Welcome to a new year. 2016 was a good one for High Rock on many levels and we will continue to work hard to add incremental value with the best risk-adjusted returns we can find.
By now, all of our clients have received their 4th Quarter and YE16 packages. In the package, you will see a note from High Rock that details some investment highlights. One highlight I want to touch on today is a shift we made in our Preferred Share (Prefs) exposure.
First, I won't go into a ton of detail here, but I will state a few facts that will help explain why a sector of the Pref market got hammered so hard the last two years or so:
Now a quick word on the two main types of Prefs in the market:
Up until the first week of November, High Rock clients did not own any Rate Reset Prefs. At the time, and it was a good call, we owned some Fixed Rate Prefs. So our clients were spared the decimation that occured in the Rate Reset market over the past two years.
So why did Rate Resets get decimated? Because interest rates (specifically 5yrs Government of Canada bonds) kept going lower and lower and the IA's woke up and realized what they put their clients in were about to Reset with a much lower dividend than they had been getting for the past 5yrs. And as I stated above, what could go wrong when retail investors are jammed full of this paper...they run for the exits. That, my friends, is why the Rate Reset market got hammered and created an opportunity for High Rock.
I started doing some in-depth work on these Rate Resets back in late August. I have a friend (way smarter than I am) who was willing to share his "math/valuation model" with me. I worked on this for two months to fully-understand the drivers of these Rate Resets. The key drivers are: 1) Obviously interest rates and the shape of the bond curve and 2) Credit spreads, or more importantly, the implied credit spread (which ain't easy to calculate). (NB, If I was a quicker study, we would have bought these Rate Resets even earlier than we did...better late than never).
Armed with this inteligence, we quickly sold all 3 of our Fixed Rate Prefs and bought 3 Rate Reset Prefs. And remember, we do everything on a block trading basis so every client participates in every trade on a pro-rata basis (this means no one client is advantaged over another and the trades happen as fast as I can put the order in).
Why did we do the switch? Because interest rates were rising (even before Trump won) so owning some floating rate instruments would help diversify our fixed rate duration (government bonds) and also because our model told us that the implied credit spreads on these beaten-up Rate Resets were very cheap vs the underlying senior corporate bonds of the various issuers. (Being well-versed (maybe even an expert?) in credit doesn't hurt when valuing credit spreads).
It worked well. Bloomberg doesn't support a total return calculation for Canadian Prefs so I can't give you hard % numbers on how much we saved and made on this switch trade but two pictures will give you an idea of the effect of the trade.
First, the Fixed Rate Pref (PWF.PR.K) we sold in early Nov at around $24.20. Note the box and arrow of our sale and note that the Pref is a fair bit lower today. Nice trade:
And the Rate Reset (PWF.PR.P) we purchased on the other side at the same time (early Nov) at a price of about $13.65: Higher today. Two nice trades.
Not bad, eh? We fully-understand that Prefs are not true Fixed Income (they are actually Senior Equity, not Fixed Income) but we do aportion them into our Fixed Income Model, nonetheless, due to some of their mathematical characteristics. They may not be in our Tactical Model but I think you would agree that we were being very Tactical by doing this switch. I think this is called "Value-added".
As an aside, we have one client (an extremely sophisticated investor who has been invested in our standard three model portfolio for well-over one year) who actually asked me about the Pref market last Aug, just as I was starting to do some research. I went to work and ramped-up the research process. He then opened a new account at High Rock in early Nov, added money and we invested 100% of that account in a very specific portion of the Rate Reset Pref market (they are not all the same, so be carfeul) and in a concentrated portfolio. He is happy today! <NB that we bought the Rate Resets for all clients and this specific client all at the same time and on a pro-rata basis.> This type of risk is definitely not for everyone but if you feel you need a specific solution to your overall portfolio (as this client did, and one before him earlier in the year did) and want to discuss, please contact us. Although we created our three models to work for everyone (and they do) finding very specific solutions outside of the three models is also part of what we do.