The two chief risks in the bond market – credit risk and duration risk
1. Credit risk is the risk that the company that is being lent money is
unable to repay the obligation, and further, in the event of default, the
risk that the sale of the business and its assets is insufficient to repay
2. Duration risk is the risk that the price of a bond goes down, based on
an increase in its yield to maturity.
How we address credit risk
We do several things in our fund that relatively few active managers do and
no passive funds do, which are specifically focused on reducing units of
credit risk per unit of expected return.
We employ default risk probability models. Primarily this means our use of
Bloomberg “DRSK,” but we also look at other objective credit risk signals,
such as Altman Z score, as well as credit default swap spreads where that
makes sense. Risk probability models look at the measurable inputs of
credit risk, including the following:
* How much working capital (cash, inventory and accounts receivable, net of
short term payables) does a company have?
* How much value does the stock market assign to the equity of the company
(which is, of course, subordinate to the bonds we own)?
* What is the level of cash flow currently being generated by the company?
* How much debt does the company have, relative to its assets and
We find that credit ratings have shortcomings that have been
well-documented and include conflicts of interest and being late to
identify changes in a trend (up or down). We use default risk models
because we believe they are a better predictor of defaults and of losses
given default, than credit ratings.
We model each holding on a valuation basis to ensure that in the event of
default our collateral value exceeds the price we pay for a bond.
Finally, we follow company reporting and newsflow carefully to ensure we
are early to spot negative trends. We have a financial forecast for each
holding. When we see actual results deviate from our expectations in a
negative way, we are prepared and able to act quickly.
How we address duration risk
At a time when long-term interest rates are near an all-time low, we
believe that duration risk is exceptionally high right now. Here is what we
do to mitigate the effects of risk.
We run one of the shortest average effective durations of any bond fund in
Canada. With average duration in the portfolio between 2.0 and 2.5 years,
we have very little exposure to the big price swings that occur out on the
long end of the “curve.”
We also own several securities with floating rates or rate reset
provisions. At Oct. 31, 2016, the fund had an 11% weight in securities with
a floating or reset component to the cash income we receive.
Long duration has a huge effect on the price swing from a rate rise. For
instance, if the current 2-year U.S. Treasury bond yield increased by 1
percentage point, its price would decline by about 1.4%. But if the current
30-year U.S. Treasury bond yield increased by 1 percentage point, its price
would decline by about 17%!
How do these efforts work in practice? How successful has the fund been in
demonstrating effective risk management?
Last year was a good year to stress-test our performance under both a
duration risk event and a credit risk event.
The following charts show how we did in each of those events. We believe
our performance under both of these stresses has been relatively strong.
We had almost no risk from duration.
Our fund does have some credit risk. We have to take some credit risk in
order to earn returns, and we believe that the risks we have taken have
been worthwhile. With a YTD return of more than 8x our largest drawdown, we
think our risk/reward equation has been very satisfactory and very
competitive with any other fund in the income space. Note that the average
return of the group of high-yield ETFs is only 2x their largest drawdown
year to date to Oct. 31 2016.
Geoff Castle, MBA, is a Portfolio Manager at PenderFund Capital Management.
Geoff Castle is an experienced investor in both public mutual funds and
proprietary investment fund management for ultra-high net worth
individuals. In addition, Mr. Castle’s background includes more than
five years of industry experience in trade credit and general corporate
management. As a fixed income manager, his focus has been on seeking
enhanced yield opportunities in situations where substantial margins of
safety exist. In particular, he has earned strong fixed income returns
for clients in the recent low interest rate environment by focusing on
“non-conforming” situations where yield opportunities existed despite
otherwise attractive credit fundamentals. Mr. Castle holds a Bachelor
of Arts degree from UBC and an MBA from the Richard Ivey School of
Business at the University of Western Ontario. He is a member of the
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