PrefBlog

The fund underperformed in June, due largely to being over-weight in DeemedRetractible issues, more particularly insurance DeemedRetractibles which didn’t just underperform – these issues actually underperformed PerpetualDiscounts, something I cannot explain.

The Canadian preferred share market performed poorly in July, with a few new twists.

ZPR, is a relatively new ETF comprised of FixedResets and Floating Rate issues, with a very high proportion of junk issues, which returned -1.48% for the month, and -3.59% over the past three months (according to my calculations from the fund’s NAV data and distribution data; our regulators are hard at work protecting you from performance data since the fund has been extant for less than a year), versus returns for the TXPL index of -1.42% and -3.49%, respectively. The fund has been able to attract assets of about $830.8-million in the eight and a half months since inception, even adding $18.0-million in June despite the market downturn but – and this is important – losing 12.6-million in assets in July. The change in assets is roughly equal to the return of the fund, meaning that although ZPR has not yet experienced any redemptions over a full month, the flow of money into the fund has stopped – at least temporarily. 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- and three-months of -0.98% and -3.40%, respectively

Returns for the HIMIPref™ investment grade sub-indices for May were as follows:

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close July 31, 2013, was 10.1673.

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 two 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. The fund occasionally finds an attractive opportunity to trade between GWO issues, which have a good range of annual coupons (but in which trading is now hampered by the fact that the low-coupon issues are trading near par and are callable at par in the near term), but is “stuck” in the MFC and SLF issues, which have a much narrower range of coupon, while the IAG DeemedRetractibles are quite illiquid. Until the market became so grossly segmented, this was not so much of a problem – 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 is, in effect ‘locked in’ to the MFC & SLF issues due to projected 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!

I have pointed out in the past that the market continues to treat regulated insurance issues (SLF, GWO) in much the same way unregulated issues (PWF); this was dramatically illustrated in June but the July results are even more dramatic.

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The first observation is that insurance issued DeemedRetractibles continued to behave much more like Straight Perpetuals than bank-issued DeemedRetractibles; the second is that the insurance issues actually underperformed Straights in July.

As the fund holds a high proportion of insurer-issued DeemedRetractibles, fund performance was hurt by this phenomenon.

A side effect of the downdraft was the return of measurable Implied Volatility:

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Those of you who have been paying attention will remember that in a “normal” market (which we have not seen in well over a year) the slope of this line is related to the implied volatility of yields in Black-Scholes theory, as discussed in the January, 2010, edition of PrefLetter. As has been previously noted, very high levels of Implied Volatility (in the 40% range) imply a very strong expectation of directionality in future prices – i.e, an expectation that all issues will be redeemed at par. The decline in Implied Volatility – which is still at very high levels – implies more uncertainty regarding this prediction.

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. 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 July 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). This presents another complication in the calculation of sustainable yield. The fund also holds positions in various SplitShare issues which also have their yields calculated with the expectation of a maturity at par.

I no longer show calculations that assume the conversion of the entire portfolio into PerpetualDiscounts, as the fund has no holdings of these issues.

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 (set at 1.31% for the May 31 calculation) to estimate dividends after reset for FixedResets.

Most funds report Current Yield. For instance, ZPR reports a “Portfolio Yield” of 4.90% as of July 31, 2013 and notes:

Portfolio yield is calculated as the most recent income received by the ETF in the form of dividends interest and other income annualized based on the payment frequently divided by the current market value of ETFs investments.

In other words – it’s the Current Yield, a meaningless number. The Current Yield of MAPF is 5.32%, but I will neither report that with any degree of prominence nor take any great pleasure in the fact that it’s higher than the ZPR number. It’s meaningless; to accord it any prominence in portfolio reporting is misleading.

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:

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The difference is because the bond’s yield calculation includes the amortization of the discount; therefore, so does the Sustainable Income estimate.

Thus, the decline in the MAPF Sustainable Income from $0.5500 per unit in June, 2012, to $0.5216 per unit in July, 2013, should be looked at as a simple consequence of the fund’s holdings; virtually all of which have their yields calculated in a manner closer to bonds than to Perpetual Annuities.

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 is 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.

Turnover returned to the quiet levels of the past two years in July, to about 4%.

There is extreme segmentation in the marketplace, with OSFI’s NVCC rule changes in February 2011 having had the effect of splitting the formerly relatively homogeneous Straight Perpetual class of preferreds into three parts:

• Unaffected Straight Perpetuals
• DeemedRetractibles explicitly subject to the rules (banks)
• DeemedRetractibles considered by me, but not (yet!) by the market, to be likely to be explicitly subject to the rules in the future (insurers and insurance holding companies)

This segmentation, and the extreme valuation differences between the segments, has cut down markedly on the opportunities for trading. Another trend that hasn’t helped has been the migration of PerpetualDiscounts into PerpetualPremiums (due to price increases) – many of the PerpetualPremiums have negative Yields-to-Worst and those that don’t aren’t particularly thrilling; speaking very generally, PerpetualPremiums are to be avoided, not traded! This effect has caused the first of the three segments noted above to be untradeable for most practical purposes.

To make this more clear, it used to be that there were 70-odd Straight Perpetuals and I was more or less indifferent as to which ones I owned (subject, of course, to issuer concentration concerns and other risk management factors). Thus, if any one of these 70 were to go down in price by – say – $0.25, I would quite often have something in inventory that I’d be willing to swap for it. The segmentation means that I am no longer indifferent; in addition to checking the valuation of a potential buy to its peers, I also have to check its peer group. This cuts down on the potential for trading.

There is no real hope that this situation will be corrected in the near-term. OSFI has indicated that the long-promised “Draft Definition of Capital” for insurers will not be issued “for public consultation in late 2012 or early 2013”, as they fear that it might encourage speculation in the marketplace. It is not clear why OSFI is so afraid of informed speculation, since the constant speculation in the marketplace is currently less informed than it would be with a little bit of regulatory clarity.

As a result of this delay, I have extended the Deemed Maturity date for insurers and insurance holding companies by three years (to 2025-1-31), in the expectation that when OSFI finally does provide clarity, they will allow the same degree of lead-in time for these companies as they did for banks. This has obviously had a major effect on the durations of preferred shares subject to the change but, fortunately, not much on their calculated yields as most of these issues are either trading near par or were trading at sufficient premium that a par call was expected on economic grounds. However, with the declines in the market over the past two months, the expected capital gain on redemption of the insurance-issued DeemedRetractibles has become an important component of the calculated yield.

Sectoral distribution of the MAPF portfolio on July 31 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 lower quality issues was due to the fund’s taking small positions in several lower quality, low spread FixedResets that plunged in value during the month, notably (month’s performance in brackets): FFH.PR.E (-7.31%), CPX.PR.E (-6.68%), TA.PR.D (-8.24%) and TA.PR.F (-10.42%).

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. 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) (and other funds) as of August 31, 2012, and published in the October (mainly methodology), November (most funds), and December (ZPR) 2012, 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 lower
• MAPF Yield is higher
• Weightings in
  • MAPF is much more exposed to DeemedRetractibles
  • MAPF is much less exposed to Operating Retractibles
  • MAPF is much more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF weighting in FixedResets is much lower