PrefBlog

The fund underperformed in March, due again to strong performance from FixedReset, Floating Rate and junk issues held by ZPR.

For example, of the sixteen BCE issues tracked by HIMIPref™ (which are heavily weighted in the indices, but which are not held at all by the fund):

By way of illustration, BCE issues comprise 10.62% of the February 28 BMO-CM 50 Index.

ZPR, is a relatively new ETF comprised of FixedResets and Floating Rate issues, with a very high proportion of junk issues, which returned a stunning +1.34% for the month, and +3.22% over the past three months (according to my calculations from the fund’s NAV data), versus gains for the TXPL index of +1.39% and +3.34%, respectively. The fund has been able to attract assets of about $518.7-million in four and a half months, $240-million of this in March alone, and I feel that has had a great effect on the prices of its targetted preferreds and their close relations.

At time of writing (March 31), the Total Return Index Values for the two S&P/TSX preferred share indices are not available, but TXPR was +0.93% on the month to March 27, while TXPL was +1.22%; there was a jump of as-yet undetermined magnitude on the last day of the month. Approximately 62.4% of TXPR is included in TXPL; a little algebra results in the estimation that the components of TXPR not included in TXPL returned a mere +0.45% in the month to March 27 – a stark illustration of the effect of ZPR and its massive secondary market requirements.

Investment-grade FixedResets as a group continued their unsustainable price appreciation in March, rising 1.18% – quite a feat when the median Yield-to-Worst (YTW) for this segment was 2.86% p.a. at February month-end! The median YTW declined to a mere 2.51% by the end of March. PerpetualPremiums also recorded an unsustainable +0.83% over the month while DeemedRetractibles were the worst performing of the three groups, returning +0.61% – which is also above their YTW expectations, but not by as much!

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close March 28, 2013, was 10.9033 after a dividend distribution of 0.130357.

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 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.

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!

In fact, one can make an argument that the SLF issues are doing better than they should be now, as they were recently downgraded by DBRS, which no longer considers them credit-equivalent to GWO and PWF.

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’ – 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 March 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 issuers. Additionally, 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 1.23% for the March 28 calculation) to estimate dividends after reset for FixedResets.

Most funds report Current Yield. For instance, ZPR reports a “Portfolio Yield” of 4.68% as of March 22, 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 5.06%, 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:

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 $0.4237 per unit in March 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.

This entry was posted on Monday, April 1st, 2013 at 12:46 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.