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Fixed-income comments – 1st quarter, 2012

April 08, 2012

The difference in rates between government and corporate bonds narrowed during the first quarter of 2012 as investor sentiment improved and North American stock markets rallied. Our fixed-income positions benefited from this spread decline, and we’re encouraged by the underlying fundamentals of the companies whose bonds we own.

We’re being prudent and risk averse by maintaining a duration of well under three years (“duration” measures interest rate risk). This is significantly less than the DEX Universe Bond Index’s duration of 6.67 years. We’ve benefited from increased rates across the yield curve this year.

We continue to find attractive corporate bonds and remain 100% invested in them. Although it’s
becoming more difficult to identify attractive investments, we’re still finding opportunities and harvesting returns on positions that we’ve held for longer periods. The following example illustrates how we solidified returns on an investment made almost three years ago.

It was the heart of the recession – in May 2009 – and The Brick was in trouble. The furniture dealer had a lot of debt and was running short of the money it needed to keep its shelves stocked and bills paid. Suppliers were restricting payment terms on the company’s inventory, forcing it to recapitalize its balance sheet to stay alive. Due to its distressed credit profile and to entice buyers, The Brick’s restructuring involved issuing 12% senior secured debentures that included warrants.

We saw a business with a good reputation among consumers and solid cash generation abilities that would enable it to pay the interest payments on the debt, even in a prolonged negative economic environment. We were also encouraged by the fact that the company founder and its largest shareholder were putting their own money into the business as part of the recapitalization, and decided to invest alongside them by purchasing the debentures.

Then a new CEO was put in place and a turnaround began. The company focused its consumer offerings and enacted strict cost controls to increase margins. The strategy worked, resulting in a stronger credit profile that gives management cheaper funding options and a willingness to eliminate the high coupon debt. We’ve accepted management’s offer to tender our bonds early at a 14% premium over par.

This has been a very successful investment for our fixed-income component. Every $1,000 we initially lent the company has returned over $4,000 or 300% when accounting for coupon payments, the early tender premium and the value of the warrants we received from the initial offering. We continued to accumulate a larger position outside of the initial offering in debentures that didn’t include warrants.

At the time, the crowd was running for cover and willing to look only at defensive investments that traditionally survive periods of uncertainty. Identifying non-obvious survivors and performing such in depth analysis as a complex recapitalization has again served us well. We’ll continue to scour the investment universe for unique ideas that we think will benefit our unitholders over the long term.