Deans Knight Income Corporation

TSX : DNC


Deans Knight Income Corporation

March 10, 2014 09:00 ET

Deans Knight Income Corporation Releases Annual Management Report of Fund Performance and Financial Statements for the Year Ended December 31, 2013

VANCOUVER, BRITISH COLUMBIA--(Marketwired - March 10, 2014) - Deans Knight Income Corporation (the "Company") (TSX:DNC) is pleased to release its annual Management Report of Fund Performance and Financial Statements for the year ended December 31, 2013.

These documents can be found on SEDAR at www.sedar.com or the Company's website: www.dkincomecorp.com.

Annual Report of Fund Performance

This annual management report of fund performance (the "Report") contains financial highlights of Deans Knight Income Corporation (the "Company"). This Report should be read in conjunction with the annual financial statements of the Company for the year ended December 31, 2013 (the "Financial Statements"), which, if not included with this Report, can be obtained at your request, at no cost by emailing info@dkincomecorp.com, visiting our website at www.dkincomecorp.com for contact details or on SEDAR at www.sedar.com. Readers may also contact us to request a free copy of the Company's proxy voting policies and procedures, proxy voting disclosure record or quarterly portfolio disclosure.

A NOTE ON FORWARD-LOOKING STATEMENTS

This Report contains certain forward-looking statements. In particular, this Report contains forward-looking statements in respect of the Company's investment strategy, behaviour of financial markets and reflects the Company's expectations regarding the growth, results of operations, performance and business prospects and opportunities of the Company and its investments, the Company's plans in respect of the meeting of shareholders to be held on April 4, 2014, payment of a special cash distribution in April 2014 and amendments to the Company's Articles of Incorporation and the Company's plans in the event that shareholders do not approve certain matters set forth for approval by the shareholders. In some cases, forward-looking statements can be identified by terminology such as "may", "will", "should", "expect", "plan", "anticipate", "believe", "estimate", "predict", "potential", "continue" or the negative of these terms or other comparable terminology. Such forward-looking statements reflect the Company's current beliefs and are based on information currently available to the Company. With respect to such forward-looking statements, the Company has made assumptions regarding, among other things, what type of debt securities will be included in its investment portfolio, currency, exchange and interest rates. A number of factors could cause actual events or results to differ materially from the results discussed in the forward-looking statements. In evaluating these statements, prospective investors should specifically consider various factors, including global equity and capital markets, business competition, technological change, changes in government regulations, unexpected judicial or regulatory proceedings, and catastrophic events and the risks outlined under "Risk Factors" in the AIF (as defined herein), which may cause actual results to differ materially from any forward-looking statement. Although the forward-looking statements contained in this Report are based upon what the Company believes to be reasonable assumptions, the Company cannot assure investors that actual results will be consistent with these forward-looking statements. Forward-looking statements are made as of the date of this Report and, other than as required by applicable law, the Company assumes no obligation to update or revise them to reflect new events or circumstances.

This Report also contains certain financial and operational information obtained from public sources in respect of certain companies included in the Company's investment portfolio. While management believes this data to be reliable, such information is subject to variations and may not be able to be verified due to limits on the availability and reliability of data inputs, the nature of the data gathering process and other limitations and uncertainties inherent in such information. Accordingly, the accuracy, currency and completeness of this information cannot be guaranteed. The Company has not independently verified any of the data from third party sources referred to in this Report or ascertained the underlying assumptions relied upon by such sources.

Investment Objectives and Strategies

The Company is a closed-end, non-redeemable investment company focused on investing in corporate debt securities. The Company's assets are actively managed by Deans Knight Capital Management Ltd. ("Deans Knight"), a respected British Columbia-based investment firm focused on managing high income and growth mandates for high net worth individuals. Deans Knight, formed in 1992, has an experienced management team and a long history of successful investing in corporate debt securities.

The Company's current investment objectives are to: (i) maximize the total return for shareholders, consisting of dividend income and capital appreciation; and (ii) provide shareholders with monthly dividends, which up to December 31, 2013 had been set at $0.0583 per common share per month. Historically, the Company has looked to achieve these objectives by investing primarily in corporate debt securities rated BBB or below by Standard & Poor's Rating Services ("S&P") or an equivalent rating by another nationally recognized statistical rating organization. The Company also invested in investment grade debt securities rated above BBB and non-rated debt securities from time to time.

The Company's Articles of Incorporation currently require the common shares of the Company are to be redeemed on April 30, 2014. Because of this fixed redemption date, the Company ceased paying a monthly dividend starting in January 2014 and began to liquidate its portfolio. Further, it has called a meeting of shareholders to be held on April 4, 2014 to consider various resolutions. See "Risk" and "Results of Operations" below.

Risk

The overall risks of the Company are as described in its annual information form of the Company dated March 6, 2014 (the "AIF").

Prior to the reorganization and change in business as discussed in note 1 of the Financial Statements, the Company had generated significant tax losses and other tax attributes as a result of its prior businesses and research activities. The Company has recorded, as a tax asset, the full amount of the potential tax benefit of such items to the extent of its projected taxable income up to April 30, 2014, being the date common shares are to be redeemed based on the Company's Article of Incorporation ("Articles").

On January 21, 2014, the Company received a proposal letter ("Proposal Letter") from the Canada Revenue Agency ("CRA"). In it, the CRA stated that it intends to reassess the Company and deny the deduction of certain non-capital losses and other tax attributes in the Company's taxation years ending in 2009 to and including 2012, which are currently the subject of an audit by the CRA ("CRA Audit"). The CRA has indicated in the Proposal Letter that it intends to deny the use of certain tax attributes by the Company on the basis that an acquisition of control of the Company occurred and on the basis of the General Anti-Avoidance Rule in the Income Tax Act (Canada). The Company, in consultation with its legal advisors, remains of the view that its tax filing position is appropriate, and does not believe any additional assessment of income tax by the CRA is appropriate. There continues to be tax litigation in progress involving the CRA and other companies which may have a bearing on the Company's own tax position with the CRA. The Company will continue to assess its position as such litigation progresses.

The Company has not yet received a notice of reassessment ("Reassessment"), which, if issued by the CRA, will provide the CRA's view of the proposed additional tax, interest and penalties owed by the Company. Based on the information in the Proposal Letter and discussions with the CRA, the Company estimates the potential tax liability to be approximately $21.7 million, or $2.06 per common share. This estimate is based on an aggregate reassessment for the 2009 through 2012 taxation years totaling approximately $22.7 million ("Disputed Amount") which is expected to be reduced by the anticipated tax refund for the Company's 2013 taxation year of approximately $1.0 million. The tax refund is based on the Company's results of operations for the 2013 taxation year. Subsequent to December 31, 2013, the Company prepaid the Disputed Amount to the CRA to minimize any further interest from accruing.

As per the Company's current Articles of Incorporation, the common shares of the Company are to be redeemed on, or around, April 30, 2014. As a result, the Company has begun to liquidate its investment portfolio. Given the liquidation of investments, distribution and the Disputed Amount discussed above, an investment in the Company may be considered to be speculative. An investment in the Company is generally suitable for investors looking for capital appreciation.

