KCG, it was good knowing you (Eulogy)

The merger closed yesterday and I received proceeds from the equity and debt today.

The equity I had purchases between $9-11/share. My first stake in the company was back in Q4-2012!

From my debt purchase at 90.5 at the end of June 2016 to 13 months later, resulted in a capital gain of 13.1% plus the 7.6% current yield, made for a 20.7% CAGR investment on a senior secured debt, first in line, on a cash flow positive entity. I’ll miss you.

Bombardier Yield Curve and Preferred Shares

The yield curve of Bombardier continues to compress:

Despite all of the negative press concerning their trade war with Boeing for the C-Series jets, it appears that the credit market is thinking that the credit side of Bombardier is quite secure – offering less than 7% for 8-year money. The company can easily raise capital with its current yield curve.

The preferred shares have had some interesting action lately, and this is because of the repricing of the BBD.PR.D dividend – because of (from the company’s perspective) an ill-timed rapid increase of the 5-year Government of Canada yield curve, their BBD.PR.D series will be giving out 3.983% on a $25 par value of dividends. Around July 10th when the market was blissfully unaware of the dividend adjustment (as they apparently didn’t read press releases), this would have translated into a 10.8% eligible dividend yield.

It is because of this that the BBD.PR.C series has traded down – there is obvious arbitrage between the C-yields and the D-yields. They were originally trading a full 200 basis points away from each other but this has now converged to about 50 basis points which is more reasonable (BBD.PR.C is worth more if you plan on interest rates to decrease, while the D’s are better if you expect them to rise in 4.9 years).

In relation to Bombardier’s bond yield curve, the preferred shares looked extremely cheap (especially the BBD.PR.D series at 10.8% yield!). Now it is around 9.3%.

Disclosure: I own some BBD.PR.C and BBD.PR.D.

State of the Canadian Debenture Market

I find the Financial Post’s compilation of Canadian exchange-traded debentures to be a very handy list to refer to. It is not comprehensive (there are a few issuers here and there missing) but for the most part is a full snapshot of the market environment.

Looking at the list, I think it is a very good time for Canadian companies of questionable credit quality to be issuing debt. Most of the debt on this list is trading at yields that do not properly represent (my own evaluation of) their risk.

Accordingly my research time is increasingly on the equity side of things in the non-indexed space. A great example of my readings included the Kinder Morgan Canada prospectus, worthy of a future post!

With regards to the debentures, I’ve sorted the debt by yield to maturity and decided to arbitrarily cut things off at 8%:

IssuerSymbolCouponMaturityYTMPithy Notes
Discovery AirDA.DB.A8.38%30-Jun-18118.28%Way behind secured debt, no control
Lanesbourough REITLRT.DB.G5.00%30-Jun-2259.10%Insolvent
Gran Columbia Gold CorpGCM.DB.U1.00%11-Aug-1843.99%81% mandatory equity conversion
Primero MiningP.DB.V5.75%28-Feb-2021.85%Operational mess, solvency issues
Argex Mining Inc.RGX.DB8.00%30-Sep-1919.07%Illiquid, no revenues!
Toscana EnergyTEI.DB6.75%30-Jun-1817.27%Senior Debt to cash flow is high
Gran Columbia Gold CorpGCM.DB.V6.00%02-Jan-2015.14%I own this
Westernone EquityWEQ.DB6.25%30-Jun-2013.94%Likely equity conversion June 30, 2018
Entrec Corp.ENT.DB8.50%30-Jun-2113.02%Cash flow negative, senior debt high
Temple HotelsTPH.DB.D7.75%30-Jun-1711.78%One month to maturity
Difference CapitalDCF.DB8.00%31-Jul-189.56%Payback not certain
Temple HotelsTPH.DB.E7.25%30-Sep-179.47%4 months to maturity
Fortress PaperFTP.DB.A7.00%31-Dec-199.22%Never figured them out
Temple HotelsTPH.DB.F7.00%31-Mar-188.11%How much $ does Morguard have?

I really don’t see anything worth locking capital into in this table at present prices. I do own one of these convertible debentures, but it is at a price where I would not buy (or sell) – my purchase price is from much lower prices and it is the only debt on this list that gives a warm and fuzzy “secured by all assets and nobody can step in front of me” arrangement.

