Q3 2014 allowed some financial terms, absent from our lexicon for several years to resurface. Indeed, despite globalization which has been accelerating for decades, many economists and investors are now once again arguing in favor of the “decoupling” of economies to the benefit of the US and UK and to the detriment of Europe and Japan.
A More Positive North-American Landscape
After a disappointing first quarter, economic data in the US & Canada improved markedly, contrary to what we’ve seen in Europe. Whether looking at leading economic indicators, GDP, or industrial production,Canada and the US did well. On the other hand, inflation remains low, the labor force participation rate in the US has resumed its downward trend, and some sectors, notably the automotive, appear to be fundamentally driven by “very accommodative” credit conditions. In short, North American growth continues, but at a slower pace. In Europe, the situation is definitely less rosy, with confidence measures, leading economic indicators and consumption all down, this time not only in peripheral countries, but also in Germany.
Optimism vs. High Expectations vs. Central Banks
The scenario seems to be repeating: Economic expectations are still high, and markets remain prone to risk-taking, however reality may be disappointing. Central banks are on diverging tangents, with anticipations for significant and rapid rate hikes in the US and UK, whereas in Europe and Japan, investors clamor for more quantitative measures. With emerging countries experiencing moderate growth, and global growth hovering around only 3%, there is a good chance that economic forecasts for the US and the UK are overly optimistic and that the market will once again be letdown by the “decoupling” theory. Oil prices, however, could act as a counterweight. With the price at the pump in the US hovering around $3.50 per gallon, it is at its lowest level in four years. The result is a defacto tax break for all consumers which may serve to stimulate consumption through the end of the year.
In the short term, the probabilities of a recession in Canada or the US remain very low; rather the economy will more likely produce further moderate growth, an outcome that should continue to support risky assets. It is worth noting that on a total return basis, medium and long term North American bonds remain attractive relative to equity markets; however, we consider the European bond market far too expensive when compared to the US and Canada.
The fixed income arbitrage segment contributed positively to the Fund’s overall performance, but to a lesser extent than during the first half of the year. Within the “credit” sub-portfolio (i.e. spreads), positive performance was driven primarily from positioning on the curve, which maximized the “rolldown” component. The Beta, i.e. the duration of the long portion of the portfolio, is still shrinking. We have also been able to add value via the interest rate curve. Our positioning, based on an anticipated flattening of the short end of the curve in Canada, was very favorable this last quarter. We are similarly positioned in the United States, but because the curve has remained steep, no gain was generated.
From a credit standpoint, the last quarter in 2014 began as the mirror image of Q3. We are employing all of the capital allocated to this strategy, but our general positioning remains very cautious. The Beta is low, still awaiting a timely decline to add to our positions. When this occurs, government credit (provinces, municipalities, agencies) will be favored as they offer a better return on capital (ROC) when compared to corporate credit.
Our expectations on the yield curve remain unchanged, and in fact, our convictions have been strengthened. We continue to foresee a flattening of the curve in Canada and the US in the 5 year and under sector, and a steepening beyond the 5 year horizon. Our outlook remains the same; we do not expect a bullish or bearish movement in the key interest rate in Canada or the US for at least a year. We are therefore looking to profit from the very steep portion of the interest rate curve, particular- ly in the US.
The market event segment of the portfolio was active with 36 new arbitrage situations added to the portfolio in the quarter; all tied to mergers and acquisitions. Of these, 25 were played in a conventional manner, i.e. through the purchase of the shares of the target, 4 using the spread between a subscription receipt of the acquirer and the shares, while in 7 situations we were able to use the target’s debt to lower the overall risk level of the arbitrage position.
The results of the 3rd Quarter showed little impact of an aborted transaction in September. The Fund suffered a loss of 1.5%, within our maximum loss limits per position, when Auxilium Parmaceuticals (AUXL), which was to be acquired by QLT Inc. in a share deal, itself become the target of a takeover bid by another pharmaceutical company. At a 50% premium this new offer obviously led to a significant loss on the short position initially established on AUXL, in combination with the QLT share price falling below pre-deal levels. A perfect storm in fact, but one that left few traces, as the rest of the portfolio performed well during the period.
The decline in rates has encouraged more issuers to refinance their debt at a lower cost, and we were able to extract attractive returns from announced redemption events. We are also actively increasing the use, where possible, of a combination of shares, convertible / straight debt or even options, of companies involved in announced merger and acquisition deals. The goal: To ensure the best possible risk / return profile for the arbitrage position, while still seeking to protect capital (see example in box).
It is only because of the proximity and collaboration of Amethyst’s three mangers (Mathieu in fixed income, Bradley in convertibles and Marc in mergers and acquisitions), that we can conduct our analysis of merger and acquisition transactions in a broader context to determine the optimal recipe for possible inclusion in the portfolio. This edge, which few competitors can offer, is based primarily on the divers and complementary skills of our mangers. It is a symbiosis that would be hard to envision or replicate outside of a hedge fund.
Convertibles continued to perform in the 3rd quarter despite low volatility and a lack of new issuance. The focus throughout
the quarter was on aligning our hedges, optimizing our positions and maintaining our defensive puts. Our continued diversification away from materials has held us in good stead despite the drop in commodity prices during the period, and we ended the quarter with less than a third of the convertibles sub-portfolio in energy and materials. Newly added positions have been in either larger, more liquid credit issuers or have been added at relatively reduced weighting in the portfolio so as to remain nimble. Prudence has been of the essence in this uncertain economic environment.
Returns were somewhat limited by a lack of volatility with coupon income becoming a larger driver of returns as a result. Credit spreads have been consistent with a general tightening bias. Despite the continued low volatility, we have been tactically trading some of our core positions by reacting to motivated buyers and sellers and being an opportunistic liquidity provider. We also continue to exploit the continuing evolution of the Canadian bank sector’s capital structure through systematic preferred share redemptions although this opportunity has become slightly less lucrative as their intent has become well telegraphed.
We continue to maintain market puts using “in the money” US convertibles. As the underlying equity has risen, we have rolled into issues with lower absolute value to maintain the put value. This way we maximize the hedging effect should markets decline systematically. We have also been enhancing the realized return using “out of the money” options with high implicit volatility with some success. In contrast to Q2, the new issues market has been quiet, with no new names added to the sub-portfolio via primary markets.
We believe that we are well positioned going into Q4 with liquid positions of relatively high coupon, high quality credits at the core of our Canadian convertible portfolio. We remain cautious and expect modest returns in Q4 as economic and geopolitical uncertainty persist.
On the eve of the closing of a fifth year of consecutive economic expansion and continued increases in North American stock markets, the positions our portfolio reflect a prudent approach. Special emphasis is placed on liquidity and protection of downside risk in order to maintain our ability to participate in the many ad hoc arbitrage opportunities, while ensuring that we can make an exit in the event that markets falter.