The Fixed Income Team at Cambridge Global Asset Management strives to build conviction in our ideas daily through research, humility and discipline. This is especially important in credit because it can humble you in the blink of an eye. However, a strong process can add significant value. In 2019, credit was an important source of alpha, or returns in excess of the market, for us. Cambridge Bond Fund returned 9.85% (excluding fees) exceeding the FTSE Canada Universe Bond Index by approximately 300 basis points (bps). The bonds of TerraFrom Power (TERP), a renewable energy producer, was one of the top contributors to our Fund’s performance, delivering a 24% return. We built conviction in the bonds of this company two years earlier.
TERP was created in mid-2014 by SunEdison, a U.S. renewable energy company. SunEdison was one of the biggest renewable energy developers in the U.S. and was looking for a way to speed up its development of renewable assets. To this end, it created TERP, which became known colloquially as a YieldCo. SunEdison developed renewable energy assets primarily in wind and solar, then “stabilized” cash flows by signing long-term contracts for the sale of the energy from these assets. SunEdison would transfer the “stabilized” assets to TERP in exchange for cash. Having a ready buyer for their assets meant SunEdison could raise cash and fund future development much faster than they could prior to the creation of TERP.
TERP was known as a YieldCo because the assets it bought from SunEdison supported a high and growing dividend yield, which was supposed to make it more attractive than SunEdison to investors desiring lower risk and stable dividend income. The treadmill of development, transfer and more development, in combination with rapid acquisitions, was fuelled, in part, by SunEdison’s leverage. It ultimately collapsed under high leverage and declared bankruptcy in April 2016. TERP was nearly brought down with it.
Companies emerging from distress can be an attractive source of alpha. TERP was such an example. As part of SunEdison’s reorganization, it agreed to sell a majority stake in TERP to Brookfield Renewable (BEP) and its institutional partners in March 2017. It was this transaction that laid the groundwork for us to build confidence in TERP’s bonds. BEP closed the transaction for a 51% stake in TERP in October 2017. The next month TERP issued 10-year bonds. We immediately built a stake in Cambridge Bond Fund at spreads ranging from 252 bps to 261 bps, just below the new issue spread of 269 bps.
Our belief in the bonds rested on the credibility of Brookfield and the debt reduction plan that was put forward. Brookfield’s presence alone stabilized funding costs for TERP, allowing it to roll over debt at more sustainable levels. More importantly, had TERP needed additional equity, Brookfield had the financial capacity to support it. Lastly, Brookfield had a good plan with manageable execution risk to reinvest in the portfolio to grow cash flows and cut expenses to improve margins. TERP was setting a path to become a top-quality high yield credit. The market had recognized progress towards this when we initially built our stake, but it was still a “show me” story. This offered attractive returns as Brookfield executed on their plan.
High Yield investing can have its bumps along the way and TERP was no exception. While TERP executed on its plan well, it did not escape the sell-off in high yield credit in 2018. We incrementally added in mid-2018 at a spread of about 299 bps, bringing our position in the Fund to approximately 2%. However, at the start of 2019, our TERP bonds were trading at a spread of around 395 bps. Today, they trade at a spread of 190 bps, well below where we initially bought the bonds. Over the two years from 2018 to 2019, the bonds returned 8.7% annually, more than doubling the 4.1% annual return on the FTSE Canada Universe Bond Index. It was our conviction in TERP that allowed us to hold the bonds through the underperformance in 2018 to ultimately produce attractive returns for our fund holders.
Source: Cambridge Global Asset Management
Credit is only one tool we use to generate alpha. Despite the underperformance of TERP in 2018, we still managed to use other tools to generate strong performance. Over the three years to the end of 2019, Cambridge Bond Fund returned 4.5% annually (excluding fees) compared to the FTSE Canada Universe Bond Index annual return of 3.6%.
To help us find more of these opportunities, we recently hired a credit analyst, Ryan Ball. He is an experienced professional who has worked in the industry for over 15 years. We are excited to have Ryan join our team. While our process remains the same, Ryan will help us respond quicker to alpha-generating opportunities, mitigate risk and broaden our universe of investable ideas. It is an exciting time for the Cambridge Fixed Income Team and we hope to carry our momentum through 2020.
|As at December 31, 2019 (%)||1 Year||3 Years||5 Years||10 Years||Since Common Inception||Inception Date|
|Cambridge Bond Fund Class I||9.85||4.52||-||-||3.03||03/27/15|
|Category: Canadian Fixed Income||5.97||2.76||2.45||3.41||1.84||N/A|
|FTSE Canada Bond Universe Index||6.87||3.57||3.18||4.41||2.46||N/A|
Source: Morningstar Direct (as at December 31, 2019)
Grant Connor, Associate Portfolio Manager
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Published February 18, 2020.