Q&A with Pender Corporate Bond Fund manager Geoff Castle
“A ship in the harbour is safe, but that is not what ships are for.”
The quote hangs on Geoff Castle’s wall, a reminder to continuously seek opportunities amidst the sometimes perilous environment of the high-yield credit market.
Castle is portfolio manager for the Pender Corporate Bond Fund at PenderFund Capital Management, where his mandate is finding “enhanced yield opportunities” while maintaining a margin of safety. PenderFund is an independent, value-based Vancouver investment manager with funds spanning small-cap, Canadian and U.S. equities, and growth.
Recently, Castle’s search for value has taken him into the beaten-down energy and mining sectors, where end-of-world pricing sometimes creates opportunities on the bond side as well.
In 15 years as a professional investor, Castle has been both an equity and credit analyst, working in both mutual fund settings as well as with large private capital organizations. Returning to his home province in 2007, his resume includes investing stints with prominent Vancouver businessmen Jimmy Pattison and Ross Beaty.
Castle’s interest in the world of investment started early. As a 12-year-old growing up pre-Internet in Kelowna, he’d pore over the stock charts in the Kelowna Daily Courier after delivering the newspaper. Then he’d take the stock listings and hand-plot charts for companies like Chrysler and CHUM. Formal education, including a Western MBA, added rigor to this nascent interest.
These days, Castle’s specialty is finding value in neglected areas of the bond world, particularly short duration (1-2 year) corporate bonds. His travels have taken him through a few stormy seas -- and provided valuable insights into making money in the midst of animal spirits that drive equity gyrations and also affect bond pricing.
“A lot of people owning equities of distressed companies think they’re being safe by buying at a low share price,” Castle points out. “But if the company has debt trading at 50 or 30 cents on the dollar, you’re actually being more aggressive than you really understand.”
One successful trade earlier this year involved buying short-dated Chesapeake Energy (CHK-NYSE) bonds while the oil price was diving -- and it got a little more exciting than he’d anticipated. Chesapeake had a $500-million maturity due in 70 days. Possessing over $1 billion in cash and a $4-billion undrawn line of credit, Castle determined that bankruptcy risk was minimal. He took an initial position targeting an internal rate of return of 15%.
“It looked at the time impossible that the company would file for bankruptcy, and that they would pay out the March 15 maturity,” Castle said. “They had been in the open market buying back bonds, that’s not something you do if you’re thinking about filing for bankruptcy.”
Nevertheless, at the height of a credit freeze in mid-February, a bankruptcy rumour hit the markets. Chesapeake stock was cut in half and its bond prices were also hit hard. Given his detailed evaluation of the company’s asset base, Castle determined that a second series of Chesapeake debt which had sold off to less than 15c on the dollar, was worth at least 40c. Shifting some weight to this bond, Castle gained over 80% on the junior security as bankruptcy concerns subsided.
That trade, combined with the successful recovery of Castle’s initial investment helped power the Pender Corporate Bond Fund portfolio to a gain of 3.1% for the month of March (Manager's Commentary).
“The Chesapeake trade was a little more nervy than our typical investment. Where I’ve kind of honed my trade, to a large degree, is in situations where we see an overwhelmingly high probability of a modest gain, not a slight chance of a large gain,” Castle said. “I think there’s a market for that.”
As for Chesapeake, the struggling oil and gas giant is still making headlines. This week the company pledged its assets against the line of credit in a deal with the banks that prompted a jump in the stock. Also since the interview, controversial ex-CEO Aubrey McClendon drove his truck into a wall in an apparent suicide after being indicted on bid-rigging charges.
Money flows are agnostic and so is Castle’s investment philosophy when it comes to the search for value. Screening the Bloomberg bond universe for companies with negative net debt is one of his favourite sources of ideas, and that’s how Twitter (TWTR-NYSE) bonds became one of the fund’s holdings (Castle tweets at Twitter.com/Geoff_Castle). Other recent investments have included convertible notes of Energy Fuels (EFR-T), as well as bonds of Volkswagen (VOW) and Teck Resources (TCK-T).
