QE = RT
« Quantitative Easing = Risk Taking »
This seems to have been the magic formula in 2013, a remarkable year for risk assets, most notably for equities and corporate bonds. The desire to “not miss the boat” seemed to dominate from start to finish. Few would have predicted such remarkable global stock market performance in 2013, with such a low volatility and despite the very real instabilities:
- Endless Budget talks and the temporary U.S. government shutdown;
- The collapse of Cyprus in the spring;
- The increase of over 100 basis points on government 10 year rates in most G7 countries, and the corre- sponding increase in the cost of borrowing for corporations;
- The debate surrounding the reduction (“tapering”), or the withdrawal of stimulus by the US Fed;
- Mitigated growth resulting from revised expectations for revenues, increasingly saturated profit margins, and the increase in labor costs and the weighted average cost of capital “WACC”.
These apprehensions didn’t slow down investors, who piled into just about everything that had done well the previous year. With a record level of new bond issues in the USA, a gain of over 7% on
USA high yield (HY) bonds despite a marked increase in reference rates (“benchmarks”), gains of nearly 30% for the S&P after a 15% run in 2012, more risk averse investors were largely penalized by opportunity cost. In fact, it is the countries with major quantitative easing (QE) programs like the USA, UK and Japan whose markets had literally extraordinary performance… and Canada was not among them.
Among the near universal enthusiasm, there were however some major disappointments: The Japanese currency falling by nearly 20%, the desertion of emerging markets and, importantly, the commodity market especially for metals, with significant corrections for gold and silver. The drops in prices were responsible for the striking underperformance of resource-tied countries such as Canada, Australia, South Africa, and whose monetary policies did not offer the luxury of stimulus. Even on the bond side, some indices such as the Canadian DEX had a negative return in 2013, a first since 1994.
Weak and in some cases, fragile growth…. but improving
Was the general state of the economy in 2013 robust enough to justify such strong performance of global risk assets?
The economic picture is less rosy than the rise in the stock market would have you believe, but it is improving. Despite growth below historical averages (about 2% in Canada and USA, and 3% globally), investor confidence is at pre- 2008 levels and leading economic indicators are approaching their 5 year peaks. Employment is improving in the United States … although the labor force is still in free fall, at its lowest level since 1978 at a time when total US population was 80 million lower than today (!). Which means that the published 7% unemployment rate is a bit of a smokescreen.
In Europe, data suggests a similar progression to that of the USA, but the area is facing the worst employment crisis in its history. With unemployment over 12% for the entire region, commercial banks are not lending, the European Central Bank is not injecting liquidity and the money supply is slowly crumbling, unlike in other G7 countries, and to top it all off, the strength of the Euro vs. the USD at $ 1.40 is seriously hampering exports. In short, there remains a lot of conflicting data in an otherwise improving but still very uncertain economic landscape.
Cautious Optimism for 2014
Despite the roller coaster at the beginning of the year, markets have definitely started 2014 on a positive note. Economists’ expectations are high, supported by the planned gradual reduction of QE in the US which is seen as a sign, on the one hand, that the economy is strong enough to take over from central banks and that on the other hand, this economic cycle will continue for the next few years, thereby again favoring risk assets. A certain level of complacency seems to have emerged. Investors are more and more ignoring certain risks while chasing returns, especially in Europe.
America is definitely doing better: stronger housing market, increased vehicle sales, stronger job creation, etc. But it is clear that companies are doing little to improve their situation. More concerned with their stock price, companies are pursuing programs for implementing special dividends and share buybacks; we believe they will be compelled to contribute directly to the economy by spending and investing the cash accumulated on their balance sheets in recent years. Otherwise, it will become increasingly difficult to justify a significant appreciation of risk assets other than by the expansion of valuation multiples.
The fixed income arbitrage sub-portfolio closed 2013 with decent performance and 10 out of 12 months positive. May and June proved to be difficult though, as a tactical and strategic positioning on the yield curve proved costly. We were nonetheless able to adjust the portfolio accordingly.
