Archive for ‘Canada’ category

Morneau Sobeco Income Trust announces corporate conversion

11 March, 2010 | Sacha Peter | No Comment

Morneau Sobeco specializes in outsourcing HR services. They have an annualized distribution of $0.94/unit, but they recently announced a corporate conversion which will take effect in 2011:

“Today, we are announcing our plans to convert to a corporation at the end of 2010,” said Bill Morneau, Executive Chairman of the Fund. “We intend to maintain our current distribution level for 2010 and provide an effective 10.6% after-tax increase in 2011 for unitholders taxable at the highest marginal rate.”

The conversion is being undertaken in response to the legislative changes enacted by the federal government that will apply a tax at the income trust level on unitholder distributions commencing January 1, 2011. The current monthly distribution level of $0.07871 per unit (or $0.94 per unit annualized) is expected to remain unchanged for the balance of 2010. Starting in January 2011, the monthly dividend level is expected to be $0.065 per share (or $0.78 per share annualized) with a sustainable payout ratio of 65% to 80% of cash flow. This dividend policy will facilitate the repayment of debt, while providing investors with an attractive yield. Going forward, the Fund’s intention is to continue to reward its investors with dividends in line with business performance. A special meeting of unitholders will be held in the second half of 2010 to obtain unitholder approval of the conversion.

A 94 cent to 78 cent reduction in distribution is a 17% decrease in distributions, and is somewhat less than what would otherwise be expected on an after-tax basis. It is not surprising that trust units are not trading too far down – about 3% at the time of this writing.

My valuation exercise on the company indicated they are trading at their fair value range, so I have not even bothered to place any orders for the units. The units are trading at $10.19 a pop, which is a 9.22% yield on their current distribution, or 7.65% in 2011. Given the risk involved, this is appropriate.

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Federal Budget 2010 – brief thoughts

6 March, 2010 | Sacha Peter | No Comment

The budgetary cycle this year from both the federal and provincial government can best be described as “nothing changing, we are staying the course”.

The federal government, in particular, managed to crunch 424 pages of relatively little of political substance in their budget document. A lot of the documentation (as always) discusses the fiscal outlook which is interesting from a macroeconomic standpoint. In terms of government operations, the summary table, as follows, is what one really needs to look at:

Once you remove the effects of the stimulus package, spending continues to increase at a slow rate. This rate is actually a faster rate of spending when you compare it to the equivalent in the 2009 budget (the tables are different sizes in the documents so you will have to click on this image to see the numbers more clearly):

It is obvious that the non-action is highly political – if the government decided to slash and burn spending and government programs, the opposition would likely topple the government and force an election about “providing government programs to Canadians”. In a minority government, the status quo is the safest political approach, to the detriment of the rest of the country. It is only until a clear majority of the public and/or the Liberal opposition starts calling for real spending cuts (compared to the Mickey Mouse “we made tough choices” line given by the Finance Minister) will it be likely that we will see less largess in the present government.

Some commentators have noted that the government is heavily depending on revenue increases to balance the budget in 5 years (which is such a far-off time horizon that nobody will be kept accountable for this plan) – I think the revenue ramp is actually reasonable, not aggressive but not conservative either. It really depends on whether companies will start to hire people, but considering the government sees the big picture with respect to investment capital and corporate tax rates (which, federally, will be dropping from 18% to 16.5% in 2011 and 16.5% to 15% in 2012), this, combined with a reasonable stability in commodity markets, should help the country get back on track economically.

The last note is that interest rates will have a large effect on the bottom line – however, the government has assumed an accounted for a 3-month T-bill rate of 0.7% for 2010 and 2.4% in 2011, both reasonable projections.

“Wait and see” seems to be the message for this budget. It has been the least exciting budget so far in this government’s administration, but this is probably a good decision given the political constraints in the House of Commons. I am not happy with the huge expense ledger, however.

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First Uranium gets whiplashed

25 February, 2010 | Sacha Peter | No Comment

I have written earlier about First Uranium’s woes – they had an environmental assessment permit that was critical to their business venture pulled.

Today they announced that they have it back.

This is what I was referring to the political instability risk concerning investing in companies that have major operations overseas – judging how burdensome the local government is very difficult unless if you are living there and have a “feel” for them.

