Month: July 2010

The fund had a very good month in June, outperforming all the relevant indices and passive funds as the Seniority Spread (interest-equivalent PerpetualDiscount yield less the yield on long corporates) declined significantly from 315bp on May 31 to 290bp on June 30. The spread narrowing was not the only part of the story, however, as long corporate yields declined from 5.65% to 5.45%.

The fund’s Net Asset Value per Unit as of the close June was $10.5770 after a dividend distribution of $0.143686 per unit.

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.

I am very pleased with the returns over the past year (which, now that the market and the fund’s returns have moderated, are now merely superb, as opposed to “ridiculous” or “nonsensical”), but implore Assiduous Readers not to project this level of outperformance for the indefinite future. The year in the preferred share market was filled with episodes of panic and euphoria, together with many new entrants who do not appear to know what they are doing; perfect conditions for a disciplined quantitative approach.

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 have been a lot of strongly motivated market participants in the past year, generating a lot of noise! The conditions of the past two years may never be repeated in my lifetime … but the fund will simply attempt to make trades when swaps seem profitable, whether that implies monthly turnover of 10% or 100%.

There’s plenty of room for new money left in the fund. Just don’t expect the current level of outperformance every year, OK? While I will continue to exert utmost efforts to outperform, it should be borne in mind that beating the index by 500bp represents a good year, and 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 Fixed-Reset issues on June 30; all of which (with the exception of YPG.PR.C) currently have their yields calculated with the presumption that they will be called by the issuers at par at the first possible opportunity. A split-share issue (BNA.PR.C) is also held; since this has a maturity date, the yield cannot be regarded as permanently sustainable. This presents another complication in the calculation of sustainable yield.

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 6.11% shown in the MAPF Portfolio Composition: June 2010 analysis (which is in excess of the 5.97% index yield on June 30). Given such reinvestment, the sustainable yield would be $10.5770 * 0.0611 = 0.6463, whereas a similar calculations for March results in $0.6457 (figures for April and May are not comparable due to distributions of dividends to unitholders).

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 picked up substantially in June to about 53%. It’s about time we saw some useful volatility!

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.

I recently received a question from a potential investor:

I just had a look at MAPF’s portfolio composition and noticed that it is very heavily in perpetual preferreds at a discount. I’m a bit surprised. I would think the general expectation is that interest rates will rise, which would reduce prices for perpetuals. What is the transient mispricing in the market for perpetuals that you are seeing now? Thanks very much in advance and best wishes,

I replied:

HIMIPref assigns a valuation to each issue which may be approximated as

V = Y + D

where Y is yield and D is Disparity.

Since PerpetualDiscounts yield so much more than FixedResets, there is somthing of a hurdle the latter class must get over before they are valued sufficiently highly to be included in a portfolio, but this effect is relatively small (see http://www.prefshares.com/overview/valuation.php)

Disparity is calclated according to the individual issue’s distance from the self-consistent yield curve. Fitting the yield curve provides several normalization factors, so that, for instance, the average disparity of all FixedResets will be zero, of all PerpetualDiscounts to be zero, of all issues rated Pfd-1(low) to be zero, etc. Note, however that the yield curve fitting is done with squared error, so that this will not be precisely true.

PerpetualDiscounts are far more widely dispersed about their mean than FixedResets; for instance, there is very obvious evidence of Credit Stratification (see http://www.prefblog.com/?p=2340) in this class, whereas the market appears to treat all FixedResets of like credit identically (see last two issues of PrefLetter).

Thus, the issues with the highest Valuation will tend to be PerpetualDiscounts.

When you write “the general expectation is that interest rates will rise”, I have to ask: which interest rates? Long, short, corporate, government? Long Corporates have been on wheels lately, fuelled by increasing speculation regarding deflation.

I guess I didn’t really answer one part of his question in detail: What is the transient mispricing in the market for perpetuals that you are seeing now? However, I show a sequence of trades below in which the fund was able to improve credit quality at what may be considered to be a low cost.

Credit distribution is:

The increase in credit quality was due in part to swaps from POW.PR.D (Pfd-2(high)) to GWO.PR.I (Pfd-1(low)):

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 the Claymore Preferred Share ETF (symbol CPD) as of August 17, 2009, and published in the September, 2009, PrefLetter. When comparing CPD and MAPF:

• MAPF credit quality is better
• MAPF liquidity is a little lower
• MAPF Yield is higher
• Weightings in
  • MAPF is much more exposed to PerpetualDiscounts
  • MAPF is much less exposed to Operating Retractibles
  • MAPF is more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF weighting in FixedResets is much lower