Turning down a very likely 12% annualized return

There is a catch to the title – the 12% annualized return is in the form of a 6.6% return over six and a half months.

I have mentioned this before (at much higher yields) but Pengrowth Energy debentures (TSX: PGF.DB.B) is probably the best low-risk/medium-reward opportunity in the entire Canadian debt market today. At the current price of 97 cents (plus 5.5 months of accrued interest payments), you are nearly guaranteed to receive 100 cents plus two interest payments of 3.125% each. The math is simple – for every 97 cents invested today (plus 5.5 months coupon which you’d get 6 months back at the end of September), you will get 103.4 cents on March 31, 2017, the maturity date. This is a 6.6% return or about 12% annualized.

By virtue of Pengrowth’s debt term structure, this one gets the first crack at being paid by their billion-dollar credit facility which was untapped at the last quarterly report.

The only risk of any relevance is that the company will opt to exchange the debt for shares of PGF at 95% of the 20-day volume-weighted average price, but considering that the debenture face value is $126 million vs. the current market cap of $1.1 billion, the equity would not incur too much toxicity if management decided to do a virtual secondary offering at current share prices.

The company did give plenty of warning that at June 30, 2016, current oil/gas price levels and a 75 cent Canadian dollar would result in them potentially blowing their covenants in mid-2017. But this is of little concern to the March 31, 2017 debenture holder. They will get cashed out at par, either in cash or shares.

I own some of these debentures, which I purchased earlier this year when things were murkier and much more attractively priced. Given some recent liquidations in my portfolio, I could have reinvested cash proceeds into this apparently very low risk proposition. But I did not.

So why would I want to decline such a no-brainer opportunity and instead funnel it into a short-term bond ETF (specifically the very-low yielding Vanguard Short-Term Canadian Bond Index ETF at TSX:VSB)?

The reason is liquidity.

In any sort of financial stress situation, debt of entities that are “near guarantees” are traded for cash, and you will suddenly see that 97 cent bid moved down as entities are pressured to liquidate. For securities that are precious and safe, such as government AAA bonds, there is an anti-correlation to market pricing that occurs and ETFs holding these securities will be bidded up in response.

VSB is not something that you are going to see move up or down 5% overnight in a real panic situation, but it will retain its liquidity in stressful financial moments. The selection of VSB is different than the longer-term cousin, which has more rate sensitivity, but something has changed in the marketplace where equity and longer term debt asset classes have decided to trade in lock-step: as demonstrated in last week’s trading in Japan and the Euro-zone. When equities and long-term government debt (nearly zero-yielding, if not negative) trade in the same direction, it gets me to notice and contemplate what is going on.

The tea leaves I have been reading in the market suggest something strange is going on with respect to bond yields, the negative-interest rate policies and their correlation to equities. I’m not intelligent enough to figure it out completely, but what I do know is that putting it into so-called “low risk” opportunities like Pengrowth debentures come at future liquidity costs in cash if I needed to liquidate them before maturity. Six and a half months can be a long time in a crisis situation, and we all see what is going on in the US President Election – markets are once again seriously considering Donald Trump’s election now that Hillary clearly isn’t healthy enough to be Commander-in-Chief of the US Military. The public will ask themselves: If she can’t stand up to attend a 15-year memorial of 9/11, what makes you think she will be able to stand up when the terrorists strike the homeland again?

The markets have vastly evolved since last February where things were awash in opportunities. Today, I am seeing very little that can be safely invested in, which is getting me to change what I am looking for, but also telling me that I should relax on the accelerator, raise cash, and keep it in a safe and liquid form until the seas start getting stormy again. And my gut instinct says exactly that: winter is coming.

15 thoughts on “Turning down a very likely 12% annualized return”

  1. Sacha –

    I stumbled onto this blog recently and wanted to record that I’ve very much enjoyed and appreciated your writing. I’m a relatively novice investor myself – typically only TSE/CVE equity and index funds, as my background is econ but little finance. Hopefully I’m not too biased by the fact that I’ve been independently building up a MIC position over the last year and a bit, while also seeing very little that’s worth buying over the last few months.

    I look forward to reading and learning more. Convertible debentures are a new thing for me. All the best.

  2. In terms of convertible debentures, have either of you considered GCM.DB.V? Definitely some geopolitical risk as the assets are in Colombia but the debt is senior/secured and the debs due in 2018 are mostly mandatory exchangeable. In addition, there is a cash sweep that started last quarter that is used to buying back debentures below par. Looks like based on current gold prices, the debt is being created at less than 1.5x EBITDA which seems very attractive.

  3. Safety,

    The series that has mandatory conversion is the GCM.DB.U series – that one traded like a proxy for the stock with the minimal coupon and mandatory conversion feature.

  4. Will,

    Yeah, I just referred to the GCM.DB.U, as the “debs due in 2018”. I was just trying to highlight, that the debt due before the GCM.DB.V in 2020 won’t use up a lot of liquidity so that they are not much of a concern for a GCM.DB.V holder.

  5. @Andrew: Thank you, and good luck. Hope for both of us that MIC will continue to appreciate.

    @Safety and @Will: The GCM complex is an interesting case. I’ll disclose I hold the senior secured .V’s.

  6. I just got robbed by PWC Capital / Versabank’s strategic review. Let’s hope it’s not another piece of crap they are trying to pull ……..

  7. The big difference here is that the GCM.DB.V holders hold the hammer because they have senior secured status. Any recap or proposal must get their approval. Valuation-wise, they won’t settle for par because there is a lot of value in the embedded call option (not to mention 3 years and a few months of the 6% coupon).

    PWC/VB was a very different situation.

  8. The board has more exposure to the GCM.DB.V than to the common shares from my calculations so I don’t expect them to try and disadvantage the debenture holders.

    I believe this may be pressure from the debenture holders to get liquidity now at fair market value as opposed to waiting for the market to place a valuation multiple comparable to its peers. Unfortunately, this might sacrifice some optionality but if its double or more from these levels, debenture holders might accept it.

  9. I do hold a tiny position senior debt myself. The number of shares increase rapidly with a lot of the junior debt converting to shares.

    Pretty much forced to sell most of my PWC note on Tuesday at the 7x cents which is slightly appreciate than what I get them for a while back. I’m extremely bitter with that one.

    Is Yellow Pages still on anyone’s radar?

  10. Will – if you are willing to consider that VB might trade near book value post-closure, then you will note that the transaction is designed to make the PWC.NT.C note holders whole. It is just a matter of waiting.

    Regarding GCM.DB.V, Sacha has it nailed.

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