Within the credit segment (i.e. spreads), which represents almost 60% of the profits generated in the sub-portfolio, we started off 2013 with a view of exploiting the very steep curve (carry roll-down) observed on mid-term provincial, banking 3 -5 years and municipal short term credits. The strategy paid off, particularly in the fall, which prompted us to reduce the sub-portfolio’s Beta given the strong year-end run-up.
Despite the strong performance, the 5-yr and less Canada credits remain at attractive levels when compared to recent US and European performance. On the flip-side, we wish to maintain a rather defensive positioning as we enter 2014, as noted previously, we believe some risk assets to be overpriced at this stage. If markets continue to perform, the sub-portfolio will benefit, but to a lesser extent given the lower portfolio Beta, while in the case of a drop, the portfolio will be less exposed and we will have some dry powder.
Positions on the yield curve represent about 40% of last year’s profits. Contrary to credit, expectations are based on a short to mid-term horizon, which by definition imply a more dynamic trading approach. The emergence in late spring 2013, of discussions among FED members about a possible reduction of QE took markets by surprise, forcing us to close certain positions and tweak our strategy, operations that bore fruit at the end of the summer. Increases on the interest curve started appearing when the US market began anticipating and pricing in increases of the Fed Funds rate for summer 2015, some- thing we find (and still find) to be opportune.
Therefore, credit wise 2014 is starting off on a defensive tone, initiated last October to lower the general risk level by seeking refuge in short term banks and municipals and profit from the steep yield curve in those areas. We expect a flattening of the yield curve in Canada and the US, and more specifically on the short term portion since no movement in Canadian or US central bank rates are expected for some time (15-18 months).
With only 90 announced transactions between compa- nies (where at least one party is public), according to Bank of American – Merrill Lynch, 2013 recorded the lowest level of mergers and acquisi- tions in Canada over the past 12 years, considerably less than the previous low of 110 transactions recorded in 2003. These figures contrast sharply with the peak of 210 transactions announced in 2009.
Despite a less severe situation in the United States, merger & acquisition opportunities south of the boarder carried very different margins than domestic deals. In Canada, the events at the end of 2012, which decimated the industry wide capital allocated to arbitrage, supported more attractive margins through 2013, despite the lower deal-flow. Throughout the year, the capital that we deployed on domestic trans- actions was constrained by our MPTL (Maximum Permis- sible Total Loss) limits and liquidity, while in the United States, the lack of expected return on the specific transaction subset of interest to the Fund seriously restricted the use of available capital. Our investment discipline remains, as always arbitrage, and as such, less capital was allocated to this segment of the portfolio than historically. Only three transactions were aborted during the year, a failure rate that is in line with the historical norm for the Fund.
We also participated in the arbitrage of seven subscription receipts, a number two to three times higher than the historical average. These receipts are issued by purchasers to finance an announced acquisition, but are conditional on its successful completion. Arbitrage of receipts tends to offer a very low risk, with the added benefit of compensating the holders for any dividends paid by the issuer. Although receipts reduce the cost related to the payment of a short dividend resulting from a delay in the closing of the transaction, however this feature can lead to adverse tax consequences for the offshore Fund by reducing the expected return. In some cases, excluding such a transaction from the offshore portfolio will create divergent performance from the onshore Fund.
Exceptionally, in 2012 Amethyst experienced two sud- den and costly cancelled bond buybacks. In 2013 no comparable events transpired – as should be the case. These 2012 cancellations were the only ones that I’ve experienced throughout my career. During the last quarter of 2013, we have been busy arbitraging the repurchase of preferred shares mainly by Canadian banks as the new Basel III rules render them obsolete. The return on these trades in not huge, but their low risk makes them attractive. Once again, when dividends are involved, these positions are rarely economically viable for the offshore portfolio given the withholding taxes to which non-Canadians are subject.