Results of Operations

The net assets of the Company at December 31, 2013 were $130,147,580 or $12.35 per common share (December 31, 2012 - $142,275,000 or $13.50 per common share). The net assets of the Company consisted of the following components:

December 31, 2013

$
Per common share(1)
%
Investments(2)65,439,969 6.21 50.3
Cash and short-term deposits64,573,401 6.13 49.6
Accrued income786,745 0.07 0.6
Prepaid expenses41,370 0.00 0.0
Future income tax asset(3)180,000 0.02 0.2
Accounts payable and accrued liabilities(873,905) (0.08) (0.7)
130,147,580 12.35 100.0
(1)Based on 10,537,263 common shares, including 10,191,592 voting common shares and 345,671 non-voting common shares, as outlined in the notes to the Financial Statements.
(2) The details of the investments are outlined in the Summary of Investment Portfolio below.
(3)Refer to the Taxation note to the Financial Statements for more detail.
December 31, 2012

$
Per common share(1)
%
Investments118,788,753 11.27 83.5
Cash and short-term deposits20,091,125 1.91 14.1
Accrued income1,662,373 0.16 1.2
Prepaid expenses56,460 0.00 0.0
Future income tax asset(2)2,390,000 0.23 1.7
Accounts payable and accrued liabilities(713,711) (0.07) (0.5)
142,275,000 13.50 100.0
(1)Based on 10,537,263 common shares, including 10,191,592 voting common shares and 345,671 non-voting common shares, as outlined in the notes to the Financial Statements.
(2)Refer to the Taxation note to the Financial Statements for more detail.

The Company began operating as an Investment Company in March 2009 to take advantage of attractive pricing in the high yield bond market with the objectives of: (i) maximizing the total return for Shareholders, consisting of dividend income and capital appreciation; and (ii) providing Shareholders with monthly dividends targeted to payout a minimum of 75% of net earnings annually. During 2013, the Company made monthly dividend payments totaling $7,371,869, or $0.70 per common share (2012 - $7,371,869, or $0.70 per common share). This represented approximately 104.4% of net investment income (2012 - 83.9%).

Since commencement of its investment business, the Company has made monthly dividend payments totaling $33,787,733, or $3.21 per common share. This represents approximately 92.4 % of net investment income earned since March 17, 2009. In December 2013, the Company announced it would cease paying its regular monthly dividend payment starting in January 2014, as part of the Company's plans to pay a cash distribution to shareholders.

The net assets of the Company decreased during the year ended December 31, 2013 to $12.35 from $13.50 at December 31, 2012. The decrease is predominantly attributed to events that lowered prices of two of our holdings during the year: Northland Resource AB and Mirabela Nickel Ltd., along with the $0.21 per common share decrease in the future income tax asset.

Northland is a producer of a high grade iron ore concentrate from their Kaunisvaara project in Northern Sweden. In January 2013, Northland announced a funding shortfall at its Kaunisvaara mine and the immediate need to raise approximately $400 million in additional capital. The unanticipated cost overruns destroyed confidence in management and fundraising efforts failed, as a result, Northland began the process of restructuring. The Company sold the position in April 2013, realizing $30 per $100 par value on the investment.

Mirabela produces nickel from a sulphide deposit in Brazil, with the capability to produce 20,000 tonnes of nickel per annum. Mirabela also has a first-class processing plant. It had cash of $108 million USD on the balance sheet at June 30th; however, with low nickel prices, was producing negative cash flow after administrative and debt servicing costs. In late September, Mirabela provided a disappointing operational update outlining higher cash costs in July and August resulting in a reduction of cash on hand to $80 million USD. In addition, Mirabela received notification from one of its two customers, Votorantim Metals, of its intention to terminate their offtake agreement at the end of November. Subsequent to December 31, 2013, Mirabela established a framework for a proposed recapitalization of the Company, whereby Mirabela will raise $115 million USD from existing bondholders. The investment was priced at $10 per $100 par value at December 31, 2013.

At December 31, 2013, the Company had a large cash and cash equivalents balance. The increase in the cash balance is the result of certain bond positions held in its investment portfolio being called by the issuers and the Company selling investments in anticipation of the pending distribution in April 2014. Since December 31, 2013, the Company has continued to liquidate the portfolio, and at February 28, 2014 the cash and cash equivalents totaled $88.7 million, not including the $22.7 million prepaid tax asset.

Net investment income for the year ended December 31, 2013 was $7,062,268 compared to $8,790,157 for the year ended December 31, 2012. The rising cash position and related smaller investment portfolio throughout fiscal 2013 are the primary drivers to the decrease in the Company's net investment income.

Recent Developments

Cash Distribution and Extension of Termination Date

On January 27, 2014, the Company called a special meeting of shareholders to be held on April 4, 2014. At the meeting, the Company intends to seek the approval of shareholders to reduce the stated capital of the voting common shares thereby permitting the Company to make a special cash distribution ("Cash Distribution") to shareholders of the Company as a return of capital (the "Capital Reduction Resolution"). Additionally, the Company intends to seek the approval of shareholders to (i) extend the term of the Company from April 30, 2014 until such time as is reasonably practicable following the conclusion of the CRA Audit or any appeal made to the Tax Court of Canada, or such other date as the Corporation deems appropriate on not less than 30 days' notice to shareholders; and (ii) remove the remove the restrictions on the business that the Corporation may carry on, which currently restrict the Corporation to carrying on investment activities in accordance with its investment objectives (collectively, the "Article Amendment Resolution"). The Company anticipates mailing an information circular in respect of the special meeting of shareholders in mid-March 2014.

In the event that shareholders approve the foregoing matters, it is the intention of the Company to pay the Cash Distribution and take actions necessary to continue as a going concern. If shareholders do not approve the Capital Reduction Resolution, the Company may: (i) pay the Cash Distribution as a dividend, which may be less tax efficient for certain shareholders or the Company; (ii) book the Disputed Amount as a liability of the Company and wind-up the Corporation in accordance with the terms of the current Articles; or (iii) delay payment of the Cash Distribution to the amended termination date of the Company provided the Article Amendment Resolution is approved or the termination date of the Company is otherwise extended.

If shareholders do not approve the Article Amendment Resolution, the Company may extend the termination date of the Company by 180 days pursuant to its discretionary power to do so under the Articles without shareholder approval or apply to a Court of competent jurisdiction for an order to extend the termination date of the Company.

Comparison of net asset value and net assets

National Instrument 81-106 ("NI 81-106") permits investment companies to have two different net asset values: (i) one for financial statements, which will be prepared in accordance with Canadian Generally Accepted Accounting Principles ("GAAP") including Section 3855 (and referred to as "net assets") and (ii) another for all other purposes, including unit pricing for investor transactions (referred to as "net asset value"). The main difference in calculating net assets and net asset value is that GAAP requires bid price to be used in valuing securities traded in an active market where quoted prices are readily and regularly available, rather than the use of a price between the bid and the ask price currently used for determining net asset value. This difference results in an insignificant difference of approximately $0.02 per common share at December 31, 2013 (December 31, 2012 - $0.08 per common share), as outlined in the notes to the Financial Statements.

International Financial Reporting Standards

Investment companies will be required to adopt international financial reporting standards ("IFRS"). The Canadian Accounting Standards Board (AcSB) previously announced January 1, 2011 as the date international financial reporting standards (IFRS) would replace current Canadian standards and interpretations as GAAP for publicly accountable enterprises, which include investment companies.

In December 2011, the AcSB issued a decision to defer adoption of IFRS for investment companies currently applying Accounting Guideline 18 - Investment Companies until years beginning on or after January 1, 2014.

Under the above noted decision, the Company's first set of financial statements to be reported on under IFRS would be for the semi-annual period ending June 30, 2014. These statements would include corresponding comparative financial information for 2013, including an opening statement of net assets as at January 1, 2013. However, the Company currently has a termination date of April 30, 2014, and as such will not be required to issue statements reported on under IFRS. If shareholders approve an extension to the April 30, 2014 termination date at the special meeting of shareholders to be held on April 4, 2014, the Company will adopt IFRS commencing January 1, 2014. The Company does not expect the adoption to result in significant measurement differences to current reporting under GAAP, though it will continue to assess the potential impact when the extension is approved.

Related Party Transactions

The officers, and certain directors, of the Company are also employees of Deans Knight, the Company's investment advisor. These officers, and directors, are not paid by the Company. Deans Knight provides investment management services to the Company, as well as administration, financial reporting and other ancillary services required by a publicly listed company. Management fees, for the services outlined above, are computed and paid quarterly, at an annual rate of 1.5% of the net asset value plus applicable taxes, and adjusted for certain non-investment related assets.

For the year ended December 31, 2013, management fees (including applicable taxes) totaled $2,122,002 (2012 - $2,311,289). At December 31, 2013, $512,138 (2012 - $589,251) was owed to the Investment Advisor, which was included in accounts payable and accrued liabilities in the statement of net assets, and is payable immediately.

A former director of the Company is a partner at a law firm that provides legal services to the Company. During the year ended December 31, 2013, the Company incurred $299,969 (2012 - $14,014) in legal services and disbursements provided by from this law firm. At December 31, 2013, accounts payable and accrued liabilities include $133,884 (2012 - $226) due to the law firm for legal fees and disbursements.

Financial Highlights

The following tables show selected key financial information about the Company and are intended to help you understand the Company's financial performance since it began operating its new business of investing in corporate debt in March 2009.

The Company's Net Assets per Common Share (1)

2013
$

2012
$

2011
$

2010
$
Period March 17 to December 31, 2009
$
Net assets, beginning of year (2)13.50 13.43 13.60 12.21 9.12
Increase from operations
Total revenue0.96 1.10 1.10 0.94 0.62
Total expenses(0.29)(0.26)(0.26)(0.24)(0.20)
Realized (losses) gains(0.50)0.44 0.36 1.82 1.25
Unrealized (losses) gains(0.41)(0.27)(0.52)(0.27)1.21
Future income taxes(0.21)(0.24)(0.15)(0.16)0.62
Total (decrease) increase from operations (2)(0.45)0.77 0.53 2.09 3.50
Dividends (2)(3)(0.70)(0.70)(0.70)(0.70)(0.41)
Net assets, end of year (4)12.35 13.50 13.43 13.60 12.21
(1)The information is derived from the Company's audited annual financial statements. Common shares outstanding are 10,537,263, including 10,191,592 voting common shares and 345,671 non-voting common shares.
(2)Net assets, beginning of the period for 2009 reflect the net assets in the Company at March 17, 2009, after giving effect to the conversion of the convertible debenture and interest owing thereon and the issuance of common shares on the Company's initial public offering less total share issue expenses.
(3)Net assets and dividends are based on the actual number of shares outstanding at the relevant time. The increase/decrease from operations is based on the weighted average number of shares outstanding over the period.
(4) Dividends were paid in cash.
(5)The net assets per share presented in the financial statements differs from the net asset value per share calculated for pricing purposes due to the provisions of CICA Handbook Section 3855. An explanation of the differences can be found in the notes to the financial statements.
Ratios and Supplemental Data (1)


2013


2012


2011


2010
Period March 17 to December 31, 2009
Net asset value (000's)$130,367 $143,065 $142,178 $143,880 $128,930
Number of common shares outstanding (000's) 10,537 10,537 10,537 10,537 10,537
Management expense ratio (2) 2.21% 1.96% 1.90% 1.91% 5.51%
Portfolio turnover rate (3) 25.23% 14.79% 79.90% 86.60% 36.69%
Trading expense ratio (4) 0.03% 0.01% 0.00% 0.01% 0.01%
Net asset value per common share$12.37 $13.58 $13.49 $13.65 $12.23
Closing market price - common share$10.01 $12.69 $11.84 $12.54 $11.40
(1)This information is provided as at December 31 of the years shown.
(2)Management expense ratio is based on total expenses for the period and is expressed as a percentage of weekly average net asset values over the year.
(3)The Company's portfolio turnover rate indicates how actively the Company manages its portfolio investments. A portfolio turnover rate of 100% is equivalent to the Company buying and selling all of the securities in its portfolio once in the course of the year. The higher a portfolio turnover-rate in a year, the greater the trading costs payable by the Company in the year. There is not necessarily a relationship between a high turnover rate and the performance of the investment portfolio.
(4)The trading expense ratio represents total commissions and other portfolio transaction costs expressed as an annualized percentage of daily average net asset value during the period. This expense is $47,875 for 2013 (2012- $11,318), as the purchasing and selling of bonds do not generally attract a commission from the buying or selling party.

Management Fees

Deans Knight provides investment management services to the Company, as well as administration, financial reporting and other ancillary services required by a publicly listed company. Management fees are computed and paid quarterly, at an annual rate of 1.5% of the net asset value plus applicable taxes, and adjusted for certain non-investment related assets.

Past Performance

This section shows the Company's past performance, since it began operating its business as an investment fund. The past performance information includes changes in net asset value and assumes the reinvestment of all dividends paid to common shareholders. It is important to note that the past performance will not necessarily indicate what performance in the future will be.

Year-by-year Returns

The accompanying bar chart (To view the bar chart, please visit the link at the end of this press release) shows the Company's performance for the years shown and illustrates how the Company's performance has changed from year to year. The bar chart shows, in percentage terms, how much an investment made from when the Company began its operation as an investment fund on March 17, 2009 to December 31, 2009, and how much an investment made for the years ending December 31, 2010, 2011, 2012 and 2013.

To view the chart accompanying this press release, please visit the following link: http://media3.marketwire.com/docs/932255Chart.pdf

Annual Compound Returns

The table below summarizes the Company's annual compound total returns for the periods ended December 31 as indicated. As a basis for comparison, we have provided the performance of the Merrill Lynch Canada High Yield Bond Index ("Index"). The Index is a broad based index that tracks the performance of the Canadian high-yield bond market. As the criteria for determining the constituents of the Company's investment portfolio and the Index differ, it is not expected that the Company's performance will mirror that of the Index. Further, the return of the Index is calculated without the deduction of management fees and fund expenses whereas the performance of the Company is calculated after deducting fees and expenses.

Annual Compound ReturnsCompanyIndex
1 Year-3.64%4.74%
2 Years1.53%9.79%
3 Years2.65%7.23%
Since Inception10.54%17.97%

Summary of Investment Portfolio

The following is a summary of the Company's investment portfolio as at June 30, 2013 (To view the summary, please visit the link at the end of this press release). This is a summary only and will change due to ongoing portfolio transactions of the Company. A quarterly update is available at www.dkincomecorp.com.

To view the table accompanying this press release, please visit the following link: http://media3.marketwire.com/docs/932255TABLE.pdf

Financial Statements

2013
$
2012
$
Assets
Investments - at fair value (cost - $68,222,974; December 31, 2012 - $117,207,284)65,439,969 118,788,753
Cash and cash equivalents64,573,401 20,091,125
Accrued interest receivable786,745 1,662,373
Prepaid expenses41,370 56,460
Future income tax benefits (note 7)180,000 2,390,000
131,021,485 142,988,711
Liabilities
Accounts payable and accrued liabilities (note 5)873,905 713,711
Net assets130,147,580 142,275,000
Shareholders' Equity
Common shares (note 3)99,366,429 99,366,429
Contributed surplus (note 3)9,904,504 9,904,504
Retained earnings (note 4)20,876,647 33,004,067
130,147,580 142,275,000
Number of common shares outstanding (note 3)10,537,263 10,537,263
Net assets per common share (notes 7 and 10)12.35 13.50
Contingencies (notes 1 and 7)
Commitments (note 1)
Subsequent events (notes 1, 7 and 9)
Going concern (note 1)
Investment income
Interest and other10,066,296 11,547,744
Expenses
Management fees (note 5)2,122,002 2,311,289
Legal fees (note 5)390,090 14,014
Public company reporting costs156,126 127,384
Director's fees and expenses136,510 148,727
Audit, accounting and tax fees91,087 82,024
Transaction costs47,875 11,318
Custodial fees43,688 50,651
Independent Review Committee fees16,650 12,180
3,004,028 2,757,587
Net investment income7,062,268 8,790,157
Realized and unrealized gains (losses) on investments
Net realized (loss) gain on investments sold (note 6)(2,572,824) 2,548,818
Net realized (loss) gain on settlement of foreign currency contracts (note 6)(2,670,520) 2,159,065
Change in unrealized depreciation on investments(4,300,675) (2,564,496)
Unrealized depreciation on foreign currency contracts(63,800) (296,595)
Net (loss) gain on investments(9,607,819) 1,846,792
(Decrease) increase in net assets from operations before tax(2,545,551) 10,636,949
Provision for future income tax (note 7)(2,210,000) (2,530,000)
(Decrease) increase in net assets from operations(4,755,551) 8,106,949
(Decrease) increase in net assets from operations per weighted average common share (note 2)
(0.45

)

0.77
(Decrease) increase in net assets from operations(4,755,551) 8,106,949
Dividends paid to common shareholders (notes 4 and 9)(7,371,869) (7,371,869)
(Decrease) increase in net assets during the year(12,127,420) 735,080
Net assets - Beginning of year142,275,000 141,539,920
Net assets - End of year130,147,580 142,275,000
Cash flows from operating activities
(Decrease) increase in net assets from operations(4,755,551) 8,106,949
Items not affecting cash
Net realized loss (gain) on investments sold2,572,824 (2,548,818)
Net realized loss (gain) on settlement of foreign currency contracts2,670,520 (2,159,065)
Change in unrealized depreciation on investments4,300,675 2,564,496
Unrealized depreciation on foreign currency contracts63,800 296,595
Provision for future income tax2,210,000 2,530,000
7,062,268 8,790,157
Cost of investments purchased (note 6)(26,749,307) (18,898,699)
Proceeds from investments sold (note 6)70,490,273 31,875,281
Net change in non-cash balances related to operations
Accrued interest receivable875,627 677,378
Prepaid expenses15,090 16,691
Accounts payable and accrued liabilities160,194 4,471
51,854,145 22,465,279
Cash flows from financing activities
Dividends paid to common shareholders (notes 4 and 9)(7,371,869) (7,371,869)
Net increase in cash and cash equivalents during the year44,482,276 15,093,410
Cash and cash equivalents - Beginning of year20,091,125 4,997,715
Cash and cash equivalents - End of year64,573,401 20,091,125
Cash and cash equivalents comprise
Cash7,665,211 9,110,875
Short-term deposits56,908,190 10,980,250
64,573,401 20,091,125


Par value1
$


Average cost2
$


Fair value2
$
Percentage of total fair
value
3
%
Fixed income - Canadian
Denominated in Canadian dollars
Athabasca Oil Corp. 7.5% 11-19-20173,500,0003,406,2503,290,0005.0
Black Press Group Libor + 5.00% 06-28-20181,127,0751,115,8041,115,8041.7
Black Press Group 10% 12-28-20181,250,0001,250,0001,278,1252.0
Crew Energy Inc. 8.38% 10-21-20201,900,0001,889,6261,923,7502.9
Directcash Payments 8.13% 08-08-20193,160,0003,169,5503,199,5004.9
Gateway Casinos 8.50% 11-26-20203,900,0003,900,0003,861,0005.9
North American Energy Partners Inc. 9.13% 04-07-20173,025,0003,039,9093,146,0004.8
Paramount Resources Ltd. 8.25% 12-13-20179,250,0009,250,0009,573,75014.6
Perpetual Energy Inc. 8.75% 03-15-20185,000,0005,000,0004,812,5007.4
Petroamerica Oil Corp. 11.50% 04-19-201544,000,0004,000,0004,000,0006.1
Sherritt International Corp. 7.75% 10-15-2015196,000152,233201,8800.3
Sherritt International Corp. 8.00% 11-15-20183,750,0003,750,0003,693,7505.6
Sherritt International Corp. 7.50% 09-24-20202,000,0002,000,0001,870,0002.9
Skylink Aviation Inc. 12.25% 05-10-2018525,800525,800320,7380.5
Western Energy Services Corp. 7.88% 01- 30 -20192,250,0002,250,0002,328,7503.6
44,699,17244,615,54768.2
Denominated in United States dollars
Mirabela Nickel Ltd. 8.75% 04-15-20189,285,0008,442,717987,5531.5
Skylink Aviation Inc. 10.00% 03-08-2015965,183982,9911,026,5691.6
Tembec Industries 11.25% 12-15-20184,250,0004,494,7794,961,0297.6
13,920,4876,975,15110.7
Total Canadian fixed income 58,619,65951,590,69878.9
Fixed income - United States
Denominated in United States dollars
99 Cents Only Stores 11.00% 12-15-20191,850,0001,926,5842,233,2943.4
Calfrac Holdings LP 7.5% 12-01-20202,350,0002,401,0452,555,6993.9
Total United States fixed income 4,327,6294,788,9937.3
Total fixed income 62,947,28856,379,69186.2
1 Par values are presented in their source currency
2 All amounts are shown in Canadian dollars
3 Percentages are shown as a percentage of total investments
4 These investments represent loans receivable


Par value 1
$


Average cost 2
$


Fair value 2
$
Percentage of total fair
value
3
%
Convertible debentures - Canada
Denominated in Canadian dollars
Niko Resources Ltd. 7.00% 12-13-20172,000,0002,000,0001,060,000 1.6
Equities - Canada
Conifex Timber Inc. - purchase warrants
$9.33 strike, 12-31-201481,726-34,195 0.1
Uranerz Energy Corp. - purchase warrants
$1.60 strike, 12-05-2015600,000-72,434 0.1
Skylink Aviation Inc. - common shares33,765-- -
Whitecap Resources Inc. - common shares531,7673,275,6866,716,216 10.3
Total equities 3,275,6866,822,845 10.5
Royalties - Canada
Denominated in Euro
RapidEye Canada Royalty -1,241,233 1.9
Investments subtotal 68,222,97465,503,769 100.2
Foreign currency contracts (note 8)
Denominated in United States dollars
Payable 17-01-2014 at 1.058702,000,000-(9,800)(0.1)
Payable 06-01-2014 at 1.0586010,800,000-(54,000)(0.1)
Total foreign currency contracts -(63,800)(0.2)
68,222,97465,439,969 100.0
1 Par values are presented in their source currency
2 All amounts are shown in Canadian dollars
3 Percentages are shown as a percentage of total investments
4 These investments represent loans receivable

1. Nature of operations and basis of presentation and going concern

Deans Knight Income Corporation (the "Company") is a corporation continued under the laws of Canada on April 11, 2001. The Company is a closed-end, non-redeemable investment company. It invests, primarily, in corporate debt rated BBB or below by recognized credit rating organizations.

Prior to its reorganization in May 2008, the Company was a life sciences company involved in the research, development and commercialization of innovative products for the prevention and treatment of life-threatening diseases. The Company maintains product liability insurance for certain claims that may arise in the future in connection with its prior business. To date, no such claims or potential claims have arisen. In March 2009, the Company completed an initial public offering, whereby it raised gross proceeds of $100,368,900 and began operating its new business as an investment company.

As per the Company's Articles of Incorporation ("Articles"), the common shares of the Company are to be redeemed on, or around, April 30, 2014, for a cash amount equal to 100% of the net asset value per common share.

On January 27, 2014, the Company called a special meeting of shareholders to be held on April 4, 2014. The meeting is to seek shareholder approval to extend the term of the Company until such time as is reasonably practicable following the conclusion of the CRA Audit or any appeal made to the Tax Court of Canada, or such other date as the Company deems appropriate on not less than 30 days' notice to shareholders. Should its shareholders vote to extend the term of the Company, it has the intent and ability to take actions necessary to continue as a going concern. The Company anticipates obtaining approval for this extension; therefore these financial statements have been prepared on a going concern basis. If the shareholders do not vote to extend the term of the Company, then in accordance with the Articles the Company must be wound up by April 30, 2014. However, the Company may, in its discretion, extend the redemption date by a period of up to 180 days, pursuant to its discretionary power to do so under the Articles, to enable illiquid securities to be converted to cash. Further, the Company would have to settle all outstanding liabilities, including tax assessments, by that date in order to obtain a tax clearance certificate.

The accompanying financial statements are prepared in accordance with Part V of the Chartered Professional Accountants (CPA) Canada Handbook, Pre-changeover Accounting Standards (GAAP). All amounts are presented in Canadian dollars, unless otherwise noted.

2. Summary of significant accounting policies

The following is a summary of significant accounting policies followed by the Company.

Financial instruments

Investments

Investments are held for trading and are recorded at fair values determined as follows:

Fixed income investments

Fixed income investments traded on a public securities exchange or traded on an over-the-counter market are valued at the closing bid price. Where no closing bid price is available, the last sale or close price is used where, in management's opinion, this provides the best estimate of fair value.

Unlisted or non-exchange traded investments, or investments where a last bid, sale or close price is unavailable, or investments for which market quotations are, in the Company's opinion, inaccurate, unreliable, or not reflective of all available material information, are valued at their fair value as determined by the Company using appropriate and accepted industry valuation techniques including valuation models. The fair value determined using valuation models requires the use of inputs and assumptions based on observable market data including volatility and other applicable rates or prices. In certain circumstances, the fair value may be determined using valuation techniques that are not supported by observable market data.

The resulting values for investments not traded in an active market may differ from values that would be determined had a ready market existed, and the difference could be significant.

Foreign currency contracts

Foreign currency contracts are recorded at fair value. The proceeds (payments) on contracts settled during the year are included in the net realized loss on settlement of foreign currency contracts (note 6). The Company's policy is to hedge 95% - 105% of the fair value of foreign denominated investments with foreign exchange forward sell contracts.

Public company equities

Publicly traded equities are recorded at bid prices as quoted on recognized stock exchanges.

The amounts at which the Company's publicly-traded investments could be disposed of currently may differ from the carrying value based on market quotes, as the value at which significant ownership positions are sold is often different than the quoted market price due to a variety of factors such as premiums paid for large blocks or discounts due to illiquidity.

Warrants

Warrants are recorded at their estimated fair value using appropriate and accepted industry valuation techniques.

The impact of changes in fair value of investments is recorded in the statements of operations.

Cash and cash equivalents

Cash and cash equivalents are accounted for at amortized cost. They consist of cash and deposits with maturities, at the time of purchase, of three months or less.

Accrued interest receivable

Accrued interest is designated as loans and receivables and is accounted for at amortized cost. Due to the immediate and short-term nature, the carrying value approximates fair value.

Financial liabilities

Financial liabilities, consisting of accounts payable and accrued liabilities, are designated as other financial liabilities and are accounted for at amortized cost. Due to the immediate and short-term nature, the carrying value approximates fair value.

Investment transactions

Investment transactions are recorded on the trade date. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of an investment, which include fees and commissions paid to agents, advisors, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. These costs are expensed and are included in the statements of operations.

Income recognition

Income from investments is recognized on an accrual basis. Interest income is accrued based on the number of days the investment is held during the year. Royalty income is recognized on an accrual basis as earned. Gains or losses on the sale of investments, including foreign exchange gain or loss on such investments, are calculated on an average cost basis.

Foreign currency contracts

Foreign currency contracts (note 8) entered into by the Company are valued at an amount that is equal to the gain or loss that would be realized if the position were to be closed out, which is equivalent to the difference between the deliverable asset and the value of the asset to be received. Changes in the value of a forward contract or the assets deliverable under such a contract are included as unrealized depreciation on foreign currency contracts in the statements of operations.

Foreign exchange

Assets and liabilities denominated in foreign currencies are translated into Canadian dollars at the exchange rate applicable on the valuation date. Purchases and sales of investments, investment income and expenses are calculated at the exchange rates prevailing on the dates of the transactions.

