months, in which the BMO-CM index lost another 12.66% has extended this period to ludicrous lengths: the total cumulative return since August 31, 2006, a period of nine-and-a-half years, is now a mere 0.73%. And note the word cumulative. I don’t mean annualized. Cumulative.

The current 114-month total cumulative return of basically zero was not exceeded during the Credit Crunch. Neither was the current 12-month total return of -22.09%, since the worst 12-month cumulative return prior to this was for the year ending November 28, 2008, for which the total return was a relatively healthy -20.93%. 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:

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 -4.36%, -15.35% and -28.84% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of -4.44%, -15.89% and -29.18% respectively. The fund has been able to attract assets of about $1,141-million $1,272-million since inception in December 2012; AUM declineded by $131-million in January/February; given an index return of -18.5% a decline of about $235-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.

TXPR had returns over one-, three- and twelve-months of -3.64%, -11.68% and -23.18% 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 February 29, 2015, was $6.9056.

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 January/February, insurance DeemedRetractibles very slightly underperformed bank DeemedRetractibles:

… but were even with Unregulated [and bank NVCC-compliant] Straight Perpetuals…

Correlations were good for insurance DeemedRetractibles (27%), excellent for bank DeemedRetractibles (49%) and good for unregulated/NVCC-compliant issues (26%, not shown).

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 December 31; 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 or Distribution Yield. For instance, ZPR reports a “Distribution Yield” of 6.19% as of January 8, 2016, but this is a meaningless number: “The most recent regular distribution (excluding year end distributions for those ETFs that distribute more frequently) annualized for frequency divided by current NAV.”. Thus, dividend cuts expected in the next five years are ignored. It’s meaningless; to discuss it in the context of portfolio reporting is misleading.

iShares reports the “12m Trailing Yield”, which is the sum of the past year’s distributions divided by the current price: meaningless. They also report the “Distribution Yield”, which has the same definition as does ZPR: meaningless.

As for MAPF … I will not attempt to mislead my customers with meaningless figures, nor will I spend the time required to bring the reporting of rinky-dink shops like BMO and Blackrock up to more professional standards. I will continue to calculate the best metric I can think of and report that to you with full explanations.

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.

As noted in MAPF Portfolio Composition: February 2016, the fund now has a large allocation to FixedResets, mostly of relatively low spread.

Many of these were largely purchased with proceeds of sales of DeemedRetractibles from the same issuer; it is interesting to look at the price trend of some of the Straight/FixedReset pairs. We’ll start with GWO.PR.N / GWO.PR.I; the fund sold the latter to buy the former at a takeout of about $1.00 in mid-June, 2014; relative prices over the past two months are plotted as:

Given that the February month-end take-out was $7.04, this is clearly a trade that has not worked out very well.

In July, 2014, I reported sales of SLF.PR.D to purchase SLF.PR.G at a take-out of about $0.15:

There were similar trades in August, 2014 (from SLF.PR.C) at a take-out of $0.35. The February month-end take-out (bid price SLF.PR.D less bid price SLF.PR.G) was $5.30, so that hasn’t worked very well either.

November, 2014, saw the third insurer-based sector swap, as the fund sold MFC.PR.C to buy the FixedReset MFC.PR.F at a post-dividend-adjusted take-out of about $0.85 … given a November month-end take-out of $6.09, that’s another regrettable trade, although another piece executed in December at a take-out of $1.57 has less badly.

This trend is not restricted to the insurance sector, which I expect will become subject to NVCC rules in the relatively near future and are thus subject to the same redemption assumptions I make for DeemedRetractibles. Other pairs of interest are BAM.PR.X / BAM.PR.N:

… and FTS.PR.H / FTS.PR.J:

… and PWF.PR.P / PWF.PR.S:

I will agree that the fund’s trades highlighted in this post may be decried as cases of monumental bad timing, but I should point out that in May, 2014, the fund was 63.9% Straight / 9.5% FixedReset while in May 2015 the fund was 12% Straight / 86% FixedReset, FloatingReset and FixedFloater (The latter figures include allocations from those usually grouped as ‘Scraps’). Given that the indices are roughly 30% Straight / 60% FixedReset & FloatingReset, it is apparent that the fund was extremely overweighted in Straights / underweighted in FixedResets in May 2014 but this situation has now reversed. HIMIPref™ analytics have been heavily favouring low-spread issues and the fund’s holdings are overwhelmingly of this type.

Getting back to price spreads between low-spread FixedResets and their Straight Perpetual comparators, we can summarize the data above in tabular form and see:

In January, 2015, a slow decline due to fears of deflation got worse with Canada yields plummeting after the Bank of Canada rate cut with speculation rife about future cuts although this slowly died away.

And in late March / early April it got worse again, with one commenter attributing at least some of the blame to the John Heinzl piece in which I pointed out the expected reduction in dividend payouts! In May, a rise in the markets in the first half of the month was promptly followed by a slow decline in the latter half; perhaps due to increased fears that a lousy Canadian economy will delay a Canadian tightening. Changes in June varied as the markets were in an overall decline.

In August we saw increased fear of global deflation emanating from China, although the ‘China Effect’ is disputed.

In September the market just collapsed for no apparent reason; in October the market reversed the September collapse for no apparent reason. In mid-December the Fed finally hiked its policy rate, but this well-telegraphed event has had no major effect as of yet.

The market collapsed in January. I don’t know why. And it got worse in February.

All in all, I take the view that we’ve seen this show before: during the Credit Crunch, Floaters got hit extremely badly (to the point at which their fifteen year total return was negative) because (as far as I can make out) their dividend rate was dropping (as it was linked to Prime) while the yields on other perpetual preferred instruments were skyrocketing (due to credit concerns). Thus, at least some investors insisted on getting long term corporate yields from rates based (indirectly and with a lag, in the case of FixedResets) on short-term government policy rates. And it’s happening again!

There is further discussion of the extremely poor performance in the seven months to July 31, 2015, of FixedResets in the post eMail to a Client. Things haven’t really changed since that was written; they’ve just gotten ever so much more so.

What happened, essentially, is that the software assumes a certain amount of efficiency in the market. For instance, in 2013 PerpetualDiscounts were trading to yield 250-300bp over FixedResets (see the chart “PDIE-FR Spread”, below, for the PerpetualDiscount Interest Equivalent – FixedReset Spread), where the yield-to-perpetuity of FixedResets was calculated using the contemporary five-year Canada yield of 1.50%-2.00% (see the chart “Historical Government Yields”, below, for the historical government yields). The software assumes the market will get the big things right, so it therefore assumed that this 250-300bp spread would be maintained; and that a spread in this range represented fair value. Therefore, it would only purchase FixedResets if they were sufficiently cheap to other FixedResets to give a good chance of making up this fairly large yield difference.

When this spread started increasing in 2014, FixedResets started looking more attractive as the system assumes a certain amount of mean reversion and the system started buying those issues that were cheap to other FixedResets. However, the underlying assumption that the market would get the big things more-or-less right appears to have been unjustified in this instance: incredibly, the market was not accounting for changes in the five-year Canada rate (and therefore for changes in the projected dividend rate on reset) during this period. So we can call this period an episode of structural change in the markets – and no quantitative system can account for future structural change unless that is programmed into the system … in which case the analysis is no longer quantitative.

Here’s the two month performance to February 29 for FixedResets that had a YTW Scenario of ‘To Perpetuity’ at mid-February.:

Correlations were good for both the “Pfd-2 Group” and the “Pfd-3 Group”, at 28% and 29%, respectively.

Three month performance correlation for both the Pfd-2 and Pfd-3 groups is also good, at 20% and 22%, respectively: