Dangers of buying callable debentures above par value

Rogers Sugar (TSX: RSI) announced at the end of trading they had a bought offering of debentures, and calling in their existing series of debentures (TSX: RSI.DB.B) effective around December 19, 2011.

Holders of RSI.DB.B will be receiving a nasty shock tomorrow because of this call announcement – they were trading around 104 before this happened, but now the debentures will only be redeemed for 100. Any recent buyers of the debentures will take a bit of a loss. The debentures were trading slightly above par because of the conversion feature embedded within them – they are convertible at $5.10 per share and with the market price recently at $5.14, it is possible there may be further conversions. The debentures will trade at 100 plus the embedded value of a call option that expires on December 19, 2011.

The deal itself is very good for Rogers Sugar – they have extended the term structure of their debentures to April 2017 and December 2018, done so at a slightly lower coupon rate, and an increased conversion price ($6.50 and $7.20 per share, respectively). Overall, Rogers Sugar has performed excellent in my portfolio and I continue to hold a position in the equity, albeit the equity is in my fair value range. Although the investment has been about as exciting as watching paint dry, they have performed solidly.

The geopolitical premium

Oil has been rising steadily over the past month:

This is, in large part, due to the geopolitical premium that has built up in the commodity on fears of supply disruption from a potential strike on Iran from Israel. Other commodities have been roughly flat, with the notable exception of Natural Gas crashing through the floor:

Until we start seeing more consolidation and shutdowns of natural gas drillers and producers, this supply-demand picture is not going to be changing anytime soon. Big fish such as Encana (TSX: ECA) look cheap, but until we start seeing liquidations of smaller players or spontaneous construction of significant amounts of natural gas burning facilities, I would not be touching natural gas commodities. Notably in the peak of the last economic crisis, natural gas went down to US$2.5/mmBtu and at that level it would bankrupt most leveraged small producers. Larger companies like Encana just need to wait with a pile of cash and mop up when the time is right.

As for the oil markets, it will remain volatile as traders are seemingly using it as a proxy for geopolitical event risk.

Holloway Lodging REIT

Forgive my sarcasm, but my favourite nearly insolvent REIT, Holloway Lodging REIT (TSX: HLR.UN) announced their latest quarterly results. They weren’t that bad relative to the previous year, but the company has a huge debt anchor around its throat while it is being asked to swim across the Pacific Ocean.

More specifically, in order to pay off an earlier debenture, the company through a related entity, borrowed money at double-digit rates of interest and continues to have about $12M outstanding at this time through that loan. There is another debenture maturing in less than 8 months worth approximately $50M face value that they admitted they won’t be able to pay off when it becomes due.

The likely scenario is that they will be doing a debt-for-equity swap. However, there is a game of “chicken” being played – there could also be a chance that the controlling shareholder would float another bridge loan to the company and pay off the debenture to avoid massive dilution – similar to what happened with the first debenture.

This is the only reason why I can think that the debenture has a bid at 50 cents on the dollar. Even with this debt anchor removed, the underlying operations are not all that profitable – most of the profit is being sucked off by the controlling shareholder through related entities.

Yellow divests a business

I don’t have enough time to fully write about it, but here are some low quality notes for Yellow Media (TSX: YLO).

Yellow Media announced they are divesting their LesPAC Inc. business unit for $72.5 million in cash. The company basically operated a craigslist-type pour les Quebecois, pardon my mauvais Français! The company generated $12.7M in revenues for the 2010 fiscal year, so on first glance, a sale at 5.71 times revenues seems good. It would probably be a more depressing figure how much they spent to build the service, so it wouldn’t surprise me in the least that with the disposition of that business there would be another chunk of goodwill and intangibles off the balance sheet if they did have to purchase some technology in order to build the site.

Now if they can just sell the rest of their business at 5.71 times revenues, then they won’t have much of a debt problem anymore. Equity holders will get $15/share and everybody will be happy. Don’t hold your breath.

That said, $72.5 million is not an inconsiderable chunk of change and increase the chances the company will be able to chip away at its credit facility due February 2013. Preferred shares C and D are trading a shade lower, yielding 38% at the bid, while debentures are trading a shade higher on reaction to this news at roughly 29 cents on the dollar. The market continues to be deeply skeptical on the ability of YLO to pay back its debt and obviously this depends on whether the “transformation to digital” will be a profitable one or not.

Slight tightening of mortgage credit

I notice that the local credit union, which used to offer prime minus 0.9% (equating to 2.1%) floating rate is now at prime minus 0.3% (2.7%).

The only conclusion that one can make is that retail credit is somewhat tightening and/or banks are getting concerned about their leverage linked to the real estate market. You wouldn’t see this in government debt rates – 1 year treasuries in Canada yield 0.90%. Five-year government bonds yield 1.35% and the best five-year mortgage rate you can find in Canada is about 3.19%.

Given the difference between the two (prime minus 0.3% versus 3.19% fixed), combined with the (albeit unlikely) potential for an interest rate spike would suggest that paying the half-percent spread for a five-year lock would be well-spent insurance money.

That said, anything around the 3% range is historically very, very, very low and would explain the high prices in the real estate market.