Q2-2016 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the second quarter of 2016, the three months ended June 30, 2016 is approximately +18.3%. The year-to-date performance for the six months ended June 30, 2016 is +33%.

Portfolio Percentages

At June 30, 2016:

44% common equities
26% preferred share equities
52% corporate debt
-21% cash

Percentages do not add to 100% due to rounding.

USD exposure: 38%

Portfolio is valued in CAD;
Equities are valued at closing price;
Values include accrued corporate bond interest, but not that from Canadian exchange-traded debentures;
Corporate debt valued at last trade price.

Portfolio commentary and outlook

Back in February 11, 2016, I wrote the following:

I do have a general rule and that is whenever [financial market panic] hits the headlines of mainstream publications, it is likely closer to the 9th inning of the ballgame rather than the beginning.

The environment right now is once again reminding me of something like mid-2008 when everything is all panicky. Bargains that have good potential for double-digit appreciation are hitting the radar in huge frequency.

Just like what I did in 2008-2009, I listened to my own advice and started deploying some cash, for dramatic effect.

This quarter can only be described as insanely positive. It was a quarter where nearly everything worked. In relation to risk, the portfolio achieved returns that were far greater than anything ever done before since the 2008-2009 financial crisis (recall that 2009 was a year where I made +104% on my portfolio, an achievement that is not likely to be surpassed in my lifetime, but in my rational estimate there was more risk taken to achieve that return).

When everything is working, there are a couple attitudes:

1) Why change direction? Why not stick with a proven strategy?
2) Keep cautious, as something that works in the markets during one time period may not work in another time frame.

I am always of the #2 mentality, but apply discretion to “let winners run”. And indeed, I am letting my portfolio run.

The actual risk exposure of the portfolio is significantly less than what the asset allocation fractions above would suggest. The corporate equity portfolio consists entirely of companies that are trading under tangible book value and all of those entities are producing positive cash flows (with the exception of Genworth Financial (NYSE: GNW), where their LTC portfolio is going to be a huge negative cash drain, but financial challenge is to calculate how much of their asset base will go out the window to pay for future claims). GNW is a small equity holding.

I would not expect to liquidate any of these equity securities until they have appreciated further than present, but even then, I only like to sell when they are above my fair value band rather than at fair value.

The preferred share securities and corporate debt securities are higher up on the capital structure and for each and every of these investments I am expecting to be paid dividends or interest. In the case of the debt, my credit risk is mitigated with either security or functional first-in-line subordination status (i.e. little in the way of further senior or secured liabilities). There are a couple long-shot, distressed debt securities in the portfolio, but these have been kept to less than 1% position limits.

A notable debt highlight is Pinetree Capital (TSX: PNP) had their senior secured debentures mature on May 31, 2016 for cash, which ended a huge saga of the previous management’s inability to manage the balance sheet. I had actually liquidated most of these holdings at 101 cents before the rights offering was announced since my calculations showed that a cash maturity was going to be very tight (and indeed, if the rights offering did not come through that they likely would have had to go into CCAA to give them time to pay off debtholders with a mostly illiquid private asset portfolio). I wish Peter Tolnai, the new CEO and indirect 31% owner, the best of success in trying to unlock the value within the corporation’s huge pool of un-utilized capital losses. You can read the whole saga from November 2013 to May 2016 at this link. I expect things to be a lot more calm with Pinetree Capital in the future, except for them probably changing their company’s name to finally turn the page. I will disclose a very small equity holding by virtue of the January debenture redemption, which gave debtholders some shares.

For my fixed-income securities (bonds and preferreds), my yield at cost was in the low double-digits for something I consider to be between very low to low risk investments, despite the fact that such securities were trading at what I considered to be distressed price levels. The current yield of this basket of securities has decreased since purchase because of price appreciation (and will continue to drop because of rate-resets occurring over the next 12 months), but there is still room to run.

The beauty of debt securities is that I can fall into a coma and when I wake up, I very likely will have interest and principal deposited into my brokerage account. I do not have to take any action unless if I have a good reason to sell (which would likely be the securities trading above par value at a point where the call risk becomes meaningful). The preferred share securities are a different story – they have to be somewhat more actively monitored for both credit risk purposes and also if they are at a point where they have appreciated enough that their current yields are inferior to a superior alternative, measured from a risk-reward ratio. Due to the considerably low 5-year government bond rate, the rate-reset mechanisms of most preferred shares have taken their value well below the range where there is call risk so it is very likely that if I woke up from such a hypothetical coma, these shares will still be in the portfolio spinning away cash.

