Manager Likes Unloved Credit for Longterm Yield

When the COVID-19 pandemic struck the corporate bond market lower-grade bonds suffered some of the worst damage, as investors fled and piled into sovereign bonds or cash. But Geoff Castle, manager of the four-star rated $944.7 million Pender Corporate Bond Fund, stayed the course and selectively picked away at securities that have been overly punished.

“The further down the rating system, the bigger the blowout,” says Castle, a portfolio manager at Vancouver-based PenderFund Capital Management Ltd. As an example, he cites one portfolio holding, W&T Offshore Inc. (WTI), a Houston-based oil and natural gas explorer that suddenly collapsed in price. In February, its bonds were trading around the mid-US$90s, yet by early April, they were down to US$21. “The CCC-rated bonds and those below had a much bigger drawdown.”

“You could see some pretty significant effects. It wasn’t the case for every security, but there was a certain number that saw a big blowout. In February, the [average yield to maturity of CCC-rated bonds was around 11% and March it went as high as 20%,” Castle noted. “There was an absence of bids and you had to be very careful about maintaining liquidity in your fund,” says Castle.

Risk Getting Pricey
February started with 350 basis points (bps) spreads between high yield bonds and treasuries, which then widened out by about 1100 bps, based on the benchmark Bank of America Merrill Lynch High Yield Master II Index. Currently, the spread is about 600 bps. “Within the index, it wasn’t a uniform move because if you went down the credit quality spectrum, there was a much larger move-out,” says Castle, a 20-year industry veteran who earned an MBA from the Richard Ivey School of Business in 1996 and worked for firms such as AIC Ltd. and Powerex Corp., before joining PenderFund in 2015. “People became afraid of bankruptcy filings and losses. It happened not just in resources, but also in travel, car rentals, hospitality, and retail---across a wide variety of industrial sectors. But there tended to be a quicker recovery in things that were not as impacted [by the coronavirus].”

Roughly speaking, Castle argues that there are three categories of bond issuers: a very small number are thriving and have come out stronger; some survivors have endured the impact and are getting by, and lastly, some companies belong, figuratively speaking, in the ICU. “You have to be careful in approaching those but obviously there are opportunities, to the extent that people have over-reacted or looked at the situation as being permanent when it’s essentially more transitory.”

Progress on Health and Financial Fronts
Castle argues that the worst may be behind us, although he cautions that one has to separate what is happening in the real world from the financial world. “In the real world, we have more experience with what this virus is. At first, it was unquantifiable. But now we are seeing a whole laboratory of different countries’ experiences and jurisdictions across the globe. Even in the worst situations, there is not that large a number of people who have been exposed to fatality and people are recovering. It is a serious issue, but one where we have a measured sense of the potential outcomes for people.” He notes that every pandemic eventually subsides, sometimes due to a mutation in the virus or the development of immunities.

On the financial side, it’s a little more complicated. “There are two parts here. There are people’s economic circumstances themselves. And there are interventions by the Federal Reserve,” says Castle. “What was not discounted in March was the rapid and substantial fiscal intervention around the world, in terms of income support, such as the CERB [Canada Emergency Response Benefit], and extended unemployment insurance in the U.S. As well, central bank interventions have been on a massive scale. “There is a ‘whatever it takes’ response from central banks,” says Castle, noting that the Federal Reserve and Bank of Canada are ready to step in to purchase corporate bonds. “And the speed at which it arrived is important, too. It took six weeks to get the kind of response that occurred a year-and-half after the great financial crisis of 2008. And on top of that, you have interest rates down towards zero percent. Almost every lever that could have been pulled, to stabilize financial conditions, has been pulled.”

The Federal Reserve’s actions are a key factor for Castle’s optimism. “A lot of people are sitting around waiting for some other shoe to drop in financial markets. From the viewpoint of credit markets, given that you have an infinite bazooka aimed exactly at this spot, you might be disappointed waiting for a re-testing of the March 23 lows, which existed without any of the support. Part of the analysis that you need to do as an investor is to consider the fact that there is a high likelihood that debts will be re-financed.”

Bonds Backed By Assurance
Since central banks made their intentions clear, investment-grade bonds, such as those rated BBB and above, have more or less recovered back to where they were at the start of the year. Not surprisingly, however, the recovery for non-investment grade bonds, or those rated B or CCC or lower, has been uneven. Even though indices have substantially recovered, Castle argues that the central bank so-called ‘bazookas’ have neglected the lower end. “Things that are CCC-rated, or defaulted securities, are not subject to central bank purchasing. Participants in the market have to do their own price discovery on them.”

Castle, who does not adhere to the benchmark Bank of America Merrill Lynch U.S. High Yield Master II Index, has allocated about 24% of the bonds to investment-grade securities, 46% to high-yield bonds rated BB and lower, 32% to unrated securities and small holdings in preferred shares.

The duration of the fund is 2.94 years, versus 4.5 years for the benchmark. The running yield for the fund is 5.24% before fees. Although Castle is a bottom-up investor, information technology is the largest sector in the portfolio, at 14%, followed by 10% in financial services and 9% energy.

From a performance standpoint, Pender Corporate Bond D returned -4.36% year to date (as of June 26), versus -2.91% for the median fund in the High Yield Fixed Income category. The performance gap is partly attributable to Castle’s investment style and the use of currency hedging. On a longer-term basis, the fund averaged 5.60% and 5.34% over five and 10 years. In contrast, the category averaged 2.71% and 4.63% respectively.

Strategic Bond Bets
Running a portfolio with about 75 securities, Castle favours names such as Zillow Group Inc. (ZG), an online real estate database firm. Castle owns an unrated July 2023-dated convertible bond, which has a 1.5% coupon and has been buying it in the last year in the US$80s. “It trades at US$106, so it’s not exactly below par at the moment. Some people consider the floor of the bond is worth US$92 and the fair value of the call option might be US$21,” says Castle. “If we feel the option value is fully priced, then we’ll sell the bond. But we feel the option value is still fairly under-represented. So we continue to hold on.”

Another holding is Morgan Stanley (MS), a leading financial services firm in the U.S., which is represented in the portfolio with a floating rate note that has a 4.82% coupon. It is also a so-called perpetual floater and trades at $89. Castle maintains the note has the potential to yield about 5%, plus it might be called. “As the market gets used to the lower spreads that exist [over treasuries], Morgan Stanley can re-issue other series of this kind of note, at continually lower yields.  They may replace it by next January or April.”