Since the last phase of “QE” in September 2012, markets have remained largely prone to risk-taking. Despite certain sectors of the market becom- ing increasingly frothy (High Yield and European Bank Credit in particular), risky assets continue to be bid up, driven by massive central bank intervention since the crisis. Just recently, the European Central Bank (ECB) once again intervened by lowering its key interest rate and by providing low interest loans to non-financial companies (the new LTRO program). Understandably, this move favored riskier Eu- ropean assets and helped to significantly decrease the cost of borrowing for countries in the Eurozone. The impacts are clearly evident: Spain and Italy are borrowing at levels never before seen… Not bad for countries with anemic growth, staggering unemployment and rising national debt!
Surprise decline in the U.S. in Q1, but course maintained
U.S. first quarter GDP was more affected by the cold temperatures than many believed. Accompanied by a slight decrease in invento- ries, economic activity in the U.S. fell by 2.9% during this period. However, data from the end of April showed encouraging signs and employment demonstrated average gains of over 200k per month. Since the beginning of the year inflation has rebounded slightly, but concentrated mostly on energy and food prices, not wages. In Canada (GDP Q1 = +1.20%), the positive growth was driven by an increase in consumption, strong demand in the resource sector (solid industrial production growth) and exports, spurred-on by the correction of the Canadian dollar. The second quarter also looks solid, but with less robust levels of construction.
Just like the first quarter, economic expectations remain strong for the second half of 2014, but the risk is that results may be much more measured. Paradoxically, companies continue to gener- ate record profits and outlooks remain positive although capital expenditure (capex) is anemic. Nevertheless, it is our opinion that the likelihood of a Canadian or USA recession remains very low in the short-term. Notwithstanding the potential external shocks or crises mentioned in our last newsletter, the North American economy is likely to continue its slow advance, a scenario which remains supportive of risky assets.
Nevertheless, the imminent end of the U.S. QE program, recent increases in rates at the short-end of the curve and complacent valuation of certain assets, could all three drive an increase in volatility in the coming months. In the event that any weakness materializes, the decline may be short-lived, but of significant amplitude. Careful selection of asset mix and investment horizons, accompanied by appropriate risk hedging is imperative in such an environment.
Like in the first quarter of 2014, the fixed income arbitrage segment of the portfolio had a positive contribution in line with the Jan-Mar period. Even the “credit spread” segment, which consists of more directional positions, although of a much smaller overall weight, performed well.
The tightening of credit spreads in some provinces, notably those in Quebec, as well as maximizing the “Rolldown” component of the portfolio were supportive of the positive results, despite a low Beta. The evolution of the interest rate curve was also favorable. Strategic positioning in this sub-segment benefited from flattening at the short end of the curve in both Canada and USA, while at the tactical level, we took advantage of range bound pricing at the long end of the curve on both sides of the border.
The third quarter began with an almost maximum allocation of capital to the fixed income arbitrage segment, however strategic positioning on credit spreads remain very prudent. Although markets continue to be “risk on”, the portfolio’s beta has been kept deliberately very low. For markets, the steady march upward continues, however, we believe that certain inves- tors are becoming complacent, ignoring the risk / return trade off. Therefore, the duration of the credit spread segment will only be in- creased on a material widening of spreads, and in the meantime, we will remain patient. Our expectations on the interest rate front remain unchanged, i.e. no movement in Canada or the United States for quite some time (12-15 months). In both Canada and the USA, we continue to anticipate a flattening of the yield curve in the 5 year and under, and a steep- ening of the curve for longer maturities. Our few directional positions seek to profit from the current unusually acute slope of the curve, es- pecially in the USA.
A rising tide lifts all ships, pushing up equity and bond prices, through tightening bond spreads. The Canadian convertible universe continues to exhibit improving underlying fundamentals and valuations, tightening spreads (50 bps during Q2) but, unfortunately for arbitrageurs like us, little to no volatility. While we keep making money as perceived credit improves, our continued commitment to adhering to our delta hedge and protecting fund capital guarantees both underperformance relative to equity indices and protection for our investors from a reversal of the uninterrupted advance in these indices.