I do not have a good feel for the intermediate interest rate environment other than that there is continued downward pressure from the capital that is awash out there as a result of central bank liquidity. Let’s pretend you were given a trillion dollars with the provisio that you’ll have to pay it back in a decade – the easiest no-brainer is to dump it into US treasury securities and skim a few bucks of interest income. Enough players doing this will depress yields and then eventually pensions and institutions become so risk-adverse to the equity side that they invest in negative-yield securities like they are doing in Europe. Something is terribly amiss in the finance world, but it is tough to tell how this will play out.

It is ironic, however, with negative yields that a real cheap way for governments to pay down their sovereign debts is by issuing more negative yield debt. Forget about inflation for now!

Economics Sermon

The following few paragraphs are some of my opinions on economics. Please realize that I did not take more economics classes than Economics 100 when I was in university.

With all of these bits of paper (dollars and Euros) floating around, eventually it needs to be spent on something in order to realize their value – currency is about trading a unit of economic storage (dollars, gold coins, sea shells, bitcoins or whatever) into something tangible (planes, trains, automobiles, or the servitude of lawyers, accountants, engineers and management consultants). Optionally, if you don’t want to spend it on something today, you can put it into future claims (stocks, bonds) where you can then buy the tangible goods. This explains the rise in asset values, but not why we haven’t seen general inflation increases in tangible products.

Presently, the world is finding it quite difficult to spend money on the products, but is finding it much easier to spend on the entertainment components – explaining why service prices and the cost of specialized labour is going up much more than product prices – a product can be mass-produced a billion times over with reasonable economies of scale, but services that cannot be automated are ultimately supply-constrained by those that can practice it – and the price of this is skyrocketing above the ambient inflation rate.

So when published reports of GDP come out, it is important to distinguish between “stuff” and “non-stuff” components.

My general theory is that it will take some sort of world war, or massive natural disaster to spur “stuff-related” (i.e. physical production) related inflation. The big exception is the price of energy – while being eroded away by significant technological advances in solar power, I still do not see fossil fuels being displaced until well into the middle to end of the 21st century. The basic story is that people can only consume so much garbage and we are exceptionally efficient at mass-producing garbage, well beyond our ability to consume it. Just take a look inside a Walmart or Costco.

That ends my economic sermon for the quarter.

Quarterly Transactions

This quarter was also very bi-polar in terms of trading – most of the transactions were performed in April, while May was dormant and June had a couple transactions – one was a significant addition of an existing portfolio component, while the other was a new position in a corporate bond that should be an “easy” 10% yield to maturity.

Another bond purchase that happened earlier was my purchase of Teekay Corporation unsecured debt (maturing January 2020), which was purchased at a significant discount to par (link to article here). At my cost level, this will most likely provide the portfolio with a near 20% yield to maturity with a lot of bad news that would have to occur in order for a payout to not happen.

There were some other transactions that took place, but I do not feel like disclosing them at present.

Cash and Margin

The portfolio right now is utilizing a large amount of margin for the first time in many years. The cost of capital is extremely cheap, and is collateralized by certain fixed-income investments that give off increased cash flows than the floating rate interest expense.

On paper, it makes logical sense – invest at something with a 10% yield, and if this is financed with a 2%, 1.5% or 1% margin loan, you can skim the yield, earning 8%, 8.5% or 9% pre-tax yields, respectively. With most equities you can get at least 2:1 leverage (i.e. put up $10k to purchase $20k of stock) and bonds that have any sort of credit rating can be purchased with leverage.

It is finance 101 speaking: To convert a 5% yield into a 5%+X return on equity, you just need to use leverage that costs less than your yield. The bigger the differential between your yield and your cost of leverage, the less leverage you need to employ. Indeed, an investment that offers a “guaranteed” 5% yield that is financed with a 4.9% fixed rate loan can magically turn into a 10% return on equity with a hundred times of financial leverage – as long as you can find an institution willing to give you this leverage at the desired rates.

These sorts of products are structured and securitized and sold on the open market. You can even invent entire corporations that have a sole purpose of doing this in life. See (TSX: EQB) for an example. There are ETFs out there that will also employ such strategies with junk debt.

