Bellatrix Exploration debentures trading lesson

I own (clarification: after today, this should be “owned”) some debentures of Bellatrix Exploration (formerly True North Energy Trust). They mature in June 2011, coupon of 7.5%. They also were a relatively safe pick to be redeemed at maturity.

Today the company announced they raised money for more debentures and announced their intention to redeem the existing debentures. The debentures have an early redemption term as follows:

Subject to closing of the Offering, Bellatrix intends to give notice on or following the closing date of the Offering of its intention to redeem its currently outstanding approximately $84.9 million 7.50% Convertible Unsecured Subordinated Debentures due June 30, 2011 (the “Existing Debentures”). The Existing Debentures are redeemable for an amount of $1,050 for each $1,000 principal amount of the Existing Debentures plus accrued unpaid interest if redeemed on or prior to June 30, 2010 or an amount of $1,025 for each $1,000 principal amount of the Existing Debentures plus accrued unpaid interest if redeemed after June 30, 2010. A determination as to the redemption date will be made prior to closing of the Offering. Proceeds from the Offering will be used by Bellatrix to partially fund the redemption of the Existing Debentures and the balance of the redemption amount is intended to be funded through bank indebtedness.

Earlier this year, Bellatrix debentures were trading very close to 102.5, which was my exit price. I was actually the asking price at one point in time, but nobody bought my asking price. I had assumed the company would wait until June 2010 to mature the debt and just left my open order at 102.5, assuming they would never consider an early redemption at 105.

I was apparently wrong – the debentures today traded from 102 to 104, settling around 103.5. The people buying above 102.5 obviously are speculating that management will be redeeming earlier than the June 30, 2010 date.

The math is pretty simple – the new convertible debenture deal closes on April 20, 2010. If the company redeems early, they will pay $2.125 million more in redemption premiums if they do it immediately after the deal closing than if they did so in June 30, 2010. If they wait the 2.3 months before redeeming, they are paying $1.22 million in interest payments, and this also does not include the company’s ability to utilize the $85 million in capital during that time period. Even if they redeem today, they will be paying $1.59M in interest expenses, much less than the $2.125 million they would save by delaying the redemption.

The calculation highly suggests the debentures will be redeemed on June 30, 2010, and anybody buying Bellatrix at 103.5 is insane. When the debentures are deemed, they will receive a -3.6% annualized return on their investment.

The trading lesson here, however, is that keeping open orders in this manner exposed myself to the risk of this happening and as a result, I am short a small amount, but an amount that certainly would have paid for quite a few ribeye steaks.

I also could have avoided this issue by actually waking up at 5:30am Pacific time and reading the press release to cancel my order, but Pacific coast investors automatically face the handicap of having the financial world set on the eastern time zone (even for an Alberta corporation) and I was obviously asleep at the time.

I am happy, however, that this trade was successful in the overall scheme of things.

Selling debentures above par value

The decision to sell debentures that are trading above par value is an interesting challenge of capital allocation and tax optimization. Assuming the premium is dictated by the underlying company’s likeliness to pay rather than a conversion premium, there are a few variables to consider. A real-life example is the best illustration.

The company formerly known as True Energy Trust (now Bellatrix Exploration) has an $86M issue of 7.5% debentures that are scheduled to mature on June 30, 2011, which is 1.4 years away. The underlying company is otherwise debt-free and has recently performed a successful equity offering to fund the next year of capital projects. Additionally, the company has a market capitalization that would suggest that even if it was not able to raise capital before the maturation of debt, that they would be able to equitize the debt upon the maturity date.

In other words, getting paid out is a very likely scenario and would only take extraordinary risks (fraud or an absolute collapse in oil prices, etc.) over the next 1.4 years to prevent debenture holders from getting paid.

The debentures have a call provision, where the company can purchase the debentures at 105 cents before June 30, 2010 and 102.5 cents after June 30, 2010. It is unlikely they will use this call provision before June 30, 2010, but there is a low probability chance they will use it just after June 30, 2010, which implies a 4.9% yield to maturity on June 30, 2010. The company will only exercise this option if they can raise cheap money – it doesn’t necessarily have to be at a lower coupon than 4.9%, but rather an extension of the maturity is the functional objective.

In terms of tax optimization, the debentures were purchased at a cost basis significantly lower than par value, which means there is a bottled up capital gain embedded within them if I choose to sell them in 2010. The other decision is to wait until January 1, 2011, which means capital gains taxes will be deferred to an April 2012 cheque to the CRA. I will also be receiving interest income as a reward for patiently waiting.

The debentures are trading at 101.5 cents between the bid and the ask, which means that I can sell today and receive a 1.5 cent capital premium in exchange for the interest I will forego between now and June 30, 2011. This does not match up to the 10.5 cents of interest income I would receive between now and the maturity date. In terms of the capital that I am locking up to receive this interest rate, it implies my current yield is 7.4% and my capital gain will be -1.3% annualized assuming I do not sell today.

In order for a sell decision to be worthwhile, I would need to be able to realize a total yield of greater than 6.3% on my subsequent investment, not factoring in the tax liability, which would increase my hurdle rate by requiring me to divide 6.3% by (1-t), where t is the marginal tax rate for selling.

Since there is nothing with this return for a comparable risk that is not already in my portfolio, it means I will be holding onto the debentures for the next little while and keep on accruing interest. 6.3% at present is about 5% better than what I can get at ING Direct for risk-free money, so taking a very slight risk for a 5% premium still is very worthwhile.