First Uranium equity today jumped by 39% and closed the day at $1.81/share. This gives them a market capitalization of $300 million. Before this fiasco began, their equity was valued at about $2.50/share. I suspect their equity is under-valued, but I am not interested in the equity – I am interested in the debt. The equity still has other risks (dealing with governance, management compensation, composition of the near-majority shareholder, etc.) that I am not interested in taking. In addition, there still is the operational risk of actually being able to get the gold refining project up assuming anybody wants to finance the operation. The operation will likely be financed with some combination of equity and debt. Future dilution is something equity holders will face, but this is already baked into the relatively low share price.

The debentures are trading at bid/ask 68/71. Now with their business prospects significantly enhanced (providing that they can raise $100 million of capital that would be require to get the project going), I believe there is a material chance that these debentures ($150M par value) will be paid off at par in 2.3 years to maturity. I am guessing that once the project gets established and the revenues come in as projected (which will be substantial) that sometime in 2011 or early 2012, the cost of capital for the company will be considerably lower and I will get paid off at par. At 69.5 cents, the debt has a 23% annualized combined yield-capital gain for an acceptable risk.

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Physics always trumps marketing

24 February, 2010 | Sacha Peter | No Comment

One reason why Robert Rapier is such a powerful writer (and a wonderful one to read) is that he rarely strays into dogma and talking points (and the times he does so, he usually signals it); his articles are quite analytical and verifiable. In his latest post, he rips into Range Fuels and Cello Energy, and also states that venture capitalist Vinod Khosla had no idea what he was investing in.

In summary, I will point out that the two primary sources of cellulosic production being counted on by the EPA for 2010 were Range Fuels and Cello Energy. Both are Vinod Khosla ventures, and neither has come remotely close to delivering despite lots of funding and taxpayer assistance. I don’t think these are isolated cases. I think they are a symptom of things to come. We have gotten a lot of overpromises, because face it, that has worked to secure funding. But what this leads to are completely unrealistic expectations regarding our energy policy, and numerous bad decisions regarding where tax dollars should be spent.

Finally, I want to make one thing crystal clear. I am not criticizing failure here. That is normal and expected. Failure is a part of what it takes to learn and move forward. What I am criticizing is the nature of the failure; that it was primarily because inexperienced people were making claims they shouldn’t have made, and taxpayers are going to get stuck with the bills. Personally, I have a problem with my tax dollars being squandered away by smooth-talking salesmen.

The underlying science (mainly the first law of thermodynamics – not even process engineering is required to understand the issue) will show that it is very difficult, if not impossible, to get a net energy return on the production of alcohol-based (methanol/ethanol) fuel. Essentially, such fuels require energy inputs far greater than their desired output, so why not just use the input directly in whatever application you require the energy for?

There are some applications where energy conversion will be desirable anyway, despite a net energy loss – for example, the conversion of a diffuse source of energy (corn) into a concentrated source (ethanol), but if you are using a source of energy with even higher energy concentration and equal portability (natural gas), what is the point?

The government and a lot of people in the US Environmental Protection Agency (EPA) got sold a bill of goods, and they took the bait, hook, line and sinker.

Here in Canada, provincial governments are enacting legislation to blend in ethanol into fuels, which is a grave mistake. Also, the emphasis of hydrogen as a fuel to eventually replace gasoline is misguided; my thoughts are that hydrogen’s potential lies with energy storage rather than replacing conventional fuels.

Politicians get sold a bunch of fancy marketing and great promises in the hope that taxpayers’ dollars will get allocated toward whatever special interest of the day is being pitched at them (in this case, “less reliance on oil” is the message, although in the case of ethanol-blended gasoline “clean fuels to prevent global warming” is the message). The politicians and staff do not have the scientific capability of properly analyzing the proposals, and they get slick marketing pitches to sell them. Next thing you know, millions of dollars of taxpayers money are wasted with inefficient proposals and the end-consumer will pay for it when governments inevitably have to raise taxes to recover their losses on the project.

In the end, physics trumps marketing, but not after a lot of money is wasted once people scale up operations are realize they have no chance of delivering what they promised.

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Canadian exchange traded debt statistics

19 February, 2010 | Sacha Peter | No Comment

There are 168 issues of exchange-traded debt available over the TSX. A lot of these issues are illiquid – 58 issues today did not trade.

None of these issues are trading below 60 cents.

There are 5 issues (3 issuers) that are trading between 60 and 69.9 cents.

There are 8 issues (6 issuers) that are trading between 70 and 79.9 cents.

