PrefBlog

The fund underperformed the the indices in July, breaking its streak of six consecutive months of outperformance. The underperformance was largely due to weakness in low-coupon insurance DeemedRetractibles.

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I continue to believe that the decline in the preferred share market remains overdone; the following table shows the increase in yields since May 22 of some fixed income sectors:

ZPR, is an ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned +0.30%, +0.60% and +3.34% over the past one-, three- and twelve-month periods, respectively (according to the fund’s data), versus returns for the TXPL index of +0.32%, +0.74% and +3.90% respectively. The fund has been able to attract assets of about $1,055-million since inception in November 2012; AUM increased by $11-million in July; given an index return of +0.32% an increase of $3.3-million was expected, indicating that money is still flowing into the fund. 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 +0.31% and +1.11%, respectively with CPD performance within expectations.

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

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close July 31, 2014, was $10.5639.

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, and in June, 2013, when the insurance-issued DeemedRetractibles behaved like PerpetualDiscounts in a sharply negative market.

This year, however, the sharp decline in the indices from early-mid-May to early-mid-June did cause sufficient changes in valuation such that some low coupon DeemedRetractibles were swapped into some low-reset FixedResets from the same issuer. This process continued in July.

At this point, the composition of the BMO-CM “50” index should be discussed; it has greatly outperformed TXPR over the year to May 30, and MAPF holders will have noticed that the fund only just returned to a positive differential against BMO-CM “50” on a year-over-year basis (again, to May 30). While I have not done a thorough analysis of the difference, I’ve done some approximations – note that the numbers in this section are approximations, but are close enough for government work.

I believe that BMO-CM “50” has benefitted greatly over the past year by being over-weight in bank Straight Perpetuals relative to other Straight Perpetuals:

Thus we see that at the beginning of the downdraft, the BMO-CM “50” was highly overweighted in Bank DeemedRetractibles, which performed quite well over the year, and highly underweighted in Straight Perpetuals, which underperformed. Weightings in the other two sectors were about right. It’s no wonder the fund struggled to outperform the BMO-CM “50” index in the period May, 2013, to May, 2014, and no wonder BMO-CM “50” outperformed TXPR!

In July, insurance DeemedRetractibles underperformed bank DeemedRetractibles:

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… and also strongly underperformed Straight Perpetuals:

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Of the regressions shown in the above two charts, the Adjusted Correlation of the Insurance DeemedRetractible performance is a mere 21%, and the other two correlations even worse.

A lingering effect of the downdraft of 2013 has been the return of measurable Implied Volatility (all Implied Volatility calculations use bids from May 30):

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It is disconcerting to see the difference between GWO and PWF; if anything, we would expect the implied volatility for GWO to be higher, given that the DeemedRetraction – not yet given significant credence by the market – implies a directionality in prices. The GWO data with the best fit derived for PWF is readily distinguishable from the best fit; the best fit has a significantly lower Sum of Squared Errors (0.55 vs 2.08):

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In the September, 2013, edition of PrefLetter, I extended the theory of Implied Volatility to FixedResets – relating the option feature of the Issue Reset Spreads to a theoretical non-callable Market Spread.

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These are very interesting results: The BPO issues are trading as if calls are a certainty, while FFH issues are trading as if calls are much less likely. The FFH series continues to be perplexing, this time with the four lower-coupon issues showing virtually no implied volatility – with the highest coupon issue (FFH.PR.K) being well off the mark … all I can think of is that the market has decided that FFH.PR.K, with an Issue Reset Spread of 351bp, is sure to be called in 2017, while the other four (highest spread is FFH.PR.C, +315) are not at all likely to be called.

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, at which point the calculation may be considered virtually meaningless) imply a very strong expectation of directionality in future prices – i.e, an expectation that all issues will be redeemed at par.

It is significant that the preferred share market knows no moderation. I suggest that a good baseline estimate for Volatility over a three year period is 15% but the observed figure is generally higher in a rising market and lower in a declining one … with, of course, a period of adjustment in between, which I suspect we are currently experiencing.

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.

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 FixedReset issues on June 30; 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. 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 only a small position in 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 1.60% for the July 30 calculation) to estimate dividends after reset for FixedResets.

Most funds report Current Yield. For instance, ZPR reports a “Dividend Yield” of 4.6% as of June 30, 2014, but this is the Current Yield, a meaningless number. The Current Yield of MAPF was 4.85% as of June 30, but I will neither report that with any degree of prominence nor take any great pleasure in the fact that it’s a little higher than the ZPR number. It’s meaningless; to discuss it in the context of portfolio reporting is misleading.

However, BMO has taken a significant step forward in that they are no longer reporting the “Portfolio Yield” directly on their website; the information is taken from the “Enhanced Fund Profile” which is available only as a PDF link. CPD doesn’t report this metric on the CPD fact sheet or on their website. I may have one less thing to mock the fundcos about!

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.

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.