In practice, there are a few relevant issues, including doing this at an individual level:

1) The price of whatever you are investing in may fluctuate and you may be forced into a spontaneous liquidation scenario if you are too aggressively leveraged (and those sales will be at the most adverse prices). These fluctuations may happen for company-specific or general macroeconomic concerns and be well beyond your control to mitigate. The macroeconomic stuff you can’t really have control over but the company-specific concerns can be mitigated through diversification;
2) Interest rates might rise, killing the entire market. This can be mitigated somewhat with shorter duration investments, but you will have adverse impact on fixed-income streams as a result of a rise in rates;
3) Margin requirements might change, increasing the “stress point” where you get into a liquidation danger zone;
4) Leverage causes psychological stress and also by definition, does not allow you to take advantage of better price opportunities in the future (i.e. you can only take advantage of market opportunities by going further into leverage).

The most important consideration is:

5) Every single institution on this planet is trying to do the same thing and you are competing against them for exactly the same perceived low-risk, high-yield return on investment.

I am painfully aware that general funds flows are going into the corporate debt market, and this generally means that bond trading is going to get crowded. It is also very difficult to buy at the bid and sell at the ask for corporate bonds, although liquidity spreads on issues (such as Bombardier) are remarkably narrow (about a penny on average). Still, one cannot flip bonds around like one can with much more liquid equities.

In order to achieve outsized returns, one must always compete in marketplaces with less eyeballs and less capability for algorithimic investors to do their magic – and I do find that there have been some opportunities in the bond space as of late.

I will not go overboard doing this, however. The investment climate is not stressed enough and I generally prefer to make my investments in times of stress, such as what prevailed earlier this year and during Brexit.

Most of the retail market (at least locally here in the Greater Vancouver region) is getting into this game in the form of residential real estate – banks will give you money at 2.5%, you go buy a house with 20% down, and voila – you’ve leveraged yourself 4:1 on an asset. As long as your piece of real estate appreciates higher than 2.5% a year net of (not insignificant) carrying costs, you’re golden.

The leverage game usually (but not always) ends badly – the 2006-2008 blowup in the US residential real estate market was a great example. But a more modern example is with oil and gas producers that simply tried to squeeze too much juice out of their balance sheets – LINN Energy, Ultra Petroleum, Magnum Hunter, Sandridge Energy, etc. On the Canadian end we have a bunch of others, including some that are in the palliative care unit (best example is the company formerly known as PetroBakken, Lightstream Resources (TSX: LTS)). A lot of these oil companies are profitable, but they just ended up leveraging too deeply and financing brought them down.

Canadian Dollar vs. US Dollar thoughts

My USD allocation has crept up somewhat, but this due to appreciation of US-denominated holdings relative to the Canadian holdings. There were some minor purchases of US currency in the quarter which also added to the percentage. My policy with currency is to not pay too much attention to it other than keeping it at a band roughly between 30-70% CAD/USD. Appreciating Canadian dollars from the beginning of the year dragged portfolio performance somewhat, but this quarter the Canadian dollar was about the same. I have no big prognostications on the fate of the Canadian dollar and consider a 50/50 equilibrium to be perfectly satisfactory. I may change my opinion if the currency swings beyond 70 or 90 cents.

Anticipated future returns

In terms of future returns, I do not anticipate that my portfolio will achieve anywhere close to the returns that were achieved in the first half of this year – a stunning 33% year to date, most it achieved from March onwards. Still, if the prices of the assets in the portfolio march up to what I consider to be a fair value, there is a double-digit percentage that can still be realized and hence I am not particularly inclined to rapidly hit the sell button. Indeed, even if asset prices went nowhere over the quarter, the current yield alone would represent a passive gain of about 8% annualized with low risk, a lot better than sticking it in a zero-risk, 1% GIC.

Portfolio - 2016-Q2 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
10.5 Years (CAGR):+16.47%+5.07%+7.26%+2.13%+5.09%

Brexit – Impact

Market volatility has been high leading up to and including after the Brexit referendum results. The VIX has climbed up to around the 25 level which is above the average ambient temperature of 15, but not ridiculously high (last August, for example, there was a spike up to 50 and I’m struggling to remember what calamity was the order of that day).

