The (yield) desert song

Choosing dry powder instead of a rock or hard place

These are funny days for people who have capital and wish to use it to derive income. At times it feels as if there is a much larger stock of capital that wants to clip coupons than the supply of credible entities that need to borrow. With most government bond yields penned below 1%, the competition for “good” lending opportunities has become fierce. From the lush meadows of last summer, credit investors must now confront a yield desert.

We believe we have identified a few oases in this desert, which offer solid return potential and reasonable trading liquidity. These include certain secured bonds and loans issued by U.S. marijuana companies, where relatively tiny debt structures are underpinned by significant equity buffers. Oil and gas is another area where investors are reluctant to extend credit, despite fairly buoyant commodity prices and some attractive looking short term paper. The biotech sector is another capital-hungry sector with spots of attractive risk/reward, and we have become involved here as well. There are a few other spots – specific defaulted entities or some preferred shares – but these niches must necessarily entail limited allocations.

Outside of a few of these anomalies, however, the credit markets are being priced at levels that have rarely existed. Ten-year junk bonds are coming to market with yields in the 3’s and 4’s. In the past 10 years there have been three occasions when the average yield of a high-yield bond has exceeded 9%. A 3.375% coupon 10-year bond, which now trades over par, would have to price in the mid 60s at a 9% yield. We understand that the cool kids are doing it. And those new issues are working right now. But in our Pender Corporate Bond Fund, we have avoided most longer-duration high yield with an eye to the unknowable future.

The cost of eschewing the new long-dated maturities is watching the continued tightening of shorter-duration spreads, particularly as call schedule dates approach. We love our 5% yield to maturity in the OpenText 2026’s, but with those bonds showing a 0.8% yield to a possible August 30 call, we wonder how long we can clip that particular coupon.

So here are, generically, the choices that are confronting income investors. Sign up for long-dated yields with inherently larger price volatility potential or suffer the slow erosion of yield on shorter-dated paper. Do you prefer a rock or a hard place? Our niche investments do cushion the blow, but we are not able to completely disassociate ourselves from the mismatch between capital stock and investment opportunities.

Increasingly we are opting for the accumulation of dry powder instead of trying to find new ways to like things we have already passed over. We continue to turn over rocks and will continue to report back on the better ideas we uncover. But our plan now also entails building reserves of dry powder to be deployed into the panic of some future tumult, be that micro or macro in nature.

In this market, discretion may be the better part of valour.

Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income – Manager’s Commentary – July 2021. Used with permission.

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