The lack of volatility, manifest since the almost uninterrupted run-up of equity indexes began in 2009 remains an undesirable opportunity cost. Although this does not result in negative performance, it does limit performance by depriving the convertible debt sub-portfolio of one of its two sources of returns: the dynamic component, generated by constantly adjusting deltas as the price of the underlying stock changes. With few opportunities to cover short positions on a pullback of the underlying equity, the full capture of the embedded option premium is incomplete.
In contrast, one thing that appears to be changing recently is liquidity and the number of new issues. We have been able to improve diversification in the convertible portion of the fund with quality new issues in Canada. While listing of the one billion dollar BlackBerry convertible was a non-event as only $4,000 face value traded, there being only three holders, other new issues have been liquid. We added 10 Canadian convertibles in the second quarter, of which 5 were via new issues, and all outside of the materials sector and of decent quality and pricing.
The Fund’s performance, although not earth shattering in the second quarter, bodes well. We strived to offer a satisfactory return to those who feel that the recent increase in equity valuations is suspect given the economic landscape. We do our best to maintain a balance between preserving upside potential while protecting investor capital against a market correction. In this latter regard, we are well hedged and would profit from a little volatility while maintaining a decent carry.
The upsurge in mergers and acquisitions, for which we have impatiently waited for quite some time continued into the second quarter in Canada and even accelerated in the US reaching a new record. The Fund participated in 13 Canadian transactions out of a total of 25 during the period, as reported by Bank of America Merrill Lynch. The only cancelled transaction was Transglobe Energy when the acquirer, CRCL, itself received and accepted a purchase offer from Glencore. The cost of the cancellation, however, was limited to less than 30 bps.
In the U.S., the record level of activity comes in part from pharmaceutical companies seeking to reduce their tax burden through the acquisition of companies located in countries with a lower tax rate (“Tax Inversion”), allowing them to relocate certain activities. We can expect the U.S. government to block this tax leakage as soon as the two chambers reach an agreement. Meanwhile, the number and size of transactions to arbitrate and the resulting spreads have turned very attractive. But just as in the Canadian segment, the Fund also experienced one deal failure in the U.S. when a buyer (MSM) became prey to a hostile bid. However, we were able to react very quickly by covering our short position on MSM and going long, even before the official market open thereby limiting the impact to 20 bps.
We continue to innovate and diversify, combining mergers and acquisition with fixed income, convertibles, and listed options. By hedging, to the extent possible, a transaction using options and equity, but using the long convertible bond as the main arbitrage instrument allows to comingle 3 important dynamics: a) a limited downside to a merger situation where the outcome is uncertain; b) a positive carry along the way, without an opportunity cost due to closing delays; and, c) still generate a generous return should the deal close as expected. The DFC Financial transaction illustrates this strategy, with a position that generated 25bps (or over 5% on capital usage) in the quarter alone.
From April to June, a total of 5 M&A positions were added to the portfolio through the target’s convertible debt. Finally, the Canadian market abounds in preferred shares issued by banks after the 2008 crisis, which are now subject to redemption. The portfolio has included 11 of these positions during the same period.
Crystalline is one of only a handful of managers offering expertise in each of the Event Driven/M&A, Convertible and Fixed Income arbitrage strate- gies, a combination that adds to our edge vs. our competi- tion who tend to stick to one or another of these strategies.
We recall the difficult period surrounding 2012 and the first half of 2013, which was marked by a sequence of negative events of unusual intensity and frequency (“fat tail” type), then followed by a sharp decline in valuations in a substantial part of the convertible portfolio. This plight, a first since the Fund’s crea- tion in 1998, was finally extinguished around June 2013.
Since then, Amethyst has generated an annual return of 8.1% (6.2% offshore), with an annualized volatility of less than 3.3%. This performance exceeds that of the short-term 3-month rate by nearly 7.1% (6.0% offshore), and reminds us of the long 10 year period from July 1998 to June 2008 when the Fund had an average annual return of 6.9% above the risk free rate, with a volatility of 4.6% and on average had positive returns on 9-10 out of 12 months.
Although we cannot predict the endurance of this new period of normal returns, we are encouraged by the quality of the issuers in our convertible portfolio, the increasing mergers and acquisitions activity, and the almost complete deployment of the Fund’s available capital.