Archive for ‘Debt’ category

First Uranium will be an interestnig story

2 February, 2010 | Sacha Peter | 1 Comment

Ever since the environmental permit for their tailings mine got revoked by the South African government, First Uranium equity has traded lower. Their debentures have also traded from roughly 75 cents to 71 cents.

Today, however, they will likely trade lower because of First Uranium’s corporate update. In it contains the following words:

The announcement of the withdrawal of the EA has not only delayed construction of the TSF, it has also disrupted certain well-advanced corporate financing opportunities, which, along with the slower than expected production buildup at the Ezulwini Mine, would, if alternative financing is not obtained, severely compromise the Company’s financial position. The Company is now reviewing strategic alternatives, and is engaged in discussions with respect to alternative financing opportunities.

My guess is that the common stock will trade down about 10% on Tuesday and the debentures will trade down another 3 cents. The company will likely have to sell more equity in future gold sales (as they have done previously), or equity in their company in a heavily dilutive offering. Management does not own too much common stock and is likely to dilute through equity to reduce the influence of Simmer and Jack.

The latest financial update from First Uranium was at September 30, 2009. The debentures are CAD$150M and they would be first in line (after a $22M facility) in the event of a default.

The valuation of First Uranium, as its operational woes continue, have to increasingly be looked with respect to what the asset value of operations would capture in the event of a bankruptcy proceeding. As long as the price of gold does not crash, there is value in the operations and debenture holders will likely be able to still make a fair recovery.

Most of the value of the debentures, assuming they are paid, will be in the form of capital gains so keeping these outside the RRSP is likely the best option – at 65 cents on the dollar, your split will be 1 part income to 3 parts capital gains, assuming they mature. Any resulting income will be taxed at around 62% of the income produced from the investment.

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Posted in Canada, Debt | 1 Comment »

Frontera Copper Note Exchange

28 January, 2010 | Sacha Peter | No Comment

Frontera Copper was acquired some time ago by a Mexican company and at that time its common shares were delisted. The company still had some notes outstanding, however. They were defaulted on by the company mainly due to financial issues that resulted from the acquired mine assets not being worth what the acquiring company believed they were worth.

There are two series of notes, both senior unsecured notes, with a coupon of 10% and a maturity date of June 15, 2010 and March 15, 2011. They are trading around 67 cents on the dollar. The company has proposed an exchange offer whereby people can tender their notes and receive 90 cents of face value (if tendered early) of new notes earning 10% interest, maturing December 2012. The terms also include that if copper goes below US$2.90/pound, the notes will give 6% interest. Also, the notes will be repaid in 25% installments, starting 18 months after they are issued, and can be extended by another 6 months if copper is below US$2.35/pound. Finally, if the notes are exchanged, unpaid interest on the previous notes will be paid.

The new notes will also be secured by a second-in-line interest on the mine assets after the bank loan, but this security is likely not worth too much.

The only kicker is that the new notes will not be exchange traded.

I am not seriously interested in these notes or the exchange offer, but thought it was an interesting offer. The fact that the market price for these notes plummeted when they announced this offer suggests that the bond market will not be expecting they will be paid in full, despite the effective 13-14% current yield they will receive after the exchange offer. Also, liquidity risk is a serious consideration with respect to the untradable nature of the notes. Finally, the international nature of the notes in question (essentially being secured by a Mexican operation and a Mexican corporation) leaves jurisdictional risk issues in case if they decide to default – who do you end up suing? A worthless BC shell corporation when the assets are held in a Mexican corporation?

It are risk factors like these that made me pass up the risk on this offer, but it might be for some other people to analyze and make a killing if the deal actually works for noteholders.

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Posted in Canada, Debt | No Comments »

Fixed income comparisons

25 January, 2010 | Sacha Peter | No Comment

There are some exchange traded products that are functionally identical but have different market prices. The reason why the prices are different is because of the individual demand/supply characteristics of the securities and individual liquidity preferences – for example, if two issues were otherwise identical in maturity date, coupon and seniority, if one issue was $200M outstanding, while the other was $20M outstanding, you would expect the $20M one to trade for less because of liquidity preference.

Right now on my radar screen, I see 7% coupon, 2028 maturity trust preferreds (backed by corporate senior debt, par value $25) trade at bid/ask 19.1/19.41 for one issue and 19.70/19.94 for another issue. Using the midpoint, we have a 9.83% yield to maturity for the first, and a 9.51% yield to maturity for the second.

