Canadian Convertible Debentures – Maturing 2023

I’ve been looking at the Canadian Convertible Debentures that are scheduled to mature between now and December 31, 2023. Some observations:

Medexus (TSX: MDP.DB, October 16, 2023 maturity) – This will mature on Monday for a cash payment at 125 of par (a very unique offering). To be honest, this one surprised me in that I was expecting some sort of distressed debt situation, but the company managed to scrape enough pennies together through a newly minted credit facility in early March 2023, some decent financial results posted on June 2023 and finally a secondary equity offering that concluded a week ago – striking while the equity was hot. Management navigated this whirlpool quite well, and at 24 employees, each person’s individual effort really counts for these types of companies. Before they get delisted I’ll post their chart, again noting that payout at maturity is 125 of par:

The rest are December 31, 2023 maturities:

Aecon Group (TSX: ARE.DB.C) – $184 million due. The company has a $600 million credit facility, of which $188 million was drawn out on June 30, 2023. Conversion is at $24/share and the stock is at $10.59/share, so very likely a cash maturity. Even a mediocre execution in the next six months will not result in these debentures getting in trouble and hence the 99% of par trading price at present. This engineering firm has been kind of lost since the Canadian government shot down its acquisition by a Chinese national firm many years back, but they continue to meander along despite being in a market where there is going to be plenty of demand going forward. The problem is that engineering firms need to retain talented individuals that need enough motivation to stay in such firms, which facilitates both the precise costing and execution of projects. It is one thing to get contract wins, it is another thing entirely to discover that your costing is so out of whack that in order to execute on such projects that you’re going to be losing money. A great example of this is the construction of the North Vancouver sewage plant which appears to be a case of a company being completely out of its depth.

Firm Capital (TSX: FC.DB.G) – $22.5 million due. Conversion is $15.25 with the stock price at $9.80. Firm Capital has many issues of convertible debentures outstanding at various maturities, trading roughly 4-5% above the government yield curve. The company proactively sent out a financial release on September 19, 2023 which attempted to reassure the market that despite their mortgage portfolio outstanding shrinking in size, that they are solvent. In particular, a $180 million credit facility remains untapped and combined with cash, this is comfortably facilitating a cash maturity of this particular issue. However, it is pretty clear that FC is going to have to make some tough choices – they traditionally have funded their loans through convertible debentures at really cheap coupons – the latest ones (FC.DB.K, FC.DB.L) were a combined $90 million out for 5 years with a 5% coupon with a conversion price well out of the money ($17.75 and $17.00/share!) – the last offering was done in January 2022 and this was PERFECT timing by management – there is no chance at all of them doing this again in the current rate environment.

Northwest Healthcare Properties REIT (TSX: NWH.DB.G) – $125 million due. Conversion is $13.35/unit with a current unit price of $4.57. The quick summary here is that the trust is in serious financial trouble. I remember this REIT being one of these “dividend starlings” that the usual retail crowd hyped up on financial twitter and the like, and unless if management is skillful, this one is potentially heading down to a zero. With specific regard to the ability to redeem this debenture, the trust is hitting a financial limit with its term facility (on June 30, 2023 there is $165 million available to be drawn). The minutiae in their last quarterly filing includes distressed paragraphs like this:

On August 2, 2023, the REIT executed an interim non-revolving tranche under its revolving credit facility to increase availability by $50.0 million. The tranche matures in October 2023 and can be extended until January 2024 under certain circumstances. The facility is secured by certain assets in the REIT’s Americas portfolio and it bears interest ranging from 10.6% to 13.8%.

… 10.6% to 13.8%! Ouch!

Subsequent to June 30, 2023, the REIT extended the maturity date of its revolving unsecured credit facility with an outstanding balance of $125.0 million credit facility by one year to November 2024, The facility bears interest ranging from 8.73% to 10.01% (previously 8.23% to 9.51%).

Banks are ratcheting the screws on the trust…

They released a September 22, 2023 financial update trying to assure the market that with some “non-core” asset sales coupled with some other measures they are “fortifying” the balance sheet, but there is indeed a danger that this convertible debenture will be partly redeemed in units by the company. While writing this post, I notice the “fantastic” SEDAR Plus is down for maintenance so I could not confirm directly that the indenture allows for this, but a previous MD&A does allude to this being an option for the company. The two other outstanding convertible debenture issues (maturing roughly in 4 years) are trading at a YTM of 12.5% so refinancing is not going to be in the cards for this REIT. My guess is that they squeeze out a cash maturity but good luck in the future!

