PrefBlog

The fund underperformed in November, due to its low weighting in junk FixedResets, which outperformed (as indicated by the performance difference between TXPR (+1.26%) and TXPL (+1.66%)). Low Reset investment-grade issues also did well, exemplified by ENB issues (four issues gaining about +3.25% and another three about about +4.5%) and TRP (average of about +2.5%)

To a certain extent, the (modest, so far) recovery may reflect an acceptance of my belief that the decline in the preferred share market has been overdone; the following table shows the increase in yields since May 22 of some fixed income sectors:

ZPR, is a relatively new ETF comprised of FixedResets and Floating Rate issues and a very high proportion of junk issues, returned +1.02% for the month, and +0.07% over the past three months (according to my calculations from the fund’s NAV data and distribution data; the figure for the past year is -1.89%), versus returns for the TXPL index of +1.66%, +0.76% and -0.53%, respectively. The fund has been able to attract assets of about $912.8-million in the year-odd since inception; a huge gain of $75-million in November. I feel that the flows into and out of this fund are very important in determining the performance of its constituents. I suspect that the November flows had a strong effect on the performance of FixedResets over the month.

The degree of underperformance of ZPR versus its index that I calculate above is very large and must be considered suspect until more data are published: tracking error of 64bp in a month for an index fund is not to be sneezed at; particularly since their published data indicate underperformance of just over 3bp in the month to November 22. I am therefore asking you to believe that tracking error in the last week of November was in the neighborhood of 60bp.

Having purchased (at great expense, I might add; the things I do for you guys!) the last two weeks of daily TXPL data, I find that:

• My purchased data agrees exactly with their published index data for the week of November 18-22; and
• There was a hell of a pop in the last two days of the month – TXPL gained just a hair under 60bp on November 28/29; and
• ZPR was flat for the last two days – up about 15bp on the 28th, erased on the 29th.

Is the indicated index performance reasonable? Sure it is: of the 299 issues currently tracked by HIMIPref™, 49 had performance over the last two days in excess of +0.60%; for the last two days of the month, the distribution of returns looks like:

It will be remembered that I calculate performance using bid prices, while the bums at the Exchange and S&P use closing prices. This difference may well have been important under the current circumstances.

So, it looks as if the jump in the index in the last two days is reasonable; and the unchanged NAV of ZPR in the last two days is what was reported by them. The scarcely credible indicated tracking error in the past two days may well be the exact truth; I will wait with bated breath for confirmation from the fund. I regret to say that I do not have daily figures for the Assets Under Management of ZPR, but it may be that a lot of their $75-million AUM increase came close to month-end. In order for new assets to enter the fund, it needs to issue units for a consideration; according to the prospectus:

For each Prescribed Number of Units issued, a Designated Broker or Underwriter must deliver payment consisting of, in the Manager‘s discretion: (i) one Basket of Securities and cash in an amount sufficient so that the value of the securities and the cash received is equal to the NAV of the Units next determined following the receipt of the subscription order; (ii) cash in an amount equal to the NAV of the Units next determined following the receipt of the subscription order; or (iii) a combination of securities and cash, as determined by the Manager, in an amount sufficient so that the value of the securities and cash received is equal to the NAV of the Units next determined following the receipt of the subscription order.

So, one way of explaining the tracking error of ZPR over the last week of November (if in fact the discrepency in returns survives panicky recalculation by management) is that they got a LOT of cash in the door and distorted the market in a major way while investing it. But we will see!

TXPR had returns over one- and three-months of +1.26% and +1.68%, respectively. Regrettably, there is not enough information on CPD’s site to allow me to make a precise calculation of returns for that index fund, so I’ll just have to wait a bit.

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

Malachite Aggressive Preferred Fund’s Net Asset Value per Unit as of the close November 29, 2013, was 10.1600.

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.

DeemedRetractibles had relatively uncorrelated performances in November, with bank issues and insurance issues performing similarly overall:

And Straight Perpetuals underperformed:

A side effect of the downdraft has been the return of measurable Implied Volatility (all Implied Volatility calculations use bids from November 1):

So we are now seeing a market evaluation of call probabilities such that GWO is now considered to have more of a directional bias than PWF.

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.

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 nonexistent.

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.

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. 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 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 only a very 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 1.72% for the October 31 calculation) to estimate dividends after reset for FixedResets.

Most funds report Current Yield. For instance, ZPR reports a “Portfolio Yield” of 4.94% as of November 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 5.14% as of November 29, 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 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.

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, December 2nd, 2013 at 7:29 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.