Investment-grade corporate bonds in the U.S. have been punished recently, as the so-called spread over treasuries has widened by about 75 basis points (bps) since October. And the fixed income environment could not get any gloomier, given that the Federal Reserve raised interest rates again on December 19th, although it did signal that the pace of increases may slow in 2019.
But bond specialist Geoff Castle is reluctant to predict where interest rate may go. “It doesn’t take a genius in the current market environment to surmise that the Fed’s opinion of the economy might have turned a little bit south,” says Castle, a portfolio manager at Vancouver-based PenderFund Capital Management Ltd. “But I have no formal forecast. There, however, is a lot of gloom and doom.”
And therein lie the opportunities, argues Castle, who oversees the 5-star $543.6 million Pender Corporate Bond Fund Series F. Castle believes in the perspective espoused by The Sound of Music’s Fraulein Maria, (“Whenever the good Lord closes a door, somewhere He opens a window”) and maintains that there is always one security probing the bottom, while another one is reaching its high. “You try to find those things are making some kind of ultimate bottom. That’s one way of making money. To do that, you have to take on an unpopular opinion.”
By way of example, Castle points to a somewhat cheeky observation his firm made in early 2018 that “Tuna is now on sale.” Castle was referring to the fact that government bonds had become very cheap and their unpopularity was a good reason to buy. And so, he added more to the portfolio.
Castle regards the U.S. economy as being in a so-called Goldilocks environment, where rate rises have eliminated the worry of runaway inflation. “Maybe business conditions are not perfect or even excellent, but they’re not spiralling. Certain things can do well, such as yield-oriented investments where there is a pretty limited link to underlying economic activity,” says Castle, an Ivey School of Business of graduate who joined PenderFund in 2015 after a variety of workplace experiences that include management consulting with global heavyweight Bain & Co., seven years with Burlington, ON-based AIC Ltd. and a spell at Vancouver-based Powerex Corp.
“One area we point to is U.S. housing. It is the kind of thing that could potentially perform. If you look at previous periods, where we tamed inflation, things like REITs have performed.”
Castle notes that the so-called cap rate, which is the rental yield on a house in the U.S. as compared to the cost of financing, looks attractive. There is also pent-up demand by millennials who are still living with their parents and want to own their own home. “As they form households they will want to get out. Whether they end up renting or owning, that will mean more homes under construction,” observes Castle. “That’s probably a pretty interesting market for residential real estate and potentially other areas such as offices.”
Among the firms he’s identified is Zillow Group Inc (ZG), an online real estate database firm. “The way people buy and sell houses is changing. Much more can be done over the Internet. It’s not like the value-add of a real estate sales agent is some impregnable fortress that cannot be competed against,” says Castle, arguing that real estate in general can do well in a Goldilocks economic scenario. Zillow is well capitalized as it has a market cap of US$6.3 billion, US$865 million in cash, and debt of about US$690 million. Castle owns the 2023-dated unrated convertible bond which has a 5% yield-to-worst (the lowest potential yield).
Castle has allocated about 9% of the portfolio to credit of firms exposed to the U.S. residential sector. He also likes Beazer Homes USA Inc (BZH), an Atlanta-based builder of entry-level priced homes. “There is a lot of hard collateral value. So the bonds are well covered by the value of homes currently under construction or already completed and ready for sale. That gives us good confidence in the credit,” says Castle, adding that the B-rated issue maturing in 2022 is yielding 8%. “With the recent decline in mortgage rates, which have gone from about 5.2% to 4.8%, purchase intentions and mortgage applications have been rising in the U.S. There are some glimmers of hope in U.S. housing.”
Another attractive area is emerging markets bonds. They have been hit by the strong U.S. dollar and corresponding weak local currencies. “The effective financing cost for many companies has been going through the roof,” notes Castle. “To the degree that the U.S. interest rate increases perhaps stop, and that causes the U.S. dollar to stop accelerating in terms of currency translation, there is a scenario where perhaps emerging market credits will do okay.”
Indeed, Castle points to a similar period in the late 1990s when the asset class went through a rough patch and then reversed course and did well. “In a world where things slow and inflation and interest rates have a lid on them, then maybe there is another open window, to offset the closing door of what had been the go-go momentum trades of the 2016-2018 period.”
Castle, who admits he is “sniffing around” in the asset class, owns bonds issued by Grupo Famsa SA (GUFAF), a Mexican consumer lender and durable goods retailer. Castle owns the U.S. dollar-denominated bond, maturing in 2020, which is trading at around US$0.90. “It could experience some relief if the exchange rate moderates and if interest rates come down,” says Castle. “We’ve already seen a bit of a rally in the five-year U.S. bonds where yields have fallen to 2.8%, from 3.1%. If that continues, that bodes well for things that have been hurt.”
Castle tends to own about 100 bonds, from 70 issuers. The portfolio has a duration of 2.5 years, versus 5 years for the benchmark Bank of America Merrill Lynch High Yield Master Index.
He also acknowledges that many positions are small. He pays close attention to “Three Sigma” events, or statistical calculations that are three standard deviations from a mean. “If you find a relationship which is really pressing and testing the edge of the historical experience, and find a security that is in that situation, then maybe it recovers. Maybe they are mean-reverting situations,” says Castle. “Last year was a tough one to make money. But that was one of the ways.”
Take, for instance, Puerto Rico government bonds, which Castle bought following the Hurricane Maria devastation in 2017. “There was a Three Sigma event if you ever saw one,” says Castle. “A senior Administration official said words to the effect that Puerto Rico should completely renege on its debt. That caused a panic and drove the bonds down to the US$20s. We thought that was a good opportunity and later sold in the US$50s. So we did okay. The key thing is finding an entity that has much more value that accrues to the credit of that issuer than is priced into the security.”
