Dredging the market for corporate debt

I’ve been doing an exhaustive examination of the available publicly traded debt from US corporations. I am specifically looking for debt that has maturity lengths of between 2-8 years, and the underlying issuer is relatively solvent. The actual parameters I used for the screen I’ll leave aside, but there were a lot of issuers to do some quick research on to see whether they were worth further investigation.

The “relatively solvent” criterion allows me to exclude companies that are basically operating entities that are encumbered with a gigantic amount of debt relative to tangible book value. These entities typically exhibit goodwill and intangibles far in excess of what the stated equity is, which means that the entity was likely a result of a previous leveraged buyout or some sort of financial restructuring to extract the maximum capital of the entity.

A good example of this is Toys R Us, a completely leveraged mess of a financial entity as a result of a leveraged buyout years ago. If you like anti-depressants, please take them while you read their last quarterly report. I would not go anywhere near their unsecured debt. Somehow this entity actually warrants a market value of an 11% yield to maturity on their 2-year debt. Amazing.

I am not interested in these entities unless if they were generating a sufficient amount of cash in relation to their debt, and in most cases they do not. This means that refinancing risk is going to be crucial for these entities – while today they might get the financing, tomorrow they might not. It is at those moments where an investor will make the optimal risk/return ratio. Today an investment will just result in a mediocre risk/return.

There were a lot of offshore drillers that are clearly in trouble, and a lot of energy-related entities in trouble. In general, I am not interested in these (in addition to having enough exposure to energy bonds via Teekay debt).

Finally, anything that did seem to be a reasonable candidate had a chart resembling this:

twi-debt

I picked Titan International (NYSE: TWI) just as an example and not something I am interested in purchasing (at current prices). It is an automobile parts manufacturing company and is fairly easy to analyze – $200 million cash in the bank, a $60 million debt issue due in January 2017 that they will pay off, and $400 million due October 2020 (which you see in the chart above). The coupon is 6.875% and the debt is senior secured, and trades at a YTM of about 8.5% at present. The corporation in the first half of this year generated about $11.6 million in free cash flow. Historically they seem to be a cash generation vehicle for management teams.

It doesn’t take a Ph.D in finance to realize that they will likely have to refinance the debt when it comes to maturity in four years. They will probably be able to do this, but who knows?

This same bond traded at nearly a 19% YTM back in February when the whole market was going haywire.

Just because the bond is trading at higher levels (lower yields) doesn’t mean that they are valuable today. But if you did buy today you’ll get a high single digit return in the compensation for the risk that you’ll be dealing with the Chapter 11 proceedings of an auto parts manufacturer that doesn’t have the capacity to generate a huge amount of cash in a very low-margin industry.

Is it worth 19% to take this risk? Absolutely. Is it worth 8.5%? Probably not. Today you can get that debt for about 94 cents on the dollar, but if you got the same debt for 80 cents a year from now, you will get a much better return (assuming the aforementioned default does not occur).

The other question I ask myself is whether we’ll likely see something in the next couple years that will resemble a bond refinancing crisis. While the future is always difficult to predict, there will always be something that will cause panic in credit – and it is in these times that one must dive in deep, just like I did back in January and February.

There are numerous examples like this littered in the bond markets today – lots of mediocre companies with bonds trading at single digit yields to maturity. Even worse are the over-leveraged messes that are just asking for recapitalization when the market sneezes.

So overall, the pickings of my bond market research have been very slim.

The results are quite depressing – out of looking at approximately a hundred issuers, I’m only interested in doing a deep research session on one corporation. Also, my initial take on this entity wouldn’t be for their debt – it would be an equity investment. My initial instinct says that their equity could double in a year, while their debt yields 7.6%. I’m eager to start the research process.

Looking at this whole exercise, I realize this following statement might be the biggest piece of confirmation bias about my own portfolio, I believe the pieces of corporate debt that I currently own represents the best risk/reward available on the publicly traded markets today. I just don’t see anything else out there worth putting capital in the corporate debt markets. It’s a classic case of doing a lot of work but achieving no tangible results for the portfolio.

Difference Capital

Difference Capital (TSX: DCF) was the venture capital corporation created by Michael Wekerle in 2012 (done via reverse merger of an existing corporate entity). It invested in a whole bunch of private entities in the hopes of making superior returns. While the going was initially good, it has steadily eroded in value as demonstrated by the five year chart.

dcf

In its modern incarnation, it has about $79 million invested (mostly in equity, and the rest of it in debentures and real estate) along a smattering of mostly private entities. They did employ some leverage in the form of a convertible debt offering and they did get in a bit of financing trouble as a result of the debt issuance, but for the most part they cleaned this up in 2015-2016 through buying back the debt at a discount, from $47 million outstanding at the beginning of 2015 to $32 million on June 30, 2016. The debt has an 8% coupon.

They also have $16 million in cash, and an extra $3 million in receivables if some of their prior asset sales do not incur claims by the end of 2017.