The UK exiting from the EU causes uncertainty in the minds of money managers. Whenever uncertainty is high, the natural desire is to raise cash and reduce portfolio risk, so futures get sold. This triggers automatic liquidations of underlying equities and debt portfolios, which leads to broad-based asset price decreases as the liquidations occur. There also may be some margin liquidation going on for more over-leveraged players.

Eventually this vicious cycle ends – the trick is anticipating when the vicious cycle ends. I believe it will be sooner than later, although the choppyness of the market will continue to confuse most market participants into believing that we are either entering into the new dark ages, or a golden era of economic productivity when neither seems to be the case.

Canadian Preferred Share price appreciation nearly done

Preferred share spreads (in relation to government) have compressed significantly since last February and it appears that the macro side of the preferred share market has mostly normalized and accounted for the incredible drop of dividends on the 5-year rate reset shares due to the 5-year government bond rate plummeting (0.62% at present with short-term interest rate futures not projecting rate increases until at least 2018).

We are still seeing significant dividend decreases as rates continue to be reset.

I have looked at the universe of Canadian preferred shares (Scotiabank produces a relatively good automated screen) and further appreciation in capital is likely to be achieved through credit improvement (e.g. speculation that Bombardier will actually be able to generate cash indefinitely) concerns rather than overall compression in yields.

As such, one should most certainly not extrapolate the previous three months of performance into the future. Future returns are likely to primarily consist of yields as opposed to capital appreciation.

While investment in preferred shares, in most cases, is better than holding zero-yielding cash (in addition to dividends being tax-preferred), one can also speculate whether there will be some sort of credit crisis in the intermediate future that would cause yield spreads to widen again. If your financial crystal ball is able to give you such dates, you can continue picking up your quarterly dividends in front of the steamroller, but inevitably there will always be times where it is better to cash out and then re-invest when everything is trading at a (1%, 2%, 3%, etc.) higher yield.

I am also finding the same slim pickings in the Canadian debenture marketplace.

Valuations have turned into such that while I’m not rapidly hitting the sell button, I’m not adding anything either and will continue to collect cash yields until such a time one can re-deploy capital at a proper risk/reward ratio. If I do see continued compression on yields I will be much more prone to start raising significant fractions of cash again. Things are very different in 2016 compared to 2015 in this respect – in 2015 I averaged about 40% cash, while in 2016 I have deployed most of it.

Small re-inspection of Bombardier

The on-again, off-again rumours regarding a billion-dollar injection with the Canadian government is purely negotiation strategies on both parts. The government wants to invest, but they also want to do it in a manner that allows them to save face. Conversely, the controlling shareholders of Bombardier want the money (it will indirectly end up in their pockets), but they also do not want to lose control over the gravy machine.

There will be a happy equilibrium where the taxpayers of Canada will transfer wealth to the owners of Bombardier, but the structure of the arrangement is up for debate. My suspicion is that some sort of arrangement will be made as long as they keep a certain number of jobs in Quebec, the Class A share owners will not be compelled to convert into Class B shares.

The credit market has been much more kinder to Bombardier, to the point where they can raise capital at a very reasonable rate:

The Class B equity has been hovering at $2/share, with the control premium (Class A shares) being around 10% of late.

Floating rate preferred shares (TSX: BBD.PR.B) has been hovering around 8.4% yield, while fixed-rate with conversion risk (TSX: BBD.PR.C) has been hovering around 9.9% of late.

As I alluded to earlier, investors must make a distinction between revenues and profit, and Bombardier is focussed on revenues at the moment. They will continue to service their debt and preferred shareholders, but I do not believe equity holders will be receiving dividends anytime soon. There is also a significant overhang with the two Quebec deals, with a significant number of warrants outstanding at US$1.66 level – although these warrants are held by institutional owners (Quebec), this will be a valuation overhang which will serve to depress the maximum upside of the common shares. If it ever gets to the point where these warrants are exercised, it would buffer the serviceability of debt and preferred share dividends.

I am of the general belief that if Bombardier plods along and returns to a profitability at a level that is somewhat less than what they have touted in their 2020 vision, and that their C-series jet clearly has a “runway” of perpetual orders keeping the assembly lines busy, that BBD.PR.C would trade around the 8% level (or roughly $19.50/share). The credit markets are indeed pointing toward this direction.

Now the corporation just has to make money.