The only reason why I am not hammering this difference is because they are non-marginable and you cannot short sell them.

Even more complicated is another issue that has identical characteristics, except it gives off a 6.5% coupon. At the current bid/ask of 17.37/17.50, we get a yield to maturity of 10.29%, which makes it more of a bargain than the other two securities – as long as you are willing to take your returns in the form of capital gains instead of coupon payments. In Canada, for taxable accounts, this is favoured. The cost of this, however, is that lower coupon issues are more sensitive to interest rate changes.

What is interesting is that if the securities in question were zero-coupon, with a 10.29% yield to maturity they would be priced about $3.965/share, while at a 9.51% yield to maturity, they would be $4.531/share, a 14.3% difference. It pays to shop around for your fixed income!

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Handbook of Fixed Income Securities

25 January, 2010 | Sacha Peter | No Comment

I borrowed from the library the “Handbook of Fixed Income Securities” (Fabozzi) and while I didn’t go through it cover-to-cover (it is as thick as a phone book), I did find his style very good, especially with examples. The art of determining what risks you are taking in the fixed income market is highly quantitative and without the quantitative backing, the benefit you may get out of the book would be limited.

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Market timing – Half luck, half skill part 2

22 January, 2010 | Sacha Peter | No Comment

You never know what you’ll get once you get into a position. Psychologically, the first few days after one gets into a position is the time that one typically pays most attention to it, at the cost of ignoring the rest of your portfolio.

With the First Uranium debentures example, my execution in hindsight was horrible – they traded as low as 65 cents today. Assuming an execution at that price, it would have resulted in a current yield of 6.5% plus a capital gain of 19.7% annualized if they paid off at par. You add these two and it’s roughly 26% you are looking at annualized, again, assuming a payoff at par 2.5 years down the line.

It appears that this was some frightened investor (likely a fund) that dumped at the bid and wanted to get out of there – now the bid/ask is 68/72 cents.

Unfortunately, looking back at charts is rather useless in terms of market timing and the only question is whether the position is still worth as much as the existing market value thinks it is. I think the debentures are still the better risk, especially at 26%. There are significant operational issues, but there is so much capital locked up in the project that they’ll have to deliver for somebody – whether it’s the equity owners, or whether it’s the debt holders that may eventually take control of the firm.

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Posted in Canada, Debt | No Comments »

Peer to Peer Lending – Prosper / Lending Club – Explaining the risk

21 January, 2010 | Sacha Peter | 20 Comments

A preliminary note on dealing with people in finance:

No sooner than 24 hours after I posted about how Peer to Peer lending is quite risky, I receive an email from Mickie Boone, who is the director of Public Relations of Lending Club. I do not believe I am breaching any confidentiality of email when she stated that:

Lending Club has always implemented tighter credit policies and invested heavily in collections, and as a result is now 3 times bigger than Prosper ($7.1M in Dec. for Lending Club against $2.2M for Prosper). Our historical default rate across ALL loans is around 3% and we produced an average of 9.68% net annualized returns.

She must be doing her homework by having good Google Alerts set to inform her of anybody writing about her employer or her competitors. Although the email was clearly marketing material, it did not feel like spam and was well crafted although it felt like she has sent something similar to many other writers on the internet. In fact, by me writing about this, she probably succeeded in increasing exposure to her employer, which is her job.

In her email, she also stated that she desired to speak with me, and to let her know when I was available to do so. After my horrific experience with exempt-offering limited partnerships (see “Worst Move” on He won’t play against the Kasparovs), one rule of mine that I religiously adhere to is to let the documentation speak, and to only let management’s words be colour in determining the credibility of the firm’s leadership.

When dealing with people from a financial perspective, you tend to take a liking to them. This is why I will never make a good financial adviser – they make their money through sales commissions, and in order to do that, you need to appear to be likable to gain clients that taking a liking to yourself. I am not a likable person when it comes to finance. I already felt like I knew Ms. Boone right after reading her email. The problem is that doing so clouds my financial judgment which is detrimental in making good financial decisions. The documentation should do most of the speaking.

