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‘Cream puffs’ offer tasty yield for this top Canadian bond fund

People walk during rush hour Bay Street in the financial district in Toronto, Wednesday June 28, 2017.

Mark Blinch/Globe and Mail

Geoff Castle's formula for beating his peers in the bond market starts with "cream puffs": his term for unrated corporate bonds whose yields are often too sweet for other investors.

Bets on companies like Just Energy Group Inc. and W&T Offshore Inc. led to a return of 23 per cent last year for the corporate bond fund Castle manages at Vancouver-based Penderfund Capital Management Ltd. That beat 98 per cent of its peers, according to data compiled by Bloomberg. This year, the fund has gained 5.4 per cent, outperforming three-quarters of its peers. Penderfund manages about $645-million ($530-million) in total, with about $160-million in credit.

The cream puffs of credit are often bonds without ratings that slip under the radar of exchange-traded funds, and a lot of active ones too. The common denominator is a high yield, along with a lot of assets that can be put to good use in case things turn sour.

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"We'll eat cream puffs all day along and the ETF holders will have to get by with stew and potatoes," Mr.Castle said in an interview. "It's a situation where there's enormous collateral and business value compared to the degree of debt the company has taken on, yet we find a yield much, much higher than comparably indebted, rated companies."

One example is Mississauga-based Just Energy, a Canadian retail energy provider with securities in the domestic market and U.S. dollar. Castle holds its 6.5-per-cent U.S. dollar convertible bonds due July 2019. In his view, the company's assets sufficiently underpin its bonds and the yield is higher than comparable-rated companies such as TransAlta Corp.

Another one is W&T Offshore, with the fund holding the company's 9-per-cent U.S. dollar bonds maturing in May 2020. In the fund manager's view, the yield they offer is attractive given the coverage the bonds get from the value of the company's assets and its cash.

Cash Reserves

The same goes for Aimia Inc., a Canadian loyalty program operator which has been in trouble since May when Air Canada said it would withdraw from a points agreement with the company in 2020. Mr. Castle holds Aimia's Canadian dollar bonds due in 2019, as he believes the company has shown it can raise cash, including the sale of Air Miles trademarks for as much as $67.5-million while offering a juicy yield after rating companies downgraded it in the wake of the Air Canada announcement.

The yield on the bonds have dropped to about 7.9 per cent from almost 20 per cent after S&P Global Ratings cut the company's credit grade to junk.

Two consecutive interest-rate increases from the Bank of Canada will create more "cracks in the system," which won't be good for credit and economic growth but will result in more pockets of opportunity for funds specializing in distressed debt, Mr.Castle said.

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"In our world, you're not necessarily dependent on what happens to the broader economy," he said. "You're typically dealing with a contract between a borrower and some lenders relating to some specific collateral for a certain period of time -- there's ways to make money even in the worst circumstances."

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