I am still long their preferred shares, but under the belief that a good quantity of upside has been realized by investors in relation to previous trading prices. I went long on preferred shares less than a year ago when there was a lot more gloom and doom, and having been called a “brave soul” by national media for doing so.

The very strange dawn of robotic marketing

This post is more of an experiment than anything from reading James Hymas’ May 25, 2016 post. A successful result will be me being sent a spam email by a robot. This is probably one of the most rarest times where receiving spam is a positive result!

On May 19, 2016, IGM Financial invested $50 million in Personal Capital, which is a robo-investing corporation.

Just so there is some information content in this post, there is clearly a scale where passive investing will deliver inferior absolute returns in relation to active managers. Although I have not done the detailed analysis (in terms of obtaining reasonable data in terms of capital flows and such), I would suspect we have already reached this point. Too much capital that is attracted to the main equities (TSX 60 and the like) will likely result in under-valuations in less liquid portions of the market – especially when there are market corrections and robotic investors decide to liquidate “roboticly” – i.e. without regard to price.

A very quiet May and some self-reflection

It has been a relatively calm month of May for me – I know the cliche of sell in May and go away has resonated in my mind, but my positioning is still quite defensive (very heavily weighted in preferred shares and corporate debt). One advantage of such a defensive portfolio structure is that it is relatively insulated to equity volatility.

The past three months have seen quite a significant performance gain and when there are gains this large I always ask myself whether it is sustainable. When I look at the fixed income components of my portfolio, I see higher room for appreciation from current levels as markets continue to normalize. For whatever reason, Canadian markets were heavily sold off in early February, especially in the fixed income space, and we are still continuing to see a normalization of these valuations.

There were a few missed opportunities on the way. I will throw out a bone for the audience and mention I was willing to pounce on Rogers Sugar (TSX: RSI) when it was going to trade below $3.75/share, but clearly that did not happen (sadly, its low point was $3.84/share) and it has rocketed upwards nearly 50% to $5.71 presently on the pretense that Canadians are going to have a sweeter tooth for sugar rather than corn sweeteners in the upcoming months (which is true – their last quarterly financial statements show an uptick in business and this should continue for another year or so and the market has priced this in completely).

My overall thesis at this point is that the aggregate markets will be choppy – there will not be crashes or mega-rallies, but there will be lots of smaller gyrations up and down to encourage the financial press that the world will be ending or the next boom is starting. When looking at general volatility, the markets usually find something to panic about twice a year and we had a large panic last February. The upcoming panic would likely deal with the fallout concerning the presidential election.

If net returns from equity are going to be muted, it would suggest that the best choices still continues to be in fixed income. The opportunities at present are not giving nearly as much of a bang for the buck in terms of risk/reward, but there are still reasonable selections available in the market. A good example of this would be Pengrowth Energy debentures (TSX: PGF.DB.B) which is trading between 94 to 95 cents of par value. Barring crude oil crashing down to US$30/barrel again, it is very likely to mature at par on March 31, 2017. You’ll pick up a 6% capital gain over 10 months and also pick up some interest at a 6.25% coupon rate. Worst case scenario is they elect a share conversion, but with Seymour Schulich picking up a good-sized minority stake in the company, I very much doubt it. (Disclosure: I bought a bunch of them a couple months ago at lower prices).

In the meantime, I am once again twiddling my thumbs in this market.

Reviewing one of my year-end predictions

For my December 31, 2015 new year’s predictions, I said the following:

* Next US President: Donald Trump will be elected as the next president of the United States, by a considerable margin. This prediction is not an endorsement of him, but it is a reflection of my political analysis and my take on what is happening in the United States at present.

I’ve been telling people since September 2015 that Donald Trump would not only win the nomination, but the presidency of the United States. The general election result is not even going to be close – Trump will get at least 350 electoral votes.

Best places to park short-term, nearly-risk free Canadian cash

As a result of the Bank of Canada’s decision to hold the overnight interest rate target at 0.5%, options for Canadian dollar cash balances are bleak.

Cash can always be held at zero yield and would be immediately available for deployment.

There are also financial institutions that will allow you to lock your money in for a 1-year GIC and earn around a 1.25% risk-free return. However, the sacrifice in liquidity in the event that you would want to deploy such capital is unacceptable from an investment perspective. One can also purchase a cashable GIC (typically redeemable within 30 days after purchase) that earns slightly less yield – my local BC credit union offers such a product with a 0.85% yield.

