Diversified Income Portfolio: Taking Advantage of Attractive Cash Generating Investments Overlooked by Many Investors
Paul Borisoff - Apr 19, 2017
Our Diversified Income Portfolio* is up 4.6% year-to-date in 2017 (to March 31st, 2017) and 20.9% over the last 12-months after all fees. Since inception, March 4th, 2008 (prior to the financial crisis), the Diversified Income Portfolio has returned 5.9% annualized per year.
* All performance statistics are “composite returns”, net of fees, for all accounts in this mandate. Gains and losses are for the model portfolio.
Traditional “Income Portfolios” rely on a combination of Bonds (Government and/or Corporate) and Stocks (common shares), with some also incorporating Preferred Shares and possibly covered call option writing strategies. While we will also hold these same “bedrock” asset classes and securities in the Diversified Income Portfolio, when it makes sense to do so, we also target and hold attractive income generating investments in other areas that are often ignored by large investors due to size constraints and often overlooked by many retail investors and their advisors for one reason or another. Specifically, two areas that we specifically target with the Diversified Income Portfolio are “Discounted” Closed-End Funds (with upcoming redemption dates at 100% of Net Asset Value (NAV)) and the Canadian Convertible Debenture market.
The Problem with “Traditional” Income Portfolios Today
Low interest rates! No surprise, right? The Canadian bond market (FTSE TMX Canada Bond Universe Index) bounced back 1.2% in the first quarter of 2017 –off-setting part of the 3.4% correction seen in the last quarter of 2016. Over the last 12 months the Canadian bond market is up 1.5% - and over the last five years the Canadian bond market is up 3.5% per year. Note, the returns cited are “pure” index numbers and therefore do not have any associated fees or tracking error - such as those associated with the iShares Canadian Universe Bond Index ETF (XBB). At quarter-end the XBB which tracks the FTSE TMX Canada Universe Bond Index had a weighted average yield-to-maturity of 2.06% - which is equivalent to a “net” yield of 1.73% once adjusted for the ETF’s Management Expense Ratio of 0.33%. The iShares Canadian Corporate Bond Index ETF had a slightly higher net yield at quarter-end – coming in at ~ 2.05% - and at quarter-end the 10-year Government of Canada Bond was yielding 1.62%.
Bond “Guru” Bill Gross highlighted in his January 2017 Investment Outlook that U.S. 10-year yields were anchored in the 2.40% to 2.60% range due to global arbitrage (Japanese 10-year yields remain pinned near 0% and the European Central Bank’s continues to support low interest rates). Japanese rates are not expected to change much in the foreseeable future and Europe generally remains mired in subpar economic growth with increasing political uncertainty along with shaky financial institutions in certain countries. Meanwhile, Trump has recently come out in support of continued low interest rates in the U.S., and additionally voiced support for Janet Yellen. As of March 31st, U.S. 10-year Treasuries were yielding 2.39% - and have recently moved lower to the 2.20% to 2.25% range in early April. Canadian rates have also moved lower: 10-year Government of Canada Bond now yields 1.47%.
Going forward, bond investors will need yields to continue to head lower in order to realize returns anywhere close to the 3.5% annual returns seen over the last five years. If this scenario does work out though it will likely be associated with deteriorating economic data and possibly weak stock market returns. For many “income” investors a return of 3.5% per year, prior to fees, is still inadequate though. Note, returns on this asset class could remain ‘weak’ going forward – similar to the last 12 months. Bond investors could also see negative periods of returns – possibly significant - if rates move to a higher level at some point. Our “base case” scenario is that Canadian bond market returns will approximate what we saw over the last 12-months – over the next 12-months.
Government Bonds do have an important role to play in portfolios for safety of capital and diversification purposes: they typically benefit from increased buying pressure (go higher and yields drop) during times of stress and stock market sell-offs. However, relying on them for income in today’s market environment does not make a tremendous amount of sense in our opinion.
Frustrated with low rates, many “GIC refugees” and traditionally more conservative investors have transitioned into portfolios with greater stock market exposure as they try and generate required income levels. Many investors though still remember panicking during the 2008, 2009 financial crisis which saw many conservative, safe-haven stocks fall over 50% in a short period of time. For these investors relying solely on the stock market for “income” exposes them to too much uncertainty relative to their comfort level. Loss avoidance has become even more important, and a primary driver for many investors in recent years – with risk tolerance levels permanently lowered in many cases.
We maintain that there are easier and safer investments (compared to low yielding bonds and/or pure stock market exposure) for retail investors and small institutions to generate income and attractive returns. Some of these investment types are not necessarily available to large institutions due to size constraints and liquidity limitations.
