Criteria for finding sleep-at-night bond holdings
How Pender builds conviction in a trying market
The investment business is not short on optimistic chatter. But there is a difference between “optimistic because I have to be” and optimism that stems from deep conviction. The optimist with conviction can bear a degree of volatility because they have weighed the evidence and are comfortable with an investment’s risk and return profile.
So let us not talk of optimism, but of conviction. In a market with an ugly tape, what parts of it strike us as being supported by firm underlying value? Where are the sleep-at-night holdings and the high-conviction risk positions that can build the gains of tomorrow?
Speaking specifically of the Pender Corporate Bond Fund, a big part of our conviction comes from healthy weights in the “brick houses” of the credit market. What’s a brick house? How about Verisign, Inc., the monopoly registrar of dot-com domain names? Currently capitalized at approximately US$20 billion, Verisign’s debt represents less than 10% of total enterprise value. Interest is covered more than 10 times by cash earnings. In this market, Versign’s 2027 bonds yield more than 4.5% to maturity. Using Bloomberg’s default probability method, Verisign’s one-year default probability registers as 0.0001%. When we think it’s hard having conviction in this market, we think about Verisign’s 2027 bonds.
This year has seen the return of a special class of credit opportunity that we like to think of as “cream puffs.” The risk economics here are similar to the brick house credits, but owing to accidents of circumstance – stale or absent ratings or a lack of research coverage to name a couple – the cream puff bonds bump along with yields of approximately 10%.
A case in point is the W&T Offshore Inc. 9.75% 2023 2nd lien bond, which sits atop a capital structure that has been reinvigorated by surging energy prices. Based on the current oil and gas pricing “strip,” the company’s net debt is just over 1 times expected 2022 operating cashflow. In their last assessment of the W&T credit in July 2020, a mere three months after the extraordinary -$37 spot fixing in the oil market, Standard & Poors rated this issuer CCC+. Were S&P to re-do their rating work today, we suspect they might be much more favourable. We have strong conviction here.
Credits with pending deals
High-quality yields are available in holding the credit of companies with agreed-to but pending takeover transactions. As an example, HP Inc.’s acquisition of Plantronics, Inc. puts the 4.75% 2029 bonds on track for early redemption on attractive terms. While nothing is entirely inevitable, we have high conviction in the successful completion of this merger.
In these foregoing categories, we are finding rather attractive yield opportunities in situations where we believe we are taking on fairly low levels of capital risk. A curious reader may then ask, “What is the reward in this market for extending a little on the risk spectrum?” Not surprisingly, perhaps, we see situations in this market that offer, in our view, potentially even higher risk-adjusted returns.
Looking at the 2% 2026 convertible obligation of Intercept Pharmaceuticals, Inc., we see an interesting opportunity. The company has an approved drug, Ocaliva, which is used for the treatment of fatty liver disorders that already generates over $300 million in annual revenue. It also possesses – pro-forma the closing of a recent deal to monetize the international sales of Ocaliva – over $800 million cash. Moreover, the company stands on the precipice of an FDA decision on whether to extend the label of Ocaliva to allow its use in addressing the much more widespread NASH liver disease.
Our shorthand estimates peg the value of Intercept at approximately $2 billion, even if the NASH extension is denied by the FDA. Total debt is only $729 million. With a value of almost 3 times total debt, we find the 2026 notes trading near 66% of face value to be quite compelling.
In a market with a down-trending price bias, it is easy to lose faith. Non-specific optimism in such an environment is often not particularly helpful. But understanding and conviction, supported by a thorough line-by-line analysis, provides us with confidence in our positions. We realize that in the short-term, prices can be volatile. But within a reasonable time horizon, we have strong conviction that attractive returns may be achieved.
Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – May 2022. Used with permission.
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