I was curious as to the best exchange-traded products that would offer some yield at the lowest risk.

There are basically two options. They are (TSX: XSB) and (TSX: VSB). Both are short-term government bond funds. VSB is significantly cheaper on management expenses (0.11% vs. 0.28% for XSB), and both portfolios offer similar durations (roughly 2.8 years), and VSB has slightly better credit quality (55% weight to AAA instead of 50% for XSB). VSB should eventually have a better net yield after expenses (roughly 1.1%) due to the smaller MER. While the 1.1% net return is small, it is better than zero and is nearly risk free – there is anti-correlation between general market movement and the likely price movement of this fund – the capital gain on VSB should rise if there was some sort of crisis due to the heavy government bond exposure of the fund.

Another alternative which is deceptively cash-like but will not serve any purpose if you wish to save money for some sort of financial crisis is the high-quality corporate bond fund also offered by Vanguard (TSX: VSC). Although VSC will offer you another 80 basis points of yield, it has the disadvantage of likely having a liquidity premium in the event there was some adverse financial event – i.e. your cash-out price will likely be materially less than NAV.

All three ETFs trade at modest premiums to NAV.

Bombardier update

It is virtually a given now that Bombardier will announce that Delta Airlines has ordered a bunch of C-series jets. The announcement will probably be Thursday as there is no reason for them to move back the earnings announcement unless if they want to have a huge feel-good party for their annual general meeting on April 29th.

However, in terms of pricing of securities, “buy the rumour, sell the news” is the cliche to follow here. Most (if not all, or even an over-reach) of this news has been baked into current market pricing, which means that investors will now have to focus on the finer details, such as: how much of a price concession did Bombardier make in order to ink the sale on the contract?

These price concessions inevitably will affect profitability of the overall entity, and while it is nice to sell jets at a near break-even profit margin, the corporation needs to eventually make money.

However, Bombardier has solved one of their massive problems which was a chicken-and-egg type matter: they now have an American purchaser of their jets, which is a lot better than how things were portrayed for them half a year ago. More importantly, they are current in a position to raise capital again from the public marketplace.

I will point out in a reduced profit scenario that the security of income from the preferred shares (or even the bonds) looks more favourable from a risk-reward perspective than the common shares. Back in February, investments were selling preferred shares (the 6.25% Series 4) at 18% yields, but today it is at a much more respectable 10%. I’d expect this to get around 7-8% before this is done.

My investment scenario is pretty much resolving to my initial projections – just have to continue to be patient and then the decision is going to be whether I sell and crystallize the gain, or just be content to collect coupons and sit on a large unrealized capital gain.

(Update, April 28, 2016): As expected, Bombardier has announced that Delta has purchased 75 C-Series jets with an option to pick up another 50. This is a huge win for the corporation, but again, the question remains: how much money will they actually be able to make when they produce these things? Let’s hope they’re able to actually get the production lines going and crank them out without issues, unlike their Toronto street cars…

I’ve glossed over their Q1-2016 financial statements, and as expected, they still show an entity that is bleeding cash, albeit they have a lot of liquidity available – US$4.4 billion in cash and equivalents when you include Quebec’s $1 billion investment. They’ve got US$1.4 billion due in 2018 on their March 2018 debt (coupon 7.5%) but this is trading at around a 6.5% YTM at the moment so they can refinance it.

The company expects the C-series program will consume $2 billion further cash for the next five years, of which the province of Quebec has generously chipped in a billion. After that they expect things to be cash flow positive. Who knows if this will happen!

(Update, April 29, 2016) The market has “sold the news” as I expected. I generally believe the common shares will have a significant drag compared to the historical charts due to dilution, but the preferred shares and debt should normalize to “reasonable” yield levels simply due to their standing being in front of line on the pecking order. This is assisted with the Beaudoin family’s very rational self-interest in maintaining their control stake with the Class A common shares which will translate into outwards cash flows being paid as scheduled. If the Government of Canada decides to chip in a billion dollars, it is icing on the cake, but it is not required as Bombardier will be busy for at least the next four years producing C-series jets. Assuming they can actually execute on the production and the jets live up to their reported (superior to competition) specifications, they should be good to at least pay off debts and preferred share dividends.