The Diversified Income Portfolio seeks out the easiest and safest ways for retail investors and small institutions to generate income and attractive returns - in any environment. Select Convertible Debentures, discounted Closed-End Funds (with upcoming redemption dates at 100% of Net Asset Value (NAV)), and select small and medium sized REITs – are examples of investment options and asset classes that we regularly exploit in the Diversified Income Portfolio. All new positions must make regular cash distribution payments – either interest, dividends, or some combination. Below, we briefly highlight discounted Closed-End Funds, and then Convertible Debentures. We will be putting together a much more detailed report on Convertible Debentures within a few weeks, to be followed with an update of our October 12th, 2016 Blog report on Discounted Closed-End Funds.
Discounted Closed-End Funds (with an Upcoming Redemption Date at 100% of NAV)
In our December Quarterly Commentary for the Diversified Income Portfolio (sent to clients on January 13th 2017) – we highlighted how we had increased our exposure to this Fund from 4.9% of the portfolio to 20.2% in 2015 via 16 separate transactions - acquired at an average discount to NAV of ~7% (redeemable at 100% of NAV in March 2017). Like any Closed-End Fund bought at a discount to NAV (with an upcoming redemption date at 100% of NAV) – the “captured discounts” will eventually boost the realized return over the holding period when the Fund is redeemed at the redemption date. This also provides a degree of protection.
This highlighted position provided a 2016 return contribution of 18.1% to the portfolio – excluding a $0.29 special distribution received on January 13th. We are expecting to receive in the redemption proceeds from the Fund by April 24th – and will be commenting on it further in our upcoming regular monthly comment in early May. If you are interested in more information on Discounted Closed-End Funds please see our October 12th Blog post.
Convertible Debentures (~ 30% of the Portfolio)
A Convertible Debenture is a hybrid security which has some of the features of both bonds and equities. It is essentially an issuer debt obligation that comes with a set coupon or “interest rate”, a set maturity date, a minimum set maturity value, and a built-in conversion option (to convert into the issuer’s stock at a set price) that can provide significant upside potential. We currently hold 17 issues from 13 different issuers. Two highlights:
The Just Energy 6.75% 31DEC21 $9.30 convertible debenture is our largest position at 5.2% of the Diversified Income Portfolio. We acquired the position in late 2016 at an average price of ~99.00 – and the debenture closed today at 107.35 – so is now up 8.4%. Just Energy which has a market cap of ~ $1.2 billion sells natural gas and electricity contracts to over 4 million residential and commercial customers via fix price contracts across North America and the UK. The largest shareholders are billionaire Jim Pattison with a ~16% stake and billionaire Ron Joyce (Tim Hortons) who own ~14% of the company (and was continuing to aggressively add to his share position at the time of the convertible debenture issue). Additionally, the CEO owns ~ 4%. If you are comfortable owing a company’s common shares you should be comfortable owing a company’s convertible debenture as they have priority over both preferred shareholders and common shareholders in the event of a restructuring or dissolution in a worst case scenario. If you are not comfortable owing a company’s underlying shares you should probably stay away from its convertible debentures unless you have a good grasp of credit analysis. In all case we engage in substantial due diligence prior to investing which continues as we continue to hold an investment in the portfolio. In this case we take comfort in the fact that Jim Pattison, Ron Joyce and the CEO would need to see their equity stakes effectively wiped-out prior to our convertible debenture position being at risk. This adds to our expectation that at a minimum this investment will generate the coupon interest payments of 6.75% per year for five years and then a return of 100% of the capital invested by the maturity date. Just Energy closed at $8.26 today, and the current consensus 12-month price target is $9.82 per share (9 firms – Bloomberg). This debenture’s embedded conversion option provides significant further upside.
In March we bought a new ~4.5% position in the Tricon Capital 5.75% 31MAR22 $10.46 USD convertible debenture on the market at 102.42 USD – which closed at 104.00 today. The company had recently announced a “Transformative Transaction” to acquire 100% of Silver Bay Realty Trust in an all-cash accretive transaction valued at ~ $1.4 billion which positions the company as the fourth largest public company owner of Single Family Residences in the U.S. with 16,809 homes, enhances the company’s market density in key markets and also provides a number of other advantages. We have followed Tricon Capital since April of 2012 and booked significant gains in both the company’s shares and other series of convertibles in the past in this portfolio. Additionally, we continue to hold an ~1% position in Tricon’s 5.6% 31MAR20 $9.80 convert in this portfolio since it was issued in Feb 2013 at par value (100 – which closed today at 121.00 (up 21%). The current consensus 12-month price target is $13.47 (Bloomberg).
We are planning on putting out a much more detailed report on Convertible Debentures within a few weeks. In the meantime if you have any questions on the topics discussed please do not hesitate to contact us.
If you would like a copy of our March 31st, 2017 Quarterly Commentary and Summary for the Diversified Income Portfolio please contact us.
Paul J. Borisoff
Senior Vice President, Portfolio Manager
Senior Investment Advisor
Canaccord Genuity Wealth Management
T: 604.643.7083 | TF: 1.800.663.1899