Lending Club vs. Prosper:

Lending Club’s website is slightly easier to get information from than Prosper. In addition, Lending Club doesn’t make the mistake of having to register to get certain information (e.g. for Prosper’s secondary marketplace). Lending Club also has their entire loan portfolio available for a convenient 10 megabyte Excel download, something I don’t see on Prosper. They also give good metrics with respect to loan performance, while with Prosper, you have a dig a little deeper, but at least not have to log in to get some quantitative results.

Both sites openly share their SEC prospectus on their sites, or you can read them where you would normally read SEC filings. Both sites also have similar cost structures (to the money lender, 1% of interest and principal).

In particular, Lending Club touts the following chart…

The chart is annotated with the following description:

A $10,000 investment in Lending Club notes in June 2007 is worth more today than the same investment in any other major asset class**

** Based on Average Net Annualized Returns from June 2007 (inception) to October 2009. This comparison does not reflect differences in liquidity. Past performance is no guarantee of future results.

… this chart clearly showing their outperformance to the market, right? Not so – a junk-of-junk bond portfolio (which is essentially what Lending Club and Prosper deal with) should have a volatility that is at least that of a short duration high-yield bond index and most definitely not mirror that of the short term treasury graph.

Be very careful of straight-line performance graphs, and this is no exception. You’ll notice even the 1-3 year treasury bond index exhibits some variation in returns, while Lending Club’s graph is nearly as straight as an arrow.

Is Lending Club’s loan portfolio vastly superior than Prosper’s?

The answer to this question is no. The reason deals with the carrying value of the loan. It assumes that loans that are not in default have a carrying value of par. As there is no secondary market for the loans on Lending Club’s books, current loans must be carried at par value even when the credit risk would result in a significant downward valuation from par.

There are two ways to default on a loan – stop making interest payments, or by not paying the principal when it is due. Lending Club’s numbers properly reflect the default rate of borrowers not making interest payments, but does not reflect the future default rates of the failure to pay principal.

Prosper has data available for loans originated from November 1, 2005 to today. The loans have been standardized for three years. 91.1% of current loans (by dollar value) are current, which means 8.9% of loans are non-current. These reflect the failure to pay interest.

In terms of principal collection, 22.9% of loans have been charged off. This is netted by 0.5% of collection agency collections, leaving a net charge off of 22.4%.

Lending Club has 9.1% of loans that are non-current ($5,559,632 late/defaulted vs. $63,651,765 funded), which is very close to Prosper’s 8.9% non-current loan rate.

Here’s the big reporting problem – Lending Club has only been in operation for 2.5 years. If they are giving out three year loans, then none of their existing loan portfolio has reached maturity yet (minus pre-payments), which means that the principal payment default risk has not been represented in their performance statistics. Prosper’s data runs back 4.2 years.

My guess is that once Lending Club’s loans start reaching maturity that the default rate will start to skyrocket, comparable to Prosper’s net 22% charge-off rate of their entire loan portfolio.

If there is any way I could short Lending Club’s portfolio at their existing carrying value, I would place a fairly heavy bet on it. Unfortunately, there is no way to do this. If my hypothesis is correct, my prediction is that in 1.7 years that Lending Club’s blended loan portfolio will look closer to Prosper’s, which currently has a 38.4% default rate on historical loans (for matured loans, Prosper is at a rate of $42,260,196 in net charge-offs vs. $110,000,706 loaned).

To say that Lending Club has a “historical default rate of 3%” is true, but the key word is “historical” – this will rise very sharply and this is why you don’t see Prosper advertising default rates – because it is ridiculously high. In order to be compensated for this risk, investors should rightfully be demanding rates that would make credit card vendors bashful.

Notwithstanding this analysis, 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.

I invite the management of either Prosper or Lending Club to comment here, rather than email. My analysis could be wrong, and would appreciate any corrections.

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Posted in Debt | 20 Comments »

Market timing is half luck, half skill

20 January, 2010 | Sacha Peter | 2 Comments

Less than 12 hours after I published my rationalization of purchasing First Uranium debentures in my TFSA, they released an adverse piece of news stating that their environmental permit for their tailings mine (which they subsequent reprocess for gold and uranium because prices have made it economical) was revoked.

The equity is down 23% as I write this; it brings their market capitalization down to $344M, which means that if shareholders wanted to capitalize the debentures, it would cost them 30% of the company instead of 25% the day before.

The debentures, however, remained within the bid-ask spread. Currently they are quoted as 75 cents bid, and 78 cents ask. I tend to trust the debt markets more than the equity markets in terms of true valuations.