For a time, Castle also had an investment blog that touched on various themes including junior mining. Here's an excerpt from a November 2010 post: "In the last ten years mining stocks have recovered and the safe money has been made. However, my read of this cycle is that a speculative blow-off phase lies ahead. The gold market didn’t spend 20 years bumping along around $350 per ounce to stop at a mere quadrupling, in my view."
Away from the markets, the father of three boys coaches minor hockey and is involved with the CFA Society of Vancouver and the Association of Vancouver Investors, where he is a cofounder.
Our interview at his PenderFund office touched on investment opportunities, a deflation spiral that looks a lot like inflation, what Castle learned from working with Ross Beaty and Jimmy Pattison, and why he’s a Twitter fan who saw value in their bonds. Here’s an edited transcript.
On opportunities in the resource sector:
“At times like these you see the larger, long-term investors in the resource sector doing very interesting deals. The Giustras and the Beatys of the world draw a deal flow that not everyone has access to. And guys like that certainly have a lot to do right now. If we close our eyes and come back in five years, I think that buying the deeply distressed securities in the resource sector in 2016 will be viewed in hindsight as a fantastic opportunity.
Will it get worse before it gets better? Quite possibly. Does your typical, older investor who’s just hoping to do bit better than the bank savings account really need to be in there? No.
But for the investor with a different risk appetite, I think the resource sector -- if it’s ever offered an opportunity, now is the time -- but you have to be prepared to sit through some large volatility. In that context, there are some safer trades around the edges where you can take quite a decent return.
On lessons learned from working with Ross Beaty and Jimmy Pattison:
“That Ross became as successful as he did is no accident. He’s a very smart guy and he’s done a lot of really, really good deals. His particular insight is being a guy who understands geology really well and understands the economics of mining. Those two together have served him enormously well.”
“Part of it is you’re more skilful than the typical person. Part of it is you get to a certain size and the deal flow that gets shown to you is better than the deal flow that gets shown to a smaller player. Ross was definitely cool in the midst of a crisis, that’s for sure. You can’t lose your head, right?
Jimmy is a testament to the value of sticking with something for a long time. So much of what Jimmy Pattison is about is buying things at good prices and holding them forever, and the businesses just grow. That’s a really good lesson for every investor to learn.
“Someone like Ross shows you that if you have specialized knowledge and you stay within your area of competence, even if the overall industry has difficulties, you yourself can do a lot better than average -- and do really well when the industry does well.”
On how the current “deflation spiral” looks a lot like inflation:
“At a time when house prices in Japan, Sweden, Vancouver are going parabolic, that doesn’t seem to me like a time of terribly low inflation. Why would I expect that there would be low inflation in the future given this money printing, really by the banks. The banks take in a dollar of deposit, they lend out 10 dollars of loans, and they create that from nothing. And that is how money gets flushed in the system. You can’t see inflation because it’s not like everyone’s getting paid more. But the money that is supporting these housing price explosions, these parabolic moves, is basically printed money. It’s just not being printed by the government, it’s being created by banks. But when the banks get in trouble then governments need to print those mistakes away. I think there’s a false read of a deflation spiral here. I think that the most likely outcome in the long run is that prices for everything will be a lot, lot higher.
On uranium and the fund’s investment in Energy Fuels convertible debentures:
I think the uranium cycle is probably a couple of years ahead of the oil and gas and other commodities because of what happened in Japan. … From that point, an awful lot of capacity is rationalized and you have a situation where Energy Fuels has more net working capital than the amount of its convertible debentures outstanding (they pay 8½% and mature in June 2017). Energy Fuels has strong cash flow and they’ve been buying other companies to take over long-term contracts that are priced higher than the spot price … Within a highly volatile industry that’s in a generational kind of distress, you do have a relatively safe security. If uranium works out, there are a hell of a lot better ways to capture upside. But in terms of probability of making a good result as opposed to hopes of making a great result, I would say the Energy Fuels converts would be amongst the highest-probability cases -- on a risk-weighted basis, an attractive investment.