Income taxes

The Company follows the asset and liability method of accounting for income taxes. Future income tax assets and liabilities are measured using rates expected to apply to the taxable income in the years in which the temporary differences are expected to be settled. The Company accounts for uncertain tax positions using the contingent liability model, whereby a provision is established only where it is likely that a payment will be required to be made.

A valuation allowance is recognized to the extent that it is not more likely than not that future income tax assets will be realized. Management has estimated the income tax provision and future income tax balances taking into account its expectation of future taxable income and an interpretation of the various income tax laws and regulations. It is possible, due to the complexity inherent in estimating income taxes, that the tax provision and future tax balances could change (note 7), and the change could be significant.

Use of estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, income and expenses. Actual results could differ from those reported and such differences could be material. Significant areas involving the use of estimates include determining the estimated fair value of investments and future income tax assets.

Net assets per common share

The net assets per common share are computed by dividing the net assets of the Company by the total number of common shares outstanding on the statement of net assets date.

Increase in net assets from operations per weighted average common share

The increase in net assets from operations per weighted average common share represents the increase in net assets from operations divided by the weighted average number of common shares outstanding during the year.

The weighted average number of shares outstanding during the year ended December 31, 2013 was 10,537,263 (2012 - 10,537,263). This weighted average includes both the voting common shares and non-voting common shares of the Company.

Future changes in accounting policies

The Company will transition to International Financial Reporting Standards (IFRS) for its fiscal year beginning January 1, 2014. IFRS comparative financial information will be required in interim and annual financial statements relating to fiscal periods beginning on or after January 1, 2013. As a result, the Company will adopt IFRS commencing January 1, 2014. The Company is assessing the potential impact of adopting IFRS and does not expect the adoption to result in significant measurement differences to current reporting under GAAP.

3. Capital stock

The Company is authorized to issue an unlimited number of voting common shares without par value, and an unlimited number of non-voting common shares without par value.

There were no changes in the number of voting and non-voting common shares issued or outstanding during the years ended December 31, 2013 and 2012.

The total shares outstanding at December 31 are summarized as follows:

2013 2012
Number of Shares Amount
$
Number of Shares Amount
$
Voting common shares10,191,592 96,273,343 10,191,592 96,273,343
Non-voting common shares345,671 3,093,086 345,671 3,093,086
Total common shares outstanding10,537,263 99,366,429 10,537,263 99,366,429

Contributed surplus

The contributed surplus balance did not change during the years ended December 31, 2013 and 2012, and consists of:


2013
2012
$ $
Surplus related to stock compensation, warrants and options associated with common shares8,030,295 8,030,295
Surplus relating to warrants associated with previously issued preferred shares1,874,209 1,874,209
9,904,504 9,904,504

4. Retained earnings

The changes in retained earnings for the years ended December 31, 2013 and 2012 are as follows:

2013
$
2012
$
Retained earnings - opening balance33,004,067 32,268,987
(Decrease) increase in net assets from operations(4,755,551) 8,106,949
Dividends paid from net investment income(7,371,869) (7,371,869)
Retained earnings - closing balance20,876,647 33,004,067

5. Related party transactions and balances

Management fees are paid quarterly to Deans Knight Capital Management Ltd. (the Investment Advisor), a corporation with certain common directors and officers of the Company, for services received in connection with the management of the investment portfolio and financial accounts, among other services provided. Management fees are computed quarterly at an annual rate of 1.5% of net asset value, adjusted for certain non-investment related assets. For the year ended December 31, 2013, management fees (including applicable taxes) totalled $2,122,002 (2012 - $2,311,289). At December 31, 2013, $512,138 (2012 - $589,251) was owed to the Investment Advisor, which was included in accounts payable and accrued liabilities in the statements of net assets, and is payable immediately.

A former director of the Company is a partner at a law firm that provides legal services to the Company. During the year ended December 31, 2013, the Company incurred $299,969 (2012 - $14,014) in legal services and disbursements provided by from this law firm. At December 31, 2013, accounts payable and accrued liabilities include $133,884 (2012 - $226) due to the law firm for legal fees and disbursements.

6. Net realized (loss) gain on investments sold and foreign currency contracts

The net realized (loss) gain on investments sold and foreign currency contracts for the year ended December 31 was as follows:

2013
$
2012
$
Proceeds from investments sold70,490,273 31,875,281
Investments at cost - Beginning of year117,207,284 125,475,983
Add: Cost of investments purchased26,749,307 18,898,699
143,956,591 144,374,682
Less: Investments at cost - End of year(68,222,974) (117,207,284)
Cost of investments sold75,733,617 27,167,398
Net realized (loss) gain on investments sold(5,243,344) 4,707,883
Net realized (loss) gain on investments sold and foreign currency contracts consists of:
2013
$
2012
$
Realized (loss) gain on investments sold(2,572,824) 2,548,818
Realized (loss) gain on settlement of foreign currency contracts(2,670,520) 2,159,065
(5,243,344) 4,707,883

7. Taxation

Uncertainty of deductibility of tax losses

Prior to the reorganization and change in business as discussed in note 1, the Company had generated significant tax losses and other tax attributes as a result of its prior businesses and research activities. The Company has recorded, as a tax asset, the full amount of the potential tax benefit of such items to the extent of its projected taxable income up to April 30, 2014, being the date common shares are to be redeemed based on the Company's Article of Incorporation.

On January 21, 2014, the Company received a proposal letter ("Proposal Letter") from the Canada Revenue Agency ("CRA"). In it, the CRA stated that it intends to reassess the Company and deny the deduction of certain non-capital losses and other tax attributes in the Company's taxation years ending in 2009 to and including 2012, which are currently the subject of an audit by the CRA (the "CRA Audit"). The CRA has indicated in the Proposal Letter that it intends to deny the use of certain tax attributes by the Company on the basis that an acquisition of control of the Company occurred and on the basis of the General Anti-Avoidance Rule in the Income Tax Act (Canada). The Company, in consultation with its legal advisors, remains of the view that its tax filing position is appropriate, and does not believe any additional assessment of income tax by the CRA is appropriate. There continues to be tax litigation in progress involving the CRA and other companies which may have a bearing on the Company's own tax position with the CRA. The Company will continue to assess its position as such litigation progresses.

The Company has not yet received a notice of reassessment ("Reassessment"), which, if issued by the CRA, will provide the CRA's view of the proposed additional tax, interest and penalties owed by the Company. Based on the information in the Proposal Letter and discussions with the CRA, the Company estimates the potential tax liability to be approximately $21.7 million. This estimate is based on an aggregate reassessment for the 2009 through 2012 taxation years totaling approximately $22.7 million ("Disputed Amount") which is expected to be reduced by the anticipated tax refund for the Company's 2013 taxation year of approximately $1.0 million. The tax refund is based on the Company's results of operations for the 2013 taxation year. Subsequent to December 31, 2013, the Company prepaid the Disputed Amount to the CRA to minimize any further interest from accruing.

Future tax asset

Canadian GAAP requires a valuation allowance to be recognized against any future tax asset to the extent that it is more likely than not that the future income tax asset will not be realized. This is also the Company's stated accounting policy.