I also note that the table is missing Yellow Media and Grenville Royalty which are both trading at 9% and 16%, respectively, but they are both unattractive for various reasons.

Toys R Us – Not for me

Most people are familiar with the Toys R Us franchise of stores – they sell toys and baby stuff. The Wikipedia entry has a good summary.

Their equity is privately held, but they are still required to report publicly because of debt covenants.

Their financial summary is more grim. They are being slaughtered by Amazon and other online retailers, so their heavy physical presence is causing an erosion of sales and pricing power to the point where they are no longer making money during most of the year.

For instance, from the end of January to the end of October (9 months) in both 2016 and 2015, the company does not make money when factoring in amortization (those physical stores and logistics still need upkeep). The interest bite takes an even bigger chunk out of the corporation.

So the Black Friday and Christmas season is critical. It makes the whole year worthwhile in terms of profitability. Even then, in the past couple years it has not been enough to offset losses of the previous 9 months (In 2016 even when factoring in CapEx and interest, they were slightly short of generating cash).

For the most recent holiday season, same-store sales in the all-critical Black Friday and Christmas period were down 2.5% in the USA and more so internationally. This clearly is not a good trend, and one has to ask whether it will continue or whether it was a one-off thing.

I’m ignoring the fact that their balance sheet is a leveraged mess.

Looking at their latest 10-Q, we have an entity in a negative equity situation (negative 1.6 billion), $420 million cash on the asset side and $5.5 billion in long-term debt.

This is a huge mess. The vast majority the debt is secured. There are convolutions of financings behind the various corporate entities under the holding firm, but suffice to say, it is about as leveraged as things get without getting recapitalized. I believe a recapitalization is inevitable.

Somehow, in August of 2016, they managed to convince the 2017 and some of the unsecured 2018 debtholders to exchange their debt for senior secured notes maturing later in time.

It is the 2018 unsecured notes (7.375% coupon) that I was looking at. They mature on October 15, 2018 and there is US$208 million outstanding (about half decided to exchange their debt for 90 cents of par value of secured debt).

The following is a chart of their trading since the exchange offer was floated:

The debt, at the asking price, has a yield to maturity of 11.3%, and a term to maturity of 1.52 years.

This looked like a Pengrowth-ish type situation where you have unsecured debt that may trump the secured debt on the basis of maturity, rather than security. There is a credit facility that has around $630 million remaining that could pay the October 2018 maturity.

Sadly, the risk of a spontaneous credit meltdown is preventing me from purchasing the unsecured debt. One can also make a legitimate case that Toys R Us will burn through enough cash to prevent them from paying off the October 2018 unsecured debt (they have to accumulate inventory for the that Black Friday / Christmas season and this will be when they need the capital the most).

Hence, I will pass purchasing this debt. I’m going to guess it will trade lower over the next 18 months.

Difference Capital – Year-End 2016 Report

I wrote about Difference Capital (TSX: DCF) in an earlier post. They reported their 4th quarter results a couple days ago and their financial calculus does not change too much. They have CAD$29.6 million in debentures outstanding, maturing on July 31, 2018. Management and directors own slightly under half the equity, and thus they want to find a dilution-free way to get rid of the debt.

At the end of 2016 they have about CAD$14.4 million in the bank, plus $60.8 million (fair value estimate of management) in investments. One would think that in 2017 and the first half of 2018 some of these investments could be liquidated to cover the debentures. The situation is similar to the previous quarter, except for the fact that they’ve retired about 10% of their debt in the quarter, which is a positive sign.

Due to their investment portfolio not making any money (they have been quite terrible in this respect), they have a considerable tax shield: $186.3 million in realized capital losses, plus $41.9 million in non-capital losses which start to expire in 2026 and beyond. If you assume that they can realize both of these at half of the regular tax rates (I just quickly assumed 13% for the capital losses and 26% for the net operating losses), that’s $17.6 million.

Considering the market cap of the corporation is $26 million, there’s a lot of pessimism baked in. Mind you, there are a lot of corporations out there with less than stellar assets, a ton of tax losses, and tight control over the corporation (TSX: AAB, PNP quickly come to mind) so it is not like these entities are rare commodities. The question minority shareholders have to ask is whether the control group wants to bleed the company through salaries, bonuses and options or whether they are actually genuinely interested in profitably building the corporation (in all three cases, to date, has not been done).