The math is simple – can they cover the $32 million in debt over the next couple years? Assuming there are no material claims, they have $37 million to pay off in interest and principal (interest expense assuming no buybacks), which leaves them about $18 million short if you completely dedicate their existing cash and receivables against their debt. Their burn rate is also about $3 million a year, excluding interest, offset by about $1 million in investment income.

The equation then becomes a matter of raising $22 million over the next couple years to service their debt, or to obtain an extension of their debentures (with some sort of sweetener). I view the latter to be the more likely scenario, but it is quite conceivable that they could cash out an investment or two and partially chip away at the $22 million figure. The other option is to equitize the debt at maturity, but this would be done at a significant discount to their proclaimed NAV.

The debt is trading at 97 cents on the dollar and given everything I have seen, I would view it as over-valued at present. The market is weighing the probability of a clean maturity to be too high.

No positions.

Petrobakken / Lightstream Resources bites the dust

Lightstream Resources (TSX: LTS), formerly known as Petrobakken (TSX: PBN), was formerly a subject of analysis on this website. Despite the company having excessively high yields and posting (and boasting) about huge cash flows through operations, I remained very skeptical of them. Then the oil price cratered at the end of 2014, and then all the excess leverage the company held came to bite it.

The senior unsecured creditors failed to reach an agreement with the company, and as a result they will be going into CCAA proceedings.

I have never held shares of this company. The entity, once restructured, should be mildly profitable in the current oil price environment, but they need to shed a healthy quantity of their debt. It is a classic case of using too much leverage when the times are good.

Turning down a very likely 12% annualized return

There is a catch to the title – the 12% annualized return is in the form of a 6.6% return over six and a half months.

I have mentioned this before (at much higher yields) but Pengrowth Energy debentures (TSX: PGF.DB.B) is probably the best low-risk/medium-reward opportunity in the entire Canadian debt market today. At the current price of 97 cents (plus 5.5 months of accrued interest payments), you are nearly guaranteed to receive 100 cents plus two interest payments of 3.125% each. The math is simple – for every 97 cents invested today (plus 5.5 months coupon which you’d get 6 months back at the end of September), you will get 103.4 cents on March 31, 2017, the maturity date. This is a 6.6% return or about 12% annualized.

By virtue of Pengrowth’s debt term structure, this one gets the first crack at being paid by their billion-dollar credit facility which was untapped at the last quarterly report.

The only risk of any relevance is that the company will opt to exchange the debt for shares of PGF at 95% of the 20-day volume-weighted average price, but considering that the debenture face value is $126 million vs. the current market cap of $1.1 billion, the equity would not incur too much toxicity if management decided to do a virtual secondary offering at current share prices.

The company did give plenty of warning that at June 30, 2016, current oil/gas price levels and a 75 cent Canadian dollar would result in them potentially blowing their covenants in mid-2017. But this is of little concern to the March 31, 2017 debenture holder. They will get cashed out at par, either in cash or shares.

I own some of these debentures, which I purchased earlier this year when things were murkier and much more attractively priced. Given some recent liquidations in my portfolio, I could have reinvested cash proceeds into this apparently very low risk proposition. But I did not.

So why would I want to decline such a no-brainer opportunity and instead funnel it into a short-term bond ETF (specifically the very-low yielding Vanguard Short-Term Canadian Bond Index ETF at TSX:VSB)?

The reason is liquidity.

In any sort of financial stress situation, debt of entities that are “near guarantees” are traded for cash, and you will suddenly see that 97 cent bid moved down as entities are pressured to liquidate. For securities that are precious and safe, such as government AAA bonds, there is an anti-correlation to market pricing that occurs and ETFs holding these securities will be bidded up in response.

VSB is not something that you are going to see move up or down 5% overnight in a real panic situation, but it will retain its liquidity in stressful financial moments. The selection of VSB is different than the longer-term cousin, which has more rate sensitivity, but something has changed in the marketplace where equity and longer term debt asset classes have decided to trade in lock-step: as demonstrated in last week’s trading in Japan and the Euro-zone. When equities and long-term government debt (nearly zero-yielding, if not negative) trade in the same direction, it gets me to notice and contemplate what is going on.

The tea leaves I have been reading in the market suggest something strange is going on with respect to bond yields, the negative-interest rate policies and their correlation to equities. I’m not intelligent enough to figure it out completely, but what I do know is that putting it into so-called “low risk” opportunities like Pengrowth debentures come at future liquidity costs in cash if I needed to liquidate them before maturity. Six and a half months can be a long time in a crisis situation, and we all see what is going on in the US President Election – markets are once again seriously considering Donald Trump’s election now that Hillary clearly isn’t healthy enough to be Commander-in-Chief of the US Military. The public will ask themselves: If she can’t stand up to attend a 15-year memorial of 9/11, what makes you think she will be able to stand up when the terrorists strike the homeland again?

The markets have vastly evolved since last February where things were awash in opportunities. Today, I am seeing very little that can be safely invested in, which is getting me to change what I am looking for, but also telling me that I should relax on the accelerator, raise cash, and keep it in a safe and liquid form until the seas start getting stormy again. And my gut instinct says exactly that: winter is coming.