As the Company's investments in debt securities are generating interest income, but are not expected to generate sufficient taxable income in order to fully utilize the available tax credits prior to April 30, 2014, the Company has recorded a valuation allowance. The difference between the total value of these tax benefits less the valuation allowance, being $180,000 (December 31, 2012 - $2,390,000), is the amount of the future income tax asset that has been recorded by the Company in the statement of net assets. The valuation allowance is reviewed, based on updated projections of taxable income, and adjusted accordingly by a credit or charge to the statements of operations.

The tax effects of temporary differences and tax credits that give rise to significant components of the future income tax assets, at the statutory enacted rates when such benefits are expected to be realized, are as follows:

2013
$
2012
$
Future income tax assets
Non-capital loss carry forward987,800 -
Research and development expenditures4,715,100 4,533,250
Investment tax credits5,322,750 5,322,750
Share issuance costs- 313,440
Total gross future income tax assets11,025,650 10,169,440
Valuation allowance(10,845,650) (7,779,440)
Net future income tax asset180,000 2,390,000
Future income tax assets expected to be realized in:
2013
$
2012
$
Less than 12 months180,000 1,930,000
Greater than 12 months- 460,000
Net future income tax asset180,000 2,390,000

The tax balances and income tax expense recognized by the Company are based on management's interpretation of the tax laws. Due to the complexity inherent in tax interpretations, regulations and legislation, there are significant estimates required to compute income tax balances. It is possible that some or all of the Company's significant components of the future income tax assets may not be deductible for tax purposes and, accordingly, the amount of future income taxes and provision for income taxes recorded in the financial statements could change by a material amount.

In determining the amount of future income tax assets recognized, management assessed the projected taxable income of the Company. Inherent in all forward looking information is uncertainty and actual amounts could differ from these estimates and the difference could be material. In developing the projection, management has assumed full payment of all contractual interest, that investments maturing prior to April 30, 2014 will be redeemed for par value, and that investments maturing after April 30, 2014 will be sold at their current value.

As per note 1, a special meeting will be held on April 4, 2014 to obtain shareholder approval to extend the term of the Company. Should that approval be obtained it is anticipated that some of the valuation allowance will be reversed to the extent that the future income tax assets are consistent with the expected term of the Company.

Tax pools available to offset future tax expense and payable

The operations of the Company and related tax interpretations, regulations and legislation are continually changing. As a result, significant estimates are required to compute income tax balances. As at December 31, 2013, the Company has accumulated scientific research and experimental development expenditures in the amount of $18,135,000 available for carry forward indefinitely. The Company incurred non-capital losses during the year ended December 31, 2013, which will expire in 2033 and amount to $2,545,551. The Company also has accumulated approximately $7,097,000 of unclaimed federal investment tax credits, which expire as follows:


Year of expiry
Investment tax credits
$
2018265,000
2019990,000
20201,872,000
20212,483,000
2022298,000
2023187,000
2024496,000
2025506,000
7,097,000

Reconciliation of income tax expense

The reconciliation of income tax computed at the statutory tax rate to income tax expense at December 31, using a 25.75 % statutory tax rate (2012 - 25.0%), is as follows:

2013
$
2012
$
(Decrease) increase in net assets from operations before tax(2,545,551) 10,636,949
Statutory tax rate25.75% 25.0%
Income tax (recovery) expense at statutory rates(655,479) 2,659,238
Use of scientific research and experimental development expenditures- (2,345,798)
Non-capital loss carry forward978,319 -
Reduction of future income tax asset2,210,000 2,530,000
Current tax deductions for offering costs(322,840) (313,440)
Provision for future income tax2,210,000 2,530,000

8. Financial instruments

Fair value measurement

Financial instruments are classified in a hierarchy that prioritizes the inputs to fair value measurement. Each level is based on the transparency of the inputs used to measure the fair values of assets and liabilities. The three levels of the fair value hierarchy are:

Level 1 - inputs that reflect unadjusted quoted prices in active markets for identical assets or liabilities;

Level 2 - inputs that reflect other than quoted prices that are observable for the assets or liabilities either directly or indirectly;

Level 3 - inputs that are not based on observable market data.

The following tables illustrate the classification of the Company's financial instruments within the fair value hierarchy:

Financial assets at fair value - December 31, 2013

Level 1
$

Level 2
$

Level 3
$

Total
$
Corporate debt-50,044,832 6,334,85956,379,691
Convertible debentures-1,060,000 -1,060,000
Equities6,716,216- 106,6296,822,845
Royalty-- 1,241,2331,241,233
Foreign currency contracts-(63,800)-(63,800)
6,716,21651,041,032 7,682,72165,439,969
Financial assets at fair value - December, 31 2012

Level 1
$

Level 2
$

Level 3
$

Total
$
Corporate debt-93,669,383 13,965,857107,635,240
Convertible debentures-2,200,000 -2,200,000
Equities8,696,425- 677,4139,373,838
Royalty-- 1,238,7701,238,770
Other-(1,362,500)-(1,362,500)
Foreign currency contracts-(296,595)-(296,595)
8,696,42594,210,288 15,882,040118,788,753

The following table reconciles the Company's Level 3 fair value measurements:

Fair value measurements of Level 3 inputs
Corporate
debt
$
Convertible
debentures
$

Equities
$

Royalty
$

Total
$
Balance - December 31, 201122,965,956 1,554,218 205,444 -24,725,618
Purchases4,000,000 - - -4,000,000
Sales(13,081,762)(1,558,378)- -(14,640,140)
Unrealized appreciation included in net gain on Investments81,663 4,160 471,969 1,238,7701,796,562
Balance - December 31, 201213,965,857 - 677,413 1,238,77015,882,040
Purchases982,991 - - -982,991
Transfers2,223,464 2,223,464
Sales(10,233,152)- (510,000)-(10,743,152)
Unrealized (depreciation) appreciation included in net gain on investments(604,301)- (60,784)2,463(662,622)
Balance - December 31, 20136,334,859 - 106,629 1,241,2337,682,721

The transfers from Level 2 to Level 3 during the year ended December 31, 2013, totalling $2,223,434, relate to corporate debt securities that experienced significant reductions in trading activity during the year. The valuation inputs for these securities were not therefore based on market observable inputs and resulted in the reclassification to Level 3.

Level 3 fair value measurements have predominantly been valued by considering data inputs such as the last price the security was traded at, most recent bid/ask information, prices of similar securities with available prices, and comparison of yields of comparable investments. Accordingly, in the absence of any reasonably possible alternative assumptions, and except as noted below, it is not practicable to provide a sensitivity analysis.

For royalty investments measured on a discounted cash flow basis the value is imputed through forecasted cash flows and discount rates. The following summarizes the affect a change in assumptions would have on total net assets at December 31, 2013:

Increase by 5% Decrease by 5%
Cash flow growth rate201,735 (192,930)
Discount rate(175,670) 222,462

Management of financial risks

In the normal course of business, the Company is exposed to various financial risks, including credit risk, liquidity risk and market risk (consisting of interest rate risk, currency risk and other price risk). The Company's overall risk management program seeks to minimize potentially adverse effects of these risks on the Company's financial performance by employing a professional, experienced portfolio advisor, monitoring daily the Company's positions and market events, diversifying the investment portfolio within the constraints of the investment guidelines and periodically using derivatives to hedge certain risk exposures. Further, the Company monitors the portfolio to ensure compliance with its investment strategy, investment guidelines and securities regulations.