On base hits (and the occasional double) vs. swinging for the fences:
“We’re not in the business of swinging for the fences. Those deeply discounted bonds, it looks like it’s swinging for the fences, at 13 cents. But if your analysis tells you that the value is relatively firm at a much higher level, and you’ve considered all the different options for the company in dealing with its different levels of security, and your holding window might not be forever, the odds are in your favour on that kind of trade. But it’s not necessarily one that anyone could do, or should do. You have to think through it carefully. … There are plenty of people out there swinging for the fences in investments that have zero value in the fairly likely event that commodity prices stay low for longer that you would expect. There are relatively few people investing in the resource sector who are really working for what I think is the classic investor, which is the retired person who used to put money in the bank, or in GICs, Canada Savings Bonds and T-bills, but can’t earn a return on savings any more. When you are working for that person your first job is to preserve capital. And one of the ways you can preserve capital is to ensure that your investments are made with deep margins of safety.
On why the fund invested in short-term Volkswagen bonds after the emissions scandal:
We bought VW bonds after the emissions scandal became public because it seemed like a high-probability payout. Volkswagen had 50 billion euros of market cap and 20 billion in liquidity.. We bought some February 2016 maturities that have now paid out. ... No one’s going to parade up and down Georgia Street because they earned 3% over 6 months, but relative to what’s available for short-term money, and given the very low risk of VW being in liquidation in 2016 based on that event, we thought it was a pretty good risk-reward.
On why Twitter is a “fantastic idea” and its 2019 bonds a “sleep-at-night” investment:
“I think Twitter is a fantastic idea whose time has come. It’s like a real-time newswire that everybody can talk back to, something that if it didn’t exist already someone would have to invent.
They have a wonderful brand equity -- what would it cost you to put your logo on every website that’s consumer-facing in the world? Well Twitter has that, for free. They have amazing reach. The company’s revenues are actually growing faster than almost any other company with more than $2 billion in revenue. Sure there are some issues … What Twitter is, even if it didn’t grow, is a profitable, wide-reaching real-time media player that actually provides customers something valuable, for basically free. They obviously have advertisers and they can monetize that.
It’s a real business, it makes money.
Your likelihood of not being able to pay the maturity on those 2019 notes is remote. You’ve got $15-$18-billion of equity market value underneath you, you’ve got the cash coverage of your bonds. The bonds are trading in the .86, .87 range, with a yield to maturity of about 4%.
Twitter is a widely known acquisition candidate. If Facebook does acquire Twitter, they’re going to have to pay out the discounted, almost zero-yield bonds at par. The base case is you made a 4% yield to maturity over 3 years, which is far far better than is available in investment-grade bond or government bond. Your likelihood of bankruptcy is very low. … Twitter is a double-B rated issuer, more because of the novelty of the company than credit fundamentals. There are plenty of triple-B rated companies with much higher risk, such as Xerox, which has a 50% higher default risk. You know, Xerox, not exactly a business for the future.
“If the company gets taken out, you get a 14% payout all at once. Is it a very high-risk bond? No, it’s a sleep-at-night bond that hasn’t moved by more than a couple points one way or the other from the time we bought it.”
On the importance of due diligence rather than reliance on investment ratings:
“Sometimes people rely on rating agencies when they should not. Investment grade securities can bear much more risk than you might believe. On Sept. 14, 2008, Lehman Brothers was A-rated. On Sept. 15, it was bankrupt, and a number of years later some people recovered cents on the dollar.” … The whole structure of how the rating agency works -- a rating agency gets paid to rate your bond, and there’s a competition between rating agencies to rate the bond, and one of the issues that could possibly come up in the consideration of the company that hires the rating agency is what the rating’s going to be. That might be the difference. If you’re a teacher in a school and you’re competing for a student whose parents are going to pay you based on whether you give them an A or a B, you just might give them an A (laughs). ... I think some private schools have discovered that. I don’t think the ratings agencies work much differently.