Each additional order of C-Series jets will be making profitable margin contributions and as these orders continue to come in, the common shares, preferred shares and debt will ratchet up, accordingly. I still believe they are under-valued but not nearly as much as they were late last year when everybody was in doom and gloom mode! The preferred shares are the sweet spot in terms of risk-reward.

Teekay Corporation – Debt

Over the past couple months I have accumulated a substantial position in Teekay Corporation’s (NYSE: TK) unsecured debt, maturing January 15, 2020. The coupon is 8.5% and is paid semi-annually. I am expecting this debt to be paid out at or above par value well before the maturity date. The yield to maturity at my cost I will be receiving for this investment will be north of 20% (and obviously this number goes up if there is an earlier redemption).


I was really looking into the common shares and was asleep at the switch for these, especially around the US$7-8 level a month ago. Everything told me to pull the trigger on the commons as well, and this mistake of non-performance cost me a few percentage points of portfolio performance considering that the common shares are 50% above where I was considering to purchase them. This would have not been a trivial purchase – my weight at cost would have been between 5-10%.

However, offsetting this inaction was that I also bought common shares (technically, they are limited partnership units) of Teekay Offshore (NYSE: TOO) in mid-February. There is a very good case that these units will be selling at US$15-20 by the end of 2017, in addition to giving out generous distributions that will most likely increase in 2018 and beyond.

The short story with Teekay Corporation debt is that they control three daughter entities (Teekay Offshore, Tankers, and LNG). They own minority stakes in all three (roughly 30% for eachUpdate on April 26, 2016: I will be more specific. They have a 26% economic interest and 54% voting right in Teekay Tankers, a 35% limited partner interest in Teekay Offshore, and 31% limited partnership interest in Teekay LNG), but own controlling interests via general partner rights and in the case of Tankers, a dual-class share structure. There are also incentive distribution rights for Offshore and LNG (both of which are nowhere close to being achieved by virtue of distributions being completely slashed and burned at the end of 2015). If there was a liquidation, Teekay would be able to cover the debt with a (painful) sale of their daughter entities.

Teekay Corporation itself is controlled – with a 39% equity stake by Resolute Investments, Ltd. (Latest SC 13D filing here shows they accumulated more shares in December 2015, timed a little early.) They have a gigantic incentive to see this debt get paid off as now do I!

The mis-pricing of the common shares and debt of the issuers in question revolve around a classic financing trap (similar to Kinder Morgan’s crisis a few months ago). The material difference that the market appears to have forgotten about is that Teekay Offshore (and thus Teekay Corporation’s) business is less reliant on the price of crude oil than most other oil and gas entities. The material financial item is that Teekay Offshore faces a significant cash bridge in 2016 and 2017, but it is very probable they will be able to plug the gap and after this they will be “home-free” with a gigantic amount of free cash flow in 2018 and beyond – some of this will go to reduce leverage, but the rest of it is going to be sent into unitholder distributions assuming the capital markets will allow for an easy refinancing of Teekay Offshore’s 2019 unsecured debt.

At US$3/share, Teekay Offshore was an easy speculative purchase. Even at present prices of US$7/share, they are still a very good value even though they do have large amounts of debt (still trading at 16% yield to maturity, but this will not last long).

The absolute debt of Teekay Corporation is not too burdensome in relation to their assets, and one can make an easy guess that given a bit of cash flow through their daughter entities, they will be in a much better position in a couple years to refinance than they are at present. They did manage to get another US$200 million of this 2020 debt off at a mild discount in mid-November 2015, which was crucial to bridging some cash requirements in 2016 and 2017. The US$593 million face value of unsecured debt maturing January 2020 is the majority of the corporation’s debt (noting the last US$200 million sold is not fungible with the present $393 million until a bureaucratic process to exchange them with original notes) – I’d expect sometime in 2017 to 2018 this debt will be trading above par value.

The debt can be redeemed anytime at the price of the sum of the present values of the remaining scheduled payments of principal and interest, discounted to the redemption date on a semi-annual basis, at the treasury yield plus 50 basis points, plus accrued and unpaid interest to the redemption date.

This is a very complex entity to analyze as there is a parent and three daughter units to go through (and realizing that Teekay Corporation’s consolidated statements are useless to read without dissecting the daughter entities – this took a lot of time to perform properly). I believe I’ve cherry-picked the best of it and have found a happy place to park some US currency. I still think it is trading at a very good value if you care to tag along.