Income Fund
October 2008
Wall Street changed forever in the third quarter of 2008. A number of the Street’s venerable institutions wrote the last chapter in their storied histories. Lehman Brothers filed for bankruptcy protection, Merrill Lynch was sold to Bank of America, and AIG, Fannie Mae and Freddie Mac all had to be rescued by the U.S. government. Washington also proposed the biggest government bailout in history, a $700 billion plan intended to inject some life into the frozen lending markets.
With the U.S. financial system and capital markets in a fragile state, fixed income investors continued to turn to the safety of government bonds. The DEX Universe Bond Index fell 0.4% in the quarter, largely due to weakness in the corporate sector. Weak sentiment led to a further widening of spreads (the difference in yield between government and corporate bonds). Many high-rated financial bonds continue to trade at substantial yield premiums over their government counterparts. This has hurt the fund, which continues to have significant exposure to the corporate sector and financials in particular.
Income trusts also struggled in the quarter along with the equity markets. REITs fared better, but were still in negative territory. All said, it was the perfect storm for the Income Fund. Strategically, the design of the fund was out-of-favour (bias towards corporate bonds and inclusion of income- equities) and tactically most of Connor, Clark & Lunn’s (the manager) strategies were working against them. The fund lost 3.8% in the quarter, and is down 3.1% over the past year.
While the fund had its most challenging quarter to date, the manager remains upbeat about its prospects. With a heavy emphasis on credit (corporate bonds) and a strategic allocation to income-equities, little has gone right for the fund. Yet, CC&L has not wavered in their conviction that these strategies will pay off once the storm has passed. With the worst credit market in recent history and the carnage in the income trust market, the manager is finding value and continues to position the fund to prosper when we go up the other side of the valley.
While CC&L has been early on their call on corporate bonds (particularly those in the financial sector), there were some positives to take away in the quarter. With the bailout package now in place in the U.S., the government will have to issue a significant amount of Treasury bonds. This will likely put upward pressure on government yields, thereby increasing the relative attractiveness of corporate bonds. Further, corporate spreads remain near historic highs and reflect a great deal of pessimism. Any positive developments in the financial sector could therefore go a long way in restoring confidence in the corporate bond market.
At the end of September, roughly 48% of the fund was comprised of corporates, while government bonds made up 28% of the portfolio, for a total fixed income weighting of 76%. This allocation was largely unchanged from last quarter.
The fund’s weighting in income trusts was increased during the quarter, from roughly 15% to 18%, as a result of opportunistic buying and the addition of a new holding, Mullen Group Income Fund. Mullen is a leading provider of specialized transportation services in the western Canadian oil and natural gas industries. Conversely, the fund’s weighting in REITs was brought down slightly, reflecting a challenging real estate environment.
As mentioned, the income-equity portion of the portfolio had a tough quarter and detracted from performance. In particular, Aeroplan (-23%), Chartwell Seniors Housing REIT (-21%), and Liquor Stores Income Fund (-15%) struggled. There were some bright spots, however, with Teranet Income Fund (+28%) and Yellow Pages Income Fund (+16%) gaining ground.
The fund continues to generate an attractive stream of income. Its pre-fee yield at quarter-end was 7.2%, a sizeable advantage over the Government of Canada benchmark 10-year bond, which was yielding 3.7%. We quote this figure as pre-fee because the post-fee yield varies for investors thanks to our Fee Reduction Program (the greater your investments with Steadyhand, the lower your fee and the higher your yield). The fund paid its regular quarterly distribution of $0.10/unit at the end of September and is well positioned to continue to pay stable distributions.
The current environment in the bond market has many analysts dazed. Rarely have opportunities appeared as attractive as they do today in the corporate sector. Yet, profits have not materialized because spreads remain stubbornly wide and the problems in the credit and lending markets have endured longer than anticipated. However, the table is being set for some attractive returns. It’s just a matter of waiting patiently for the dinner bell to ring.