It might actually be a good time to look at the equity as a more serious investment candidate if I was a little more risk-taking, but I will be continue to be happy with the debt. The foreign country operational risk is something I find very difficult to quantify and measure beyond a “gut feel” and this is the overriding factor in my decision. I believe something “political” is going on with this news release, but I have no way to judge whether it is a genuine operational aspect, or whether some politician is trying to wring a campaign donation out of the company or its management.

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Posted in Debt | 2 Comments »

Peer to peer lending is quite risky

20 January, 2010 | Sacha Peter | 2 Comments

I find the fellow that writes Bad Money Advice to be quite entertaining. His latest article is written about his experience with Prosper.com, which is the foremost in peer-to-peer lending. He put $1,000 into it three years ago and managed to transform it into $1,029 – which apparently is an above-average performance on the site. At least it was better than the S&P 500, but certainly less than what a risk-free GIC would have yielded.

If you are Joe Consumer and need a loan for whatever reason, you can request a loan and have people bid rates on your loan. Prosper makes money by taking a slice of both the lender and the lendee.

Putting $1,000 into Prosper and attempting to transform it into a market-beating rate is actually money well spent even if you have your entire portfolio default – the reason being that it is a first-hand experience why banks and credit card companies charge such high rates for (relatively) unsecured consumer loans. In effect, it is an educational expense. It might not even be a bad idea to give younger people an account with a modest amount and get them to “invest” the money in an attempt to educate them why making money through banking is not as easy as it seems.

The only debt investing I do is through publicly traded companies and there is some legal protection because such companies have to file a prospectus and report quarterly – when dealing with consumers, you have no such protection other than the good faith of the person behind the internet wire. In most cases, if they have to borrow money through a place like Prosper, chances are they are in bad shape to begin with and your only proper compensation for this risk are rates that would otherwise be considered usury – around 30%.

This is why “payday loan” companies charge relatively high rates – they experience the same kind of default rates as people on Prosper. Payday loan companies are vilified for charging these high rates, but without doing so, they would go bankrupt.

I love the idea of Prosper.com – I just wouldn’t invest there unless if I knew I had some form of collection that was a little more powerful than the (expensive to implement) threat of a collection agency.

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Posted in Debt | 2 Comments »

Harvest Energy offers debenture repurchase

20 January, 2010 | Sacha Peter | No Comment

As the Harvest Energy debenture agreement requires them to repurchase them at 101 cents on the dollar within 30 days of a change of control, Harvest Energy has made the offer today. The expiration of the offer is as follows:

Series                          Trading Symbol                  Expiry Date
----------------------------------------------------------------------------

6.50% Debentures due 2010       TSX: HTE.DB.B                 March 4, 2010
6.40% Debentures due 2012       TSX: HTE.DB.D             February 11, 2010
7.25% Debentures due 2013       TSX: HTE.DB.E                 March 4, 2010
7.25% Debentures due 2014       TSX: HTE.DB.F             February 25, 2010
7.50% Debentures due 2015       TSX: HTE.DB.G             February 25, 2010
7 7/8% Senior Notes due 2011    N/A                       February 16, 2010

An investor should look at the market price of the debentures before considering to tender and also look at the yield they would get by holding onto the debentures vs. the risk they would have to take until they mature. Right now all of the debentures are trading above 101, which likely means they will not be tendered by investors – they can be dumped on the open market for a higher price. I dumped my “D” debentures at 101.5 and my “E” debentures at 102.0 in January in a lucky feat of trading execution.

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Next TFSA investment – First Uranium

19 January, 2010 | Sacha Peter | 1 Comment

Following the success of getting out of Harvest Energy debentures, I had a lot of cash in my TFSA, especially after the January 2010 contribution of $5,000. There was only one debenture candidate left on my radar that appeared to have a good risk/reward characteristic. Although it wasn’t great, it was good enough and I executed a trade on it.

Continuing with my less than diversified strategy, I have placed the sum of the TFSA into the debentures of First Uranium (FIU.DB). The debentures give a 4.25% coupon, maturing in June 2012. They are convertible into equity at $16.42/share, but this is unlikely to be a factor in the valuation. The total issue was for CAD$150M. They went as low as 41 cents in the debenture crash of early 2009.