There are 9 issues (8 issuers) that are trading between 80 and 89.9 cents.

There are 23 issues (21 issuers) that are trading between 90 and 99.9 cents.

The rest of the issues (123) are trading at 100 cents or greater.

If you compared these statistics with the same statistics one year ago, it would have been significantly different – there were lots of issues that were trading well below 80 cents.

The exchange traded debenture market on the TSX right now is mostly a done deal and investors should not look toward them to provide disproportionate returns beyond coupon payments. I have thoroughly analyzed the various issues that are trading cheaply, and there is limited value.

The events that occurred in late 2008 and early 2009 was likely a once in a decade opportunity in the corporate debt market. Time to start looking at equities again once everything matures.

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Replacing ING Direct

19 February, 2010 | Sacha Peter | No Comment

The place where I normally park cash is in ING Direct, which has been a mainstay financial institution for myself for a very long time. When they first opened, they were by far and away the best place to park cash. Now they are a mediocre offering of the many online products that are available out there. I am guessing that they achieved their desired level of deposits and have achieved their desired debt-to-equity ratio with their residential mortgage offerings.

ING Direct hasn’t contaminated their customer experience by spamming their customer base with too many useless services, but this encroachment to simplicity has been eroding at a faster pace as of late – see my post about RSP loans, for example. It is simplicity that has caused me to stick around with ING Direct instead of shopping for other services. However, that time has now come.

So today I sent in a cheque to Ally, which used to be known as GMAC. Obviously since GM tarnished their brand with their bankruptcy filing and investing money in an institution that shares the same name with a bankrupt entity doesn’t inspire much confidence, they changed their name in 2009. In Canada, they are run by a firm called ResMor Trust Company, which otherwise does mortgages. In any event, they are CDIC insured and this means that the taxpayers of Canada will be picking up the guarantee for deposits up to $100,000.

Since I will not be depositing more than $100,000 in Ally, the safety issue of the institution is more or less mitigated.

Their peak offering is a savings account which delivers 2% interest (which is subject to change at anytime), but since this is significantly higher than ING Direct’s offering at 1.2%, it is a trivial process to click a few mouse buttons and transfer the money. Every dollar counts.

As interest rates rise, it will be interesting to see the spread between these two institutions since they are competing for the same bucket of capital from Joe Saver.

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Canadian Interest Rate Projections

19 February, 2010 | Sacha Peter | No Comment

The financial media is catching wind that interest rates are going to be increasing. Although I believe the Bank of Canada is fairly firm in holding their overnight rate at 0.25% until the end of June, the question remains how much they will raise rates in July. I thought that it was going to be an evolutionary 0.25% increase over the next scheduled meetings of the central bank, but there might be a larger jump.

Futures markets are signaling the following compared to the same time last month (January 2009):

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 MR 0.000 99.545 99.550 99.550 -0.005 4412
+ 10 AL 0.000 0.000 0.000 99.510 0.000 0
+ 10 MA 0.000 0.000 0.000 99.460 0.000 0
+ 10 JN 0.000 99.400 99.410 99.410 0.000 16860
+ 10 SE 0.000 99.030 99.040 99.030 0.000 19502
+ 10 DE 0.000 98.630 98.640 98.630 0.000 17457
+ 11 MR 0.000 98.240 98.250 98.250 0.000 2335
+ 11 JN 0.000 97.900 97.920 97.910 0.000 1360
+ 11 SE 0.000 97.550 97.620 97.600 -0.010 175
+ 11 DE 0.000 0.000 97.350 97.300 -0.050 56
+ 12 MR 0.000 97.000 97.090 97.050 0.000 0
+ 12 JN 0.000 96.740 96.870 96.810 -0.040 7
+ 12 SE 0.000 96.530 96.670 96.600 -0.030 7
+ 12 DE 0.000 96.320 96.500 96.370 0.030 7

We can see the projected interest rate for December 2010 is 1.36%, while December 2011 is around 2.7%.

Another metric to look at is long term bond rates – 5-year bond rates (which determine how expensive 5-year fixed rate mortgages will be) are currently trading at 2.56%, but this has not changed too much over the past half year.  If the markets were anticipating significant amounts of inflation, they would most likely hit the longer term bond markets first.

