Fund Manager
Eric Dzuba
With the passing of the Federal budget and little to no possibility of an election in Canada in the near future, it appears inevitable that income trusts will merge, be taken over or convert to a corporate structure over the next four years. While trusts will form a less significant part of the Canadian investing environment, demographics in Canada are such that yield will remain a top priority for retail and institutional investors. Fund flows following the October announcement have gone largely to dividend paying bank stocks and the tax-exempt REIT sector. Both are now, generally speaking, becoming expensive, yet one is challenged to argue with fund flows. The larger question over this year will be where to find yield on a going forward basis.
At this time, we have answered this question with a mix of equities, income trusts, fixed income securities and collateralized debt obligations (CDOs). We feel this combination, managed long-short, will produce significant risk-adjusted returns over time, resulting in a steady growth of capital while minimizing correlation to most major equity indicies.
Collateralized debt obligations (CDOs) are securitizations of corporate obligations. From commercial loans, bonds, asset and mortgage backed securities, CDOs achieve exposure to a wide variety of debt and commensurate yield. Synthetic CDOs achieve this exposure through the use of credit default swaps. The swaps make periodic payments to the noteholder in return for ‘insurance’ against default from the reference entity.
The developments within the CDO space in the last few years have brought innovation and flexibility in managing risk relative to yield. As CDOs are issued in classes of debt and equity and as each tranche has a different risk/reward profile, the manager can adjust weightings with relative ease. Cash flows generated by assets in the CDO pay the highest tranches first, then the mezzanine, equity and subordinate tranches in turn. As one would conventionally expect, the first paid receive the lowest return and the last receives the most – all commensurate with risk and return.
Over the history of the Front Street Long/Short Income Fund we have initiated an approximate 10% portfolio weight in CDOs. In addition to being in cash CDOs, we have an investment in one equity piece and a few BBB and mezzanine pieces. The amortizing nature of the underlying securities, and the fact that significant payments have already occurred, provides the benefits of time decay in older vintages. From a performance attribution perspective, we estimate that 15% of our returns resulted from this space over the course of 2006. Notwithstanding the sub-prime sell-off, we believe that any impact from a mildly slowing economy in our investments should be minimal. Conversely, a massive deterioration in credit and widening of spreads could present excellent buying opportunities within this space. These CDOs offer us high yields that have little correlation to the equity and income trust holdings of the fund.
We continue to see opportunity in the trust space in terms of take-over potential as well as some growth opportunities. We continue to hold REITs and select business trusts where we believe valuations or business are attractive to strategic buyers. As for growth opportunities, we have begun buying natural gas weighted energy trusts again, covering our short positions in Q1, and beginning to go long these trusts (as well as some gas-weighted equities). Reduced capital programs by the E&P companies announced over the winter could put pressure on natural gas prices by the fall if weather patterns return to more seasonal levels.
The challenges in the near term remain the mixed economic signals. While employment and demand in the Canadian economy remains strong, weakness in the manufacturing sector and consumer fatigue in the United States - our largest trading partner - remains something to watch. Core inflation in Canada has also been accelerating since late 2006. Over the longer term, recent spending initiatives announced in the recent Canadian budget, could be simulative to an economy that does not need this stimulus at this time.
Eric Dzuba - Q1 2007 Commentary
Date Published
Fund Manager
With the passing of the Federal budget and little to no possibility of an election in Canada in the near future, it appears inevitable that income trusts will merge, be taken over or convert to a corporate structure over the next four years. While trusts will form a less significant part of the Canadian investing environment, demographics in Canada are such that yield will remain a top priority for retail and institutional investors. Fund flows following the October announcement have gone largely to dividend paying bank stocks and the tax-exempt REIT sector. Both are now, generally speaking, becoming expensive, yet one is challenged to argue with fund flows. The larger question over this year will be where to find yield on a going forward basis.
At this time, we have answered this question with a mix of equities, income trusts, fixed income securities and collateralized debt obligations (CDOs). We feel this combination, managed long-short, will produce significant risk-adjusted returns over time, resulting in a steady growth of capital while minimizing correlation to most major equity indicies.
Collateralized debt obligations (CDOs) are securitizations of corporate obligations. From commercial loans, bonds, asset and mortgage backed securities, CDOs achieve exposure to a wide variety of debt and commensurate yield. Synthetic CDOs achieve this exposure through the use of credit default swaps. The swaps make periodic payments to the noteholder in return for ‘insurance’ against default from the reference entity.
The developments within the CDO space in the last few years have brought innovation and flexibility in managing risk relative to yield. As CDOs are issued in classes of debt and equity and as each tranche has a different risk/reward profile, the manager can adjust weightings with relative ease. Cash flows generated by assets in the CDO pay the highest tranches first, then the mezzanine, equity and subordinate tranches in turn. As one would conventionally expect, the first paid receive the lowest return and the last receives the most – all commensurate with risk and return.
Over the history of the Front Street Long/Short Income Fund we have initiated an approximate 10% portfolio weight in CDOs. In addition to being in cash CDOs, we have an investment in one equity piece and a few BBB and mezzanine pieces. The amortizing nature of the underlying securities, and the fact that significant payments have already occurred, provides the benefits of time decay in older vintages. From a performance attribution perspective, we estimate that 15% of our returns resulted from this space over the course of 2006. Notwithstanding the sub-prime sell-off, we believe that any impact from a mildly slowing economy in our investments should be minimal. Conversely, a massive deterioration in credit and widening of spreads could present excellent buying opportunities within this space. These CDOs offer us high yields that have little correlation to the equity and income trust holdings of the fund.
We continue to see opportunity in the trust space in terms of take-over potential as well as some growth opportunities. We continue to hold REITs and select business trusts where we believe valuations or business are attractive to strategic buyers. As for growth opportunities, we have begun buying natural gas weighted energy trusts again, covering our short positions in Q1, and beginning to go long these trusts (as well as some gas-weighted equities). Reduced capital programs by the E&P companies announced over the winter could put pressure on natural gas prices by the fall if weather patterns return to more seasonal levels.
The challenges in the near term remain the mixed economic signals. While employment and demand in the Canadian economy remains strong, weakness in the manufacturing sector and consumer fatigue in the United States - our largest trading partner - remains something to watch. Core inflation in Canada has also been accelerating since late 2006. Over the longer term, recent spending initiatives announced in the recent Canadian budget, could be simulative to an economy that does not need this stimulus at this time.