Pengrowth Energy Debentures – cash or CCAA

A quick research note. Pengrowth Energy debentures (TSX: PGF.DB.B), something I have written in depth about in the past as being one of the easiest risk/reward ratios in the entire Canadian debt market, has reached the “point of no return” with regards to its redemption. They are to be redeemed on March 31, 2017 for cash (and an extra half year of accrued interest at 6.25% annually). For the company to exercise its option to redeem them for shares (of 95% of TSX VWAP), they needed to give 40 to 60 days of notice from the redemption date.

(Update, February 21, 2017: Pengrowth announced they will be redeeming the debentures on maturity at March 31st. Also on their senior debt covenants, it looks like somebody is trying to steal the company… they might be forced into making an equity offering.)

My math says that the next market opening, February 20, 2017, will be 39 days before March 31st.

Barring some sort of mis-interpretation of the legalese, this means that the company must redeem this debt (CAD$126.6 million) for cash. The alternative is CCAA, which I do not deem is likely considering Seymour Schulich would likely have something to say about that particular option (he controls 109 million shares or 19.9% of the company at present). There is no longer any time to negotiate an extension with debenture holders.

This debenture issue was acquired as a result of the NAL acquisition back in 2012. It was originally CAD$150 million but they company repurchased some at a considerable discount to market earlier this year.

Pengrowth is in the middle of a silent negotiation with their senior creditors as they are in covenant troubles. Their senior creditors will no doubt be unhappy with the fact that some company cash is going towards a junior creditor.

Sadly I have no good candidates for re-investment at this time. Suggestions appreciated.

Bombardier credit market completely out of the woods now

Bombardier’s bonds have traded considerably higher since their latest 8.75% bond issue (maturing December 2021) which is now trading at a premium to par.

They have to be looking at this and thinking about securing further long-term funding. It also gives them a lot more negotiating power with the Canadian government, who wants to inject some more money into the corporation (whether they need it or not) for political reasons.

Floating rate preferred shares are yielding 8%, while the fixed rate is yielding 9% (quite the premium to pay for a floating rate). Given the difference between the bond market and the preferred share market, I still believe the preferred shares are trading slightly cheap to what they actually should be.

The equity is also receiving quite a bid as of late, despite the massive warrants overhang in their earlier year government fundings. If they receive another large order for C-Series aircraft (something slightly larger than Air Tanzania), it is quite likely the stock will rise even further.

The rise of interest rates

Something that was a direct result of the US Presidential election was the entire yield curve lifting. The short end in the USA will likely change upwards 0.25% on December 14.

Canadian interest rates are inevitably linked to US interest rates due to the very close economic connection between both countries.

I generally do not profess to have a good radar when it comes to interest rates, but I do observe the trends and notice that the 5-year Canadian government bond yield (which determines most, if not all, rate-resets on Canadian preferred shares) has eclipsed 1.00% for the first time in over a year:

5yrrates

The last time it reached 1% was briefly in November 2015, and then before that it was briefly above 1% in May and June of 2015. Before that it was only consistently above 1% before January 2015.

The question is whether this is a short-term rise up as a knee-jerk reaction to Donald Trump’s election, or whether this will be something that will be sustained (and if so, rates will likely not settle at 1% and will head higher). I have no idea what will be happening.

Pengrowth Debentures – To be redeemed

(Update, December 21, 2016: The proposal was shelved because PGF’s senior debt holders did not want cash to go to junior creditors.)

A short couple months ago I wrote an article about a “very likely 12% annualized gain” in the form of buying (TSX: PGF.DB.B) at 97 cents.

So it looks like I gave up that return (at least with some idle cash holdings, I do have a position from far cheaper prices earlier this year) as management announced today they are seeking consent from debtholders to allow the company to redeem them as if they have matured on March 30, 2017 (i.e. you’d get about 3 months of accrued interest paid out to you immediately).

So it looks like debtholders will be paid off at $1.03116 per dollar of debt. The redemption will occur on December 30, 2016.

The choice of getting paid today vs. getting paid the same amount in three months is a no-brainer: take the money today and move on.