World is choking on US government debt

Today in finance we have 30-year government bond yields the highest they’ve been in a long time (early 2011 to be precise):

This yield is a fundamental variable in a lot of risk-free calculations out there. The higher that yield goes, the lower the capitalized asset prices go! After all, if the US Government is going to give you 4.5% a year for 30 years, why should you bother investing in NVidia that is trading at 50 times earnings?

My suspicion, despite all of the dysfunction about the congressional debt limit, is that the world is finally reaching a limit in terms of how much US debt they can swallow.

This doesn’t bode well for Canada either – although our fiscal situation is better than what is going on in the USA, given our economic linkage to the USA we are going to be along for the ride.

There are potential future outcomes where inflation is not contained and rates have to rise further. Already we are seeing the economic stress and strain of 5% short term interest rates. Economically it is akin to a submarine approaching crush depth. If inflation refuses to taper off (just look at the last CPI report and their components), Tiff Macklem (and Jerome Powell) will have to continue plunging the submarine deeper.

One frequently cited counterargument I hear is that by diminishing demand from higher interest rates (people that are choked with debt will have to spend their money servicing debt instead of engaging in discretionary consumption) will have an effect on lowering inflation. This may not necessarily be true considering that it does not factor in the supply side of the argument. For example, in the current Canadian real estate market, demand (based off of sales volume) has definitely tapered lower, but prices have remained relatively high because there has been an equivalent decrease in supply – listings are very low. Currently in that specific market we are at a sort of “Mexican standoff” where there is no volume at the current price.

However, for the overall economy, it appears that non-discretionary components of inflation are continuing to increase in price while discretionary items are being held in check. A great example of this is mobile phone plan pricing – instead of getting 10 gigabytes of data for $40 a year ago, you can now get 20 gigabytes for the same price. That’s a deflation of 50%!

Survival is the name of the game here – look carefully at your portfolio and avoid companies with excessive debt leverage. Keep that cash handy. Finally, the only glimmer of green that I see in the markets today is that of crude oil futures – at US$90/barrel for spot WTI, many of the well-known names out there are pulling in a huge amount of cash flow.

Crown Capital Partners debenture refinancing proposal

A hat-tip to Frank L. for pointing out that Crown Capital Partners (TSX: CRWN), a little-known microcap financing company, on April 11, 2023 issued a proposal to refinance their $20 million face value of convertible debentures trading as (TSX: CRWN.DB).

The salient features they are offering are:

* Extending the maturity date of the Debentures from June 30, 2023 to December 31, 2024;
* Amending the interest rate on the Debentures from 6% to 10% effective July 1, 2023;
* Removing the conversion right of the Debentureholders; and
* Removing the right of the Corporation to repay the principal amount of the Debentures in common shares of the Corporation (“Common Shares”) on the new maturity date or any redemption date.

This company wasn’t on my radar but I gave it a closer look and glossed through their annual financial statement.

First, I noticed that there is quite a bit of consolidation going on in their entity (which means it takes a lot of time to dig through – time I, quite frankly, did not want to spend). A material amount of their assets are in the non-current category consisting of their investments (Crown Partners Fund, leased distributed power equipment, and other property and equipment). Needless to say it isn’t exactly of the variety that you can put it up on Ebay and dump for some quick cash.

The other thing that struck out at me is that they had $7.2 million cash on their balance sheet, and $11.9 million in mortgages payable (November 2023), $18 million in credit facilities (long-dated), and of course the $20 million in convertible debentures.

The credit facility’s fine print, is the following:

Effective February 7, 2023, the Corporation entered into a new senior secured corporate credit facility with Canadian Western Bank of up to $43,500 to be used to fund a full repayment and cancellation of lender commitments in respect of the Crown Credit Facility, support working capital and growth capital requirements of the Corporation and its operating businesses, and to fund the Corporation’s remaining capital commitment in respect of Crown Power Fund. The new senior secured corporate credit facility replaced the Crown Credit Facility and includes an amortizing term loan of up to $30,000 with a maturity date of February 7, 2028, an operating loan of up to $10,000 with availability subject to margin condition restrictions, and a letter of credit facility of up to $3,500. The term loan is comprised of an initial advance of $25,000 plus $5,000 to be advanced upon request by the Corporation prior to June 30, 2023. The term loan and the operating loan provide financing at variable interest rates based on Prime Rate plus 165 bps to 265 bps and 200 bps to 300 bps, respectively, and feature a customary set of covenants.