2013 was a difficult year with respect to the perfor- mance of our convertible bond portfolio. While volatility may have been low, perfor- mance was negative despite us deploying additional resources for credit analysis and modeling, our continual delta adjustments, membership on creditor committees, preemptive legal action with distressed companies and many other progressive steps initiated by Crystalline. On the flip-side, we take some comfort in knowing that we outperformed our competition, some of who experienced considerable drawdowns.
Traditionally, Canadian convertible bonds and warrants offer an acceptable level of liquidity in both the primary and secondary markets, while hedging is cheap with stock borrow readily available and no dividends offsetting coupon income. Attractive opportunities have largely been concentrated in the energy and materials sector. However, with the price of gold and other metals re- treating, the viability of mining projects initially financed using 2011 and 2012 commodity prices were put into question and access to further financing dried up leaving some companies scrambling. As a result, some investors began to price companies using a worst case scenario which was exacerbated by selling as investors reduced exposure to resources generally. Many of these companies have had difficulty readjusting to lower commodity prices and tighter access to capital.
This macro picture also had a pernicious effect on the market structure as well. As fund money flows have been against resources, redemptions forced managers to liquidate positions, if not winding down entirely. The closing of FlatIron in November 2012 had repercussions stemming first from distressed selling, and then from lower demand and liquidity. Other players merely exited the Canadian convertible space and put their capital to use elsewhere.
The result was a three tier pricing matrix in the Canadian convertible market: Retail yield seekers keeping at-the- money convertibles priced around par and trading on yield; US distressed funds owning the busted (below 50% of parity) space; and carry-trade hedgers seeking full-delta positions on deep in-the-money converts. This left demand at the $50, $100, and above $120 levels, resulting in liquidity buckets rather than on a smooth continuum. Consequently, paired positions hedged on a delta basis delivered inconsistent returns as bond prices remained sticky around these levels while the underlying equity price varied. This behavior was observed not only across resources related issues, but across all economic sectors of the Canadian market.
As we all know, it is not in the interest of long term returns to throw out the proverbial baby with the bathwater – although prudent risk management remains imperative. Despite the below normal liquidity, throughout the year we have successfully reduced our exposure to commodity dependent convertibles by a third and rede- ployed this capital towards non-cyclical sector positions. We fully expect much of the drawdown in the convertible portfolio to bounce back as companies prove our analysis right by demonstrating their viability. Though some losses have necessarily been crystallized, the Fund is in a position where the risk of downsides is contained and upside remains considerable.
Several factors lead us to believe that the worst is behind us. One should keep in mind that the performance of Amethyst and Topaz are positive for the second half of 2013 and conditions favor the continuation of this trend.
On the one hand, the growth of corporate balance sheets over the last five years and low level of Canadian M&A activity in 2013, suggest a rebound in M&A transactions is on the horizon. In the resource sector, opportunities for acquiring assets are plentiful, and shareholders of many companies are beginning to run out of patience. In addition, the margins ob- served in 2013 are likely to persist if activity increases. A rebound will allow us to deploy more capital into M&A opportunities with higher profitability.
Convertible debt prices are currently abnormally low in Canada. In some cases, pricing and implied credit spreads are comparable to the through of 2008. As we said then, such situation can- not remain in the long term, as investors inevitably realize that risk premiums are inflat- ed and push prices back in line. The outlook for 2014 is for a reversal to the mean where volatility will return and pricing will normalize. Already we are seeing a return to the resource sector as valuations stabilize and worse case scenarios fail to materialize. We continue to monitor risk and diversify the portfolio as necessary across issuers and industry sectors.
Despite the long period of sub-par performance in recent quarters, it was imperative that we devote the effort and attention necessary to protect the capital in the Fund while still ensuring that we maintain suitable levels of upside potential.
We are extremely grateful for the trust and patience of our investors, and believe they will be well rewarded as the portfolio gradually recovers and its regains its normal cruising speed and annualized return objective.