Chesapeake Energy – What a basket case

Chesapeake Energy (NYSE: CHK) is the second largest natural gas producer in the USA.

It has a few claims to fame. The most positive and negative aspects of the company seem to be directly related to its CEO, Aubrey McClendon. Concentrating on the negative side of the story, is that McClendon formerly owned about 5% of the company, got liquidated out on a huge margin call in the 2008 economic crisis. He was forced to liquidate his stake in the company at very adverse market prices. This would be a pretty good signal to anybody that the main person at the top is one tremendous risk-taker, but that risk is a double edged sword.

The corporation’s board of directors are directly in McClendon’s pocket as they subsequently awarded him a $75 million bonus in deferred compensation relating to well drillings and other such matters, but this presumably related to rubbing a salve on the huge financial wound that was incurred back in 2008.

His financial troubles have recently re-emerged when it was revealed that he had partial ownership stakes in natural gas wells that were also jointly owned by the corporation and this created a conflict of interest with respect to liquidation. Basically the conflict is that McClendon was in a position to front-run his own company or otherwise receive preferential treatment. Compounding the matter was the rumour that he apparently has a billion dollars that he loaned to take such an interest in these wells.

It is not helping the company that natural gas prices have reached record lows, which will be depressing the company’s profit margins.

So why the heck would anybody want to invest in this basket case? The only rationale is that investors would have to believe that the board of directors would be overturned and they would be able to no longer be in the back pocket of management.

Perhaps the way out for the company is an outright buyout, but this is assuming there are no other lingering financial matters within a corporation that has management that does not exactly seem to be aligned with shareholders’ interests.

I haven’t had time to do a more rigorous financial analysis on the firm, but it appears to be another oil-and-gas type company that is blowing more money out on the capital expenditure side than receiving in operating cash flow, and with the decrease of natural gas prices, those capital expenditures will have to slow down quite quickly.

Despite all of these internal struggles, the bond market appears to be somewhat calm with the credit-worthiness of the company – an example would be their bonds maturing in 2020, trading from a yield to maturity of about 6% to about 7.25% in recent times over the past three months. Preferred shares are also trading at around the 6% level, which is odd to say the least.

Yellow Media – alive for how much longer?

I notice that Yellow Media did not announce it was suspending interest payments on its convertible debentures (TSX: YLO.DB.A). If they would have done so it would have guaranteed them going into creditor protection.

They have about 11 months to figure out a solution to their imminent debt situation before they will go into default. The medium term notes (which are equal in level to the bank debt in seniority) trade at around 50 cents on the ask at present. The convertible debentures (junior to the MTNs and bank debt) are at about 12 cents on the dollar, while preferred shares are at about 3 cents on the dollar.

The logical investment conclusion is to buy the MTNs if you believe the entity has value after restructuring, or buy the preferred shares if you believe there will be a hugely messy process but not something that wipes out the preferred shareholders. The “middle ground” debentures will probably profit less than the preferred shareholders if there is some sort of recovery.

Five year vs. Ten year mortgage rates

The five year rates currently advertised is a record low 2.98%; 10-year rates are around 3.84%.

With the best floating rate mortgages currently at prime minus 0.25% (prime currently being 3%), it seems fairly obvious that a 5-year fixed rate is an optimal solution compared to floating rate mortgages.

However, the 10-year rate, while historically at record lows, assumes that your next 5-year renewal will be at 4.7%, which still is relatively low historically. That said, there is no optimal answer – it depends on one’s risk tolerance and other factors, such as the leverage ratio of the debt. The spread between 5 and 10 year money on the bond market is currently 0.53%, so a consumer locking into the 10-year rate of 3.84% is overpaying slightly when comparing the true cost to the bank – which is why the banks are probably trying to muddy the waters by getting people on 10-year mortgages.

There is also an implicit bet on inflation with the selection of term – if you expect inflation to rise significantly in the next five years, go with the 10-year rate. If you expect inflation to be roughly the same or, heaven forbid, deflation were to strike the economy, then go with the 5-year rate and you will probably receive just as good a renewal rate.

At 2.98%, the banks are not going to be making much money on 5-year mortgages. It may be tempting to look for a little more levered spice in your portfolio and spread it in bonds of companies that will have a very high chance of paying back their investors with roughly the same duration structure – e.g. Rogers Sugar convertible debentures (TSX: RSI.DB.C) maturing on April 30, 2017 has a yield to maturity of 4.75% (just make sure to note there is call risk as the debt is trading above par). Of course, every institutional investor on the planet is trying to do this on margin as well, so your compensation accordingly is less than 200 basis points and is certainly not “risk-free”.