(You want to know why Canadian Western Bank (TSX: CWB) is trading like it will go First Republic Bank (NYSE: FRC) any moment?)

Pay attention to the rate paid. Prime is 670bps at the moment, so the term loan is 8.35% to 9.35% and the operating loan is 8.7% to 9.7%, floating.

In addition, you have the mortgage payable which has the following fine print:

Effective May 27, 2022, the Corporation entered into an agreement for a mortgage payable of $11,900 that is secured by the value of property under development, has a maturity date of November 30, 2023, and bears interest based on Prime Rate plus 570 bps (with a floor of 8.40%) per annum.

Prime plus 570bps is a 12.4% mortgage! Holy moly!

So why on planet earth would the convertible debenture holders agree to an unsecured 10% coupon when clearly the cost of capital for the other secured lending the corporation is taking is at much higher rates and you lose the (nearer) maturity date advantage? They generously offer a 1% consent fee for a yes vote!

The last thing I’ll point out is that they spent $24.8 million on share repurchases over the past two calendar years. Money that could have been better spent on… perhaps redeeming this debt?

The debentures are really illiquid, the stock is unshortable, and I have no positions in this company, nor do I intend on taking any.

Yield-seekers – a 13.3% coupon on investment-grade debt!

This is a couple months late, but one of the casualties of the high-CPI environment is the issue of debentures that Constellation Software (TSX: CSU) made many years ago.

At the end of every March, they update it to CPI plus 6.5%. This year, bondholders will get a coupon of 13.3%!

CSU has the right to call the debt with 5 years’ notice in the last 15 days of March each year, and otherwise it matures on March 2040.

If they exercise this right, and if the 13.3% coupon keeps up for the next five years (doubtful), you are looking at a 3.3% yield to maturity, due to the fact that the debt is trading at 38 cents over par.

But for current yield seekers, I find some humour that the largest coupon available on the debt market right now is from a top-rated company.

The next TSX-traded debt issuer that has the largest coupon is Valeo Pharma (TSX: VPH) with a 12.0% coupon. With a market cap of $44 million, it is miles away from the financial condition that CSU is in.

Long-term government bonds

Yields are now higher on 30-year government bonds than they have been since 2011.

There was a time where you could put money away into government debt and earn a satisfactory return on investment, especially if you are into the annuity-type investments. For example, if you bottom-ticked the 30-Year US treasury bond in September 1981, your yield to maturity would have been north of 15%. Ignoring the coupon differential (as those bonds surely at the time would have been trading at a discount), pouring a million dollars into fixed income would yield off $150k/year for the next 30, virtually guaranteeing a high cash stream.

At the same time, your dreams of going into margin to buy such a financial product would have been unattractive because short term rates would have spiked up to 21% at the time. Speculating on buying 30-year government debt was exceptionally difficult at the time – high inflation, a massive recession, and just doom and gloom everywhere. Of course, such times tend to be perfect for buying assets which are being liquidated wholesale.

Timing the market is always subject to psychological urges and always looks easier in retrospect. One year earlier, in September 1980, the same bond yielded around 11%. At that time, CPI inflation from 1979 to 1980 averaged 13.5% and such a long-term investment would seemingly have been locking in a real negative rate of return. Had you invested in the 11% yielding long bond at the time, over the course of the following year you would still be sitting on significant capital losses (about 25%) a year later and looked quite stupid.

I don’t think we’re going to get to that magnitude of interest rates, but there is going to be a parallel between how CPI persists, and the continuing downward slope of the yield curve. It doesn’t appear to be the right time to pounce. It’s just not painful enough.

Don’t get me started on whoever got trapped into buying these things a year ago when yields were less than 2% – they’ve lost over a third of their capital at present. A large cohort would be pension funds that have gotten annihilated on fixed income, coupled with insurance companies that keep the bulk of their capital into the same financial instruments. Look to see massive losses on the comprehensive statements of income from these entities when they announce their upcoming quarters.