The price I received was 74.5 cents on January 11, which is a 5.7% current yield and an implied annualized capital gain of 13.0%. Assuming a 1.2% (short term interest rate) reinvestment of coupon, this is a realized return of about 16.8%, which is (barely) above my investment threshold. The previous Harvest Energy investment was above 30% at the time and price I made it, but the spring of 2009 was a very special investment climate where buying anything would give you massive returns. Today, things are much different and you really have to pull out a high powered microscope since anything with a high return has a lot of baggage you have to sift through. First Uranium is no exception.

First Uranium is a Toronto corporation, but with operations primarily in a South African mine with uranium and gold reserves. The name is misleading in that the bulk (~85%) of the company’s revenues are expected to be from gold sales. The foreign nature of their operations introduces a risk, but South African mining operations have been able to operate sustainably in other circumstances. Although I have my geopolitical concerns about South Africa in the medium term (10 years out), I have discounted such concerns in the 2.4 year timeframe of this present investment. It is also likely that coming closer to maturity that the investment may be liquidated sooner than later, or when the yield shrinks to my sell target (around 95 cents presently).

Most of the operations have been financed by equity – the last financing was done in June 1, 2009 at CAD$7/share. Today the common shares are at $2.66/share with 167M shares outstanding – a market capitalization of about $444M. Some portion of the gold reserves have been hedged off at below-market rates for up-front financing. In addition, the mining operations are still at the end of the initial capital injection phase before they can start producing sustainable positive cash flow, which is expected in the March 2010 to March 2011 fiscal year.

In terms of management and ownership risk, this is an interesting story. Simmer and Jack, another (larger than junior) South African mining company, owns 37% of the company as of September 2009. There has been a recent management and board struggle dealing with the Simmer and Jack management, who have moved over to First Uranium after they were kicked out of the Simmer and Jack board. The kicked-out CEO and Chairman, Gordon Miller, owns 1.66% of Simmer and Jack and roughly 0.1% of First Uranium. Although this struggle has an indirect impact on the value of the debentures (mainly that I am concerned about being paid off rather than owning the company), it is worthy to note that some deal must have been cut with the existing Simmer and Jack board such that he be allowed to run First Uranium since the 37% minority ownership of Simmer and Jack would likely be able to prevent him from doing so if they did so voluntarily.

There is a complex relationship here with respect to the debentures – Simmer and Jack is highly incentivized to make sure the debenture holders don’t take over the company so they can realize value of their equity stake. Gordon Miller likely wants to make a ton of money out of the deal and try to get some sort of revenge against Simmer and Jack and try to wrestle control away from the company. Either way, the debentures will have to be paid and it seems likely at this point it will be done by a simple equity swap – the current market capitalization is sufficient to pay off the debentures with about 25% dilution to existing shareholders.

On the balance sheet, First Uranium has US$60M in cash at the end of September and they have poured in about US$563M into their mining operations. Their only significant liabilities are a $22M loan from Simmer and Jack, and the CAD$150 of debentures. The income side is ugly when one looks back, but the corporation should start to generate cash through mining operations in the upcoming year and slow down capital expenditures – and perhaps even pay some common share dividends sometime in the second half of 2011 if things really go well and the refinancing of the debentures are in the bag.

The risks otherwise are typical of a mining firm – commodity pricing (gold and uranium) and realization of “proven” reserves into actual output. There is also some currency risk – they report in US dollars and their equity and debentures are denominated in Canadian dollars. Reading the technical report on the main mine and getting a feel for the operation is also essential (and rather dry) reading.

Although this investment is not the most ideal, I do believe that the company will be able to pay off the debentures, whether by refinancing, equitizing the debt or generating cash flow before the June 2012 maturity. There is enough of a margin of error to feel comfortable, but not “home free”, which is why the market value is trading significantly below at present. Assuming their story turns out, the equity side is also a compelling story, but it contains a high degree of risk that I am not willing to take – especially concerning the future of gold prices. That said, I expect these debentures will be made whole and will be a positive decision in terms of my risk-reward profile and being able to avoid income tax and capital gains tax by virtue of it being in the TFSA.

I also prefer short duration plays simply because when interest rates rise again, cash might be a more attractive option.

(Subsequent note: Operational risks include adverse news releases after hitting the “publish” button, although I do not think this one is too severe to my underlying investment thesis.)

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Posted in Canada, Debt, Taxation | 1 Comment »

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