The expectation theory states that long term rates are a representation of the short term rates that will existing throughout the maturity of the debt.  As such, the markets are expecting an average of 2.56% over the next five years – since rates for the next 5 months will be at 0.25%, it hints there will be a period of time where we will see short term rates at or around 3%.  Interest rate futures say this will be around March and June of 2012.

My financial crystal ball suggests that the markets are pricing this in correctly.

Since the yield spread (between the 10 year and 2 year bond) is around 2.1%, it does suggest that there will be some sort of economic recovery – my sense in terms of how to play this is to load up on commodities until the yield curve flattens.  When the yield curve flattens, the party is over.

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Canada Pension Plan, Q3-2010

11 February, 2010 | Sacha Peter | No Comment

The Canadian Pension Plan reported its fiscal third quarter, with a 1.8% return on investments between October 1 and December 31, 2009. The asset mix of the fund is as follows:

* Equities represented 56.1 per cent of the investment portfolio or $69.5 billion. That amount consisted of 43.9 per cent public equities valued at $54.4 billion and 12.2 per cent private equities valued at $15.1 billion.
* Fixed income, which includes bonds, money market securities, other debt and debt financing liabilities represented 30.0 per cent or $37.3 billion.
* Inflation-sensitive assets represented 13.9 per cent or $17.2 billion. Of those assets,
o 5.8 per cent consisted of real estate valued at $7.1 billion
o 4.9 per cent was infrastructure assets valued at $6.1 billion
o 3.2 per cent was inflation-linked bonds valued at $4.0 billion.

The TSX reported a 3.1% gain over the same period of time, so when one considers their asset mix (together with the fact that fixed income yields have slightly risen, thus resulting in value declines), the CPP had an average quarter.

The CPP requires a 6.2% nominal rate of return (4.2% real rate) in order to meet its long term investment objectives. While this number is realistic, it will also be challenging to realize these returns strictly within the North American confines – in order to achieve disproportionate returns, the CPP investment managers need to be looking abroad. Investing outside your known jurisdictions, however, can be very hazardous to your financial health, so I hope these guys know what they are doing.

Since April 1999 the CPP has realized 5.3% nominal returns, which means they are trailing by about 15% when you do the math – the actuary will likely have to boost the target rate of return needed to keep the CPP solvent to around 6.4% in order to catch up.

Still, the CPP is light-years ahead of the USA equivalent, social security. Canada did most of the heavy lifting on this issue in the 1990’s and it is one of the unspoken achievements of the Jean Chretien administration to put in a relatively permanent fix to this issue.

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The Canadian version of Prosper – CommunityLend!

9 February, 2010 | Sacha Peter | No Comment

I couldn’t help but notice that I signed up some time ago to be informed when Canada’s peer-to-peer lending service, CommunityLend, would go active. The service is otherwise very similar to that of Lending Club and Propser – people can bid on other people’s loan requests and the lenders get charged a 1% fee on the money they receive, while the borrowers have a significantly larger charge depending what credit bracket they are in. On the front page of CommunityLend, they advertise that you can borrow money with a 6% to 29% return:

Right now you can only lend money through CommunityLend in the provinces of Ontario and Quebec, although they are trying to expand to other provinces. The other hitch is that you have to be an “accredited investor“, which is a securities legislation definition of an investor that can legally purchase securities while waiving the standard legal protections that you would otherwise get if you weren’t exempt from the accreditation criteria.

The only issue for CommunityLend is that the easiest way to qualify to being an accredited investor is having net financial assets of greater than $1,000,000, or to be a registered adviser. Just by this stratification, which was likely discovered during the consultation process with the respective provincial securities commissions, the lenders are going to be a much smarter breed of people. Judging that the risk taken by people using the Canadian peer-to-peer lending facilities aren’t going to be any less riskier than those using the US equivalents, I would guess that interest rates received on loans will be slightly higher simply because you will have less people bidding rates down.

My prior statement about peer-to-peer lending remains the same:

There is educational value for people to invest small (and I mean small) amounts of money just to demonstrate how difficult it is to make money even when allured with the promise of high rates of return. Instead of a return on capital, the return of capital becomes paramount in the loan business.

Just to give future investors some sort of barometer, you can pick up corporate debt from relatively stable and smaller publicly traded corporations with a 3 year maturity for about a 9% yield to maturity. Thus, anybody bidding for unsecured consumer debt at a 6% interest rate should get their heads checked.

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Selling debentures above par value

8 February, 2010 | Sacha Peter | No Comment

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.

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