PrefBlog

The fund outperformed in September, due largely to stellar performance by insurer-issued DeemedRetractibles and BNA.PR.C. … all this for the third straight month! However, there was a change in overall performance in that DeemedRetractibles in general and FixedResets in general underperformed, returning 26bp and 27bp respectively while PerpetualPremiums won 92bp and Floaters excelled with a stellar +1.86% total return.

The fund’s Net Asset Value per Unit as of the close September 28, 2012, was 10.6703 after a dividend distribution of 0.131430.

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 year 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 has done well by trading between GWO issues, which have a good range of annual coupons, 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). 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.

SLF DeemedRetractibles may be compared with PWF and GWO:

It is quite apparent that that the market continues to treat regulated insurance issues (SLF, GWO) no differently from unregulated issues (PWF) – despite the fact that the PWF issues are much more subject to unfavourable calls in the near term and should, logically, be deprecated on those grounds alone without any fancy-pants arguments about imposition of the NVCC rule!

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. The relationship is still far too large to be explained by Implied Volatility – the numbers still indicate an overwhelming degree of directionality in the market’s price expectations.

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’. 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 September 28; 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. This presents another complication in the calculation of sustainable yield. The fund also holds a position various SplitShare issues which also have their yields calculated with the expectation of a maturity at par.

I will no longer show calculations that assume the conversion of the entire portfolio into PerpetualDiscounts, as there are currently only four such issues of investment grade, from only two issuer groups. Additionally, the fund has no holdings of these issues.

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.

Thus, the decline in the MAPF Sustainable Income from $0.5500 per unit in June to $0.4934 per unit in September should be looked at as a simple consequence of the funds 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.

This entry was posted on Monday, October 1st, 2012 at 12:16 am and is filed under MAPF. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.