Fair value risk

The Company's investments are exposed to market price risk and this risk affects the fair value of the investments. All investments have an inherent risk of loss of capital. The maximum risk resulting from investments is determined by their fair value. The Company seeks to manage valuation risks by careful selection of fixed income investments prior to making an investment and by regular ongoing monitoring of the investment performance of the individual investee companies. Due to the predominantly fixed income nature of the investment portfolio, the Company has minimal direct price risk. A 10% change in the value of the Company's equity investments (excluding warrants) would have a $671,622 impact on net assets, on an after tax basis.

Credit risk

Credit risk is the risk that a counterparty to a financial instrument will fail to discharge an obligation or commitment that it has entered into with the Company.

All transactions executed by the Company in listed securities are settled/paid for upon delivery using approved brokers. The risk of this settlement not occurring is considered minimal, as delivery of securities sold is only made once the broker has received payment. Payment is made on a purchase once the securities have been received by the broker. The trade will fail if either party fails to meet its obligation. Since the Company invests in high-yield debt instruments and derivatives, this represents the main concentration of credit risk. The fair value of debt securities includes consideration of the creditworthiness of the debt issuer. The maximum credit exposure of these assets is represented by their carrying amounts. This maximum exposure may be offset to varying degrees in each investment, based on the collateral held, if any. Collateral may include such things as a general security agreement over all assets, or specific security over specific assets. It may also entitle the debt holder to take over the overall business through restructuring of the investment.

The Company's credit risk exposure, by credit ratings on its investments, is listed as follows:

As a % of net assets
20132012
Credit rating
BB+4.44.4
BB-1.8
BB--0.9
B+2.88.3
B4.36.0
B-15.210.6
CCC+11.630.3
CCC-3.1
CCC--2.4
D0.9-
Not rated11.115.7
50.383.5

Credit ratings are obtained from various credit rating agencies and sources. Where one or more rating is obtained for a security, the lowest rating has been used.

Credit risk associated with the Company's cash and cash equivalents is not considered significant, as they are held with Tier 1 Canadian Financial Institutions.

The Company's credit risk exposure by sector on its investments is as follows:

As a % of net assets
20132012
Sector
Consumer goods6.58.4
Energy30.349.8
Financial services2.5-
Forestry3.86.2
Industrial/manufacturing-4.3
Materials and metals5.213.7
Services1.00.2
Technology1.00.9
50.383.5

Interest rate risk

Interest rate risk arises from the possibility that changes in interest rates will affect future cash flows or fair values of financial instruments.

The Company invests primarily in interest-bearing financial instruments. As such, the Company is exposed to the risk that the value of such financial instruments will fluctuate due to changes in the prevailing levels of market interest rates. The table below summarizes the Company's exposure to interest rate risk by term to maturity on its investments:

Fair value
2013
$
2012
$
Maturity
Less than 1 year--
1 - 3 years5,228,44920,543,660
3 - 5 years38,100,24946,527,959
Greater than 5 years14,110,99042,639,891
57,439,688109,711,510

As at December 31, 2013, if the prevailing interest rates had been raised or lowered by 1%, assuming a parallel shift in the yield curve, with all other factors remaining constant, net assets could possibly have decreased or increased, respectively, by $2,100,000, or approximately 1.6 % of net assets (2012 - $4,000,000, or approximately 2.8% of net assets).

Liquidity risk

As the Company is a publicly traded, closed-end investment company with a fixed number of common shares outstanding, unlike an open-ended mutual fund, it is not exposed to the liquidity risk associated with daily cash redemptions of securities.

Investments in fixed income investments may not be able to be liquidated quickly at an amount close to their fair value to respond to specific events such as deterioration in the creditworthiness of any particular issuer. Fixed income investments purchased by the Company may be subject to resale restrictions such as hold periods. The resulting values for fixed income investments may differ from values that would be realized had a ready market existed.

The Company actively reviews its investment portfolio, and the fixed income market, to assess liquidity risk on its holdings.

Currency risk

Currency risk is the risk that the value of a financial instrument will fluctuate due to changes in foreign exchange rates. The Company invests a portion of its assets in securities that are denominated in a currency other than the Canadian dollar, which represents the functional currency of the Company. Consequently, the Company is exposed to currency risk as the value of the portfolio securities denominated in currencies other than the Canadian dollar will vary due to changes in foreign currency exchange rates.

The Company enters into foreign currency contracts with financial institutions to hedge the value of foreign currency denominated investments. The fair value of these contracts is reflected in investments. Gains or losses arising from these contracts offset the gains or losses from translation of the underlying investments. The unrealized gains or losses are reflected in unrealized appreciation/depreciation on foreign currency contracts on the statements of operations. The potential impact to net assets of a 5% change in foreign currency rates against the Canadian dollar, assuming all other variables remain constant, would be $160,000 (2012 - $16,000).

9. Capital management

The capital of the Company is divided into voting and non-voting common shares, each having an unlimited authorized amount. The number of voting and non-voting shares outstanding and changes thereto, are outlined in note 3.

The Company manages its capital in accordance with the Company's investment objectives. The Company's investment objectives are to: (i) maximize the total return for common shareholders, consisting of dividend income and capital appreciation; and (ii) provide shareholders with monthly dividends targeted to payout a minimum of 75% of net investment income annually. Net investment income, in reference to the Company's dividend payments to shareholders, excludes any realized and unrealized capital gains and losses from debt securities in the portfolio and any income or loss not derived from debt securities in the portfolio. The Company commenced its dividend payments on June 30, 2009, making monthly payments of $0.0583 per voting and non-voting common share. During the year ended December 31, 2013, the Company made dividend payments of $7,371,869 (2012 - $7,371,869).

The Company has ceased its monthly dividend payment starting in January 2014. Further, it has begun to liquidate its investment portfolio, with proceeds not being reinvested in new opportunities.

10. Comparison of net asset value per common share and net assets per common share

In accordance with Section 3.6(1) of National Instrument 81-106, the Company's net asset value per share, the net assets per share calculated in accordance with Canadian GAAP for financial reporting purposes, and an explanation of the differences between such amounts, are required disclosures in the notes to the financial statements. For investments that are traded in an active market, Canadian GAAP requires that bid prices be used in the fair value of instruments, rather than the use of the last traded price, as currently used for the purpose of determining net asset value. This change accounts for the difference between the net asset value and the net assets.

December 31, 2013
$
December 31, 2012
$
Net asset value per share12.37 13.58
Canadian GAAP adjustments(0.02)(0.08)
Net assets per common share12.35 13.50

Contact Information

  • Deans Knight Income Corporation
    Craig Langdon
    Chief Executive Officer and Director
    (604)669-0212

    Deans Knight Income Corporation
    Mark Myles
    Chief Financial Officer
    (604)669-0212
    www.dkincomecorp.com