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Fixed-income comments – 4th quarter, 2013

December 31, 2013
  1. Investors will always look for higher returns

    Investors will always look for higher returns, sometimes to their detriment. This is amplified during periods of low interest rates like we’ve experienced since the financial crisis. Low rates have pushed many investors to take on substantial risk to earn a higher yield on their fixedincome investments. Our industry is quite good at finding places for you to earn that higher yield but generally fails to highlight the associated risks. This is often the case in bull markets as investors are much more focused on return than risk. We don’t believe these can be considered independently and our investment approach focuses on analyzing risk ahead of return.

    2013 once again proved that flavour-of-the-day investing simply doesn’t work. One just has to look at the returns earned in emerging market and municipal bonds (-11.5% and -7.2% respectively†) to see that the extra yield you were earning may not have been compensating for the risks. You can’t paint an entire asset class with the same brush but as a whole, investors in
    funds marketed as a cure for low rates didn’t experience the returns they were hoping for.

  2. Credit analysis is always important

    Credit analysis is always important but even more so when credit spreads are tight compared to historical averages and investors are unlikely to benefit materially from further tightening. Our primary job is to protect capital, avoiding securities whose yields aren’t compensating us for the inherent credit or interest-rate risks. The second part of our job is to identify investments that are unloved and trading at yields that are attractive base on our analysis.

    We have followed Alere Inc. for years and have a thorough understanding of its business, growth opportunities and balance sheet. We’ve owned the stock and the preferred shares for some time and increased our position in the preferred shares in 2013. We felt the selloff in the preferred shares wasn’t warranted by the fundamentals of the business and were rewarded as the security increased in value throughout the year. Our average cost is approximately $220, with purchases as low as $185. Today, shares are closer to $287. Understanding the credit of an issuer is crucial to having the conviction to purchase more in the face of a declining price.

  3. Investing works when you have an Edge

    We’ll be patient if we’re not finding attractive opportunities. The existence of volatility gives us confidence that the next opportunity is just around the corner. Interest rates will continue to be volatile and we continue to believe that we don’t have an edge in forecasting rates. We invest with a broad opinion when it comes to interest rates, but our Edge lies in fundamenta credit analysis. Volatility for individual issuers will always be present. Regardless of the interest rate environment, there’ll always be businesses stealing market share, expanding margins or using debt to finance highr eturn acquisitions or capital spending. It’s our job to find the businesses
    that the market deems risky and we deem creditworthy. Developing a proprietary insight is a core part of our investment process as we seek to find companies that are misunderstood by the market and can use their free cash to grow the business or reduce their debt.

    Our position in Tervita Corp.’s senior debt is an example of a company that has to pay a high coupon of 9% to attract bond investors but whose business is backed by attractive assets that are hard to replicate and provide strong coverage to bondholders. Our understanding of Tervita’s business and several of its competitors allows us to thoroughly understand the drivers of its business and the assets it’s building to provide a solution to customers. We can invest with conviction in an underfollowed private company’s bonds if our analysis gives us confidence in its ability to make interest payments and return our principal at maturity.

  4. Capitalism works

    Last year continued to prove that if prices don’t reflect the underlying value of a business, either buyers will emerge or companies will buy back their shares. North American corporate balance sheets are strong, the U.S. economy is improving and credit is readily available to companies interested in issuing debt to finance such activities as mergers and acquisitions and share buybacks. This activity will undoubtedly create volatility as investors struggle to understand the implications of transactions on both the acquired and the purchaser.

    This volatility will likely create opportunities. One of our equity holdings, IROC Energy Services Corp., was purchased by Western Energy Services at the beginning of 2013 in a transaction partially financed with debt. Our knowledge of IROC’s business model and high-quality asset base, as well as our understanding of the energy service sector, gave us confidence that Western Energy would be a stronger company after the transaction, making it an attractive fixed-income investment. We participated in a re-opening of their debt issue with a yield of 7.43%. The combined company now has one of the newest drilling and servicing fleets in Canada and can use free cash to reduce the debt of the business.

    These tenets will likely continue in 2014 and we’re confident we’ll continue to uncover attractive investments.

†Source: BofA US Emerging Markets external sovereign index. US Municipal Securities index.