I have no idea where I will re-invest the proceeds. There was nothing nearly as “safe” as this specific debt issue. Any suggestions out there?

Dredging the market for corporate debt

I’ve been doing an exhaustive examination of the available publicly traded debt from US corporations. I am specifically looking for debt that has maturity lengths of between 2-8 years, and the underlying issuer is relatively solvent. The actual parameters I used for the screen I’ll leave aside, but there were a lot of issuers to do some quick research on to see whether they were worth further investigation.

The “relatively solvent” criterion allows me to exclude companies that are basically operating entities that are encumbered with a gigantic amount of debt relative to tangible book value. These entities typically exhibit goodwill and intangibles far in excess of what the stated equity is, which means that the entity was likely a result of a previous leveraged buyout or some sort of financial restructuring to extract the maximum capital of the entity.

A good example of this is Toys R Us, a completely leveraged mess of a financial entity as a result of a leveraged buyout years ago. If you like anti-depressants, please take them while you read their last quarterly report. I would not go anywhere near their unsecured debt. Somehow this entity actually warrants a market value of an 11% yield to maturity on their 2-year debt. Amazing.

I am not interested in these entities unless if they were generating a sufficient amount of cash in relation to their debt, and in most cases they do not. This means that refinancing risk is going to be crucial for these entities – while today they might get the financing, tomorrow they might not. It is at those moments where an investor will make the optimal risk/return ratio. Today an investment will just result in a mediocre risk/return.

There were a lot of offshore drillers that are clearly in trouble, and a lot of energy-related entities in trouble. In general, I am not interested in these (in addition to having enough exposure to energy bonds via Teekay debt).

Finally, anything that did seem to be a reasonable candidate had a chart resembling this:

twi-debt

I picked Titan International (NYSE: TWI) just as an example and not something I am interested in purchasing (at current prices). It is an automobile parts manufacturing company and is fairly easy to analyze – $200 million cash in the bank, a $60 million debt issue due in January 2017 that they will pay off, and $400 million due October 2020 (which you see in the chart above). The coupon is 6.875% and the debt is senior secured, and trades at a YTM of about 8.5% at present. The corporation in the first half of this year generated about $11.6 million in free cash flow. Historically they seem to be a cash generation vehicle for management teams.

It doesn’t take a Ph.D in finance to realize that they will likely have to refinance the debt when it comes to maturity in four years. They will probably be able to do this, but who knows?

This same bond traded at nearly a 19% YTM back in February when the whole market was going haywire.

Just because the bond is trading at higher levels (lower yields) doesn’t mean that they are valuable today. But if you did buy today you’ll get a high single digit return in the compensation for the risk that you’ll be dealing with the Chapter 11 proceedings of an auto parts manufacturer that doesn’t have the capacity to generate a huge amount of cash in a very low-margin industry.

Is it worth 19% to take this risk? Absolutely. Is it worth 8.5%? Probably not. Today you can get that debt for about 94 cents on the dollar, but if you got the same debt for 80 cents a year from now, you will get a much better return (assuming the aforementioned default does not occur).

The other question I ask myself is whether we’ll likely see something in the next couple years that will resemble a bond refinancing crisis. While the future is always difficult to predict, there will always be something that will cause panic in credit – and it is in these times that one must dive in deep, just like I did back in January and February.

There are numerous examples like this littered in the bond markets today – lots of mediocre companies with bonds trading at single digit yields to maturity. Even worse are the over-leveraged messes that are just asking for recapitalization when the market sneezes.

So overall, the pickings of my bond market research have been very slim.

The results are quite depressing – out of looking at approximately a hundred issuers, I’m only interested in doing a deep research session on one corporation. Also, my initial take on this entity wouldn’t be for their debt – it would be an equity investment. My initial instinct says that their equity could double in a year, while their debt yields 7.6%. I’m eager to start the research process.

Looking at this whole exercise, I realize this following statement might be the biggest piece of confirmation bias about my own portfolio, I believe the pieces of corporate debt that I currently own represents the best risk/reward available on the publicly traded markets today. I just don’t see anything else out there worth putting capital in the corporate debt markets. It’s a classic case of doing a lot of work but achieving no tangible results for the portfolio.