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The bullish bond fund manager on the make spends a lot of time these days promoting the idea that after nearly four years of surging yields, a slowing economy will lead to lower inflation and a sustainable bond market rally. Fair enough. We are inclined to agree.
But where we disagree with that bond fund manager is whether we should be satisfied with pursuing only that one opportunity. What if it takes longer for that falling-rates trade to materialize or their decline is less than anticipated? What else do you have? Well, we have a lot more. And it comes from looking beyond that single macro idea to a broad array of very interesting other options that can allow us to generate excess returns from corporate credit. Let us enumerate a few.
Often, we look beyond the specific credit strengths of an issuer to seek support from a related entity that would be inconvenienced or embarrassed by the failure of a connected but non-guaranteed entity.
For example, our own historic success in SunPower Corp bonds was due in part to our confidence in the implicit support that entity had from its controlling shareholder Total SA, which brandished SunPower Corp as its renewable energy “fig leaf” in the heyday of ESG investing.
Similarly in the current market context, we can look past some of the more stretched credit ratios of Pemex to see a Mexican state that, while not the formal guarantor of Pemex, essentially shares the company’s P&L statement. If a borrowed U.S. dollar costs the Mexican sovereign only 6%, why should it not lend a hand to its troubled energy monopoly Pemex for whom the same borrowed dollar costs 11%.
On other occasions a bond may be either unrated or perhaps poorly rated, yet on closer inspection default risk is de minimis. One might expect an efficient market to adjust pricing for low-risk bonds without high ratings, but in this era of passive investing there just are not enough people doing the work.
Consider Centrus Energy’s 8.25% notes due in 2027. Providing enriched uranium to power plants in North America, this issuer is a highly profitable monopoly. Centrus’ balance sheet cash is 3x debt outstanding, and its trailing operating income covers interest charges by 40 times1. A yield of 8.8% seems too high for an issue of this quality, but we will take it.
A delightful opportunity can materialize when a fundamentally undervalued company is required to refinance or extend a convertible bond at a time when its equity is trading at a steep discount. Recently we have seen several of these opportunities in issuers such as OPKO Health Inc, Cineplex Inc., and Equinox Gold Corp. Equity investors may be blasé about return potentials of 50% to 100%, but in the world of fixed income, these modeled opportunities are really special, considering that par can provide a critical floor to a well-covered credit.
As any bond market veteran will attest, traditional credit analysis involves wearing a heavily starched white dress shirt and looking backwards into the long history of a company’s financial performance. While we are not ones to question things that have worked, a market that leans too heavily on this approach tends to miss certain opportunities.
What of the company with stretchy credit metrics that has developed a better mousetrap and is poised to grow strongly in the coming years? That company will produce increasingly stronger financial results, and its bond prices ought to improve accordingly. Here, we point to the 2028 0.5% convertible bonds of Stem Inc., which we believe will appreciate far above their current trading level in the mid-40s as the company’s important position in the emerging field of utility-scale battery operating systems becomes more widely appreciated.
The world has more than one type of opportunity. And in a field as wide and as varied as corporate credit, we find that there are many ways to win.
Notes
1. Source: Centrus Energy company report.
Geoff Castle is Lead Portfolio Manager of PenderFund Capital Management’s Fixed Income Portfolios, including the Pender Corporate Bond Fund. Excerpted from the Pender Fixed Income Manager’s Commentary, April 2024. Used with permission.
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