Redeemable Preferred Shares – only 2 remaining

I’m going to track back to my previous post on the matter of redeemable preferred shares and point out today that Birchcliff preferreds (TSX: BIR.PR.C) traded at $24, which if you put back to the company on June 30, 2020 will result in roughly a 12% YTM. There is the equity risk of the company choosing to redeem in shares at 95% of weighted average trading prices, or a $2 minimum, which BIR equity is trading awfully close to. The company itself, however, even with depressed natural gas markets, is in no danger of becoming insolvent as its line of credit is healthily above the redemption amount of the preferred share series (CAD$50 million), coupled with the fact that the equity itself (despite management shrewdly engaging in a self-enrichment process at their last annual general meeting) appears relatively cheap.

Mentioning that you purchased these preferred shares is not going to draw much of a crowd at cocktail parties, however.

Kinder Surprise – KML taken out by PPL

Kinder Morgan Canada (TSX: KML) has agreed to be taken out by Pembina Pipeline (TSX: PPL), subject to a 2/3rds shareholder vote of KML holders, which will most certainly be approved. Details on this news release.

KML shareholders will get 0.3068 shares of PPL, which based on the closing price today (not the date of announcement) is about CAD$15.06/share for KML.

My comments are the following:

1. I thought this would happen in 2020 – my guess is while doing the strategic review they received a bunch of low-ball offers (and did not take any), but after the review ended they received a credible offer which was close to the initial KML IPO price of CAD$15/share (guessing their target price).

2. With regards to the preferred shares, I will point out that PPL has two preferred share series with minimum rate resets: PPL.PR.K (575bps, resets at +500bps with a 575bps mininmum rate) and PPL.PR.M (575bps, resets at +496bps with a 575bps minimum rate). Both trade above par value and both reset in the middle of 2021.

KML.PR.A (525bps, resets at +365bps with a 525bps minimum rate) and KML.PR.C (520bps, resets at +351bps with a 520bps minimum rate) are significantly worse featured – a reset rate of about 140bps adverse and a minimum rate of 50bps adverse. Both are trading slightly up (about a dollar) to ‘synchronize’ with the above – as PPL is a better credit.

Note that PPL is under no obligation to take out the preferred shares at par. Holders of KML preferred shares can keep clipping their coupons and have a little more confidence that the size of PPL will back it up.

3. Pembina is in a great position to take over the Trans-Mountain pipeline project (KML’s Vancouver terminal and Edmonton storage project synergize greatly with the pipeline). Although they claim they are not interested in it due to the obvious political mess, you can be sure if the Canadian government is going to give it away for cheap, Pembina will be right there bidding.

As such I think PPL was a great strategic buyer for these assets.

Thoughts on Canadian preferred shares (Reply)

Chris posted a comment with the following question:

Do you have any thoughts on Canadian Pref shares? I’m watching a few for potential multi-year hold.

I asked for his thoughts first, and he replied:

I’m seeing a few yielding around 7% (taxed as dividend), with resets 3 to 4 years out. I can’t predict where they 5 year bond will be at that time, nor can I pick the bottom on these moves, but 7% for a few years followed by a reset at 5 year bond + 2.9% (based on $25, as you know) seems like a decent place to put some longer term money to work. BAM.PF.A is an example. Prefs are a bit outside my wheelhouse, but it seems that they present an opportunity every now and then. Thanks for any insight.

…

I forgot to mention that Brookfield has been buying back some of their prefs in the open market recently.

Chris – One thought is fairly obvious and you touched upon – those 5 year rate resets are awfully sensitive to the bond yield!

Example (above): TRP.PR.B (current coupon 2.152%, resets at 1.28% above 5yr, the reset is June 2020) – an investor since October 2018 will have lost 45% of their capital to date (when the 5yr yield was roughly 240bps)! That’s very heavy, and a double-whammy because the equity from October 2018 to present has gone up! Normally you’d expect capital gains/losses for preferred shares to be muted to the equity. The company itself hasn’t materially changed in credit profile.

Currently the 5yr government yield is 121bps – at present rates you’ll get a reset at 6.2%, but you can be sure if 5yr yields go down to 60bps (which is conceivable and mirrors the lows a few years back) TRP.PR.B will be trading at around $7.60-ish, all things being equal, or almost another 25% of capital loss!

There also appears to be a law of dividing by small numbers effect going on. Let me illustrate with an example – pretend something yields 3% at present. Going from 3.0% to 2.5% is a 17% difference. Going from 2.5% to 2.0% is an 20% difference. Going from 2.0% to 1.5% is a 25% difference – low-rate reset preferred shares such as TRP.PR.B are getting absolutely killed because of the small denominator.

So if you want to take your 6-7% coupons and run with them, you need to take into consideration that there’s a good chance that you won’t be able to unlock the capital without taking losses, and ultimately you want to eventually see a day where interest rates are higher than when you initially purchased the preferred securities – who knows if/when this will be?

Hence, those 5 year rate resets are much more risky than people probably thought – they have been wildly volatile in the past five years.

You can dampen the risk by buying rate resets that are further out in time (e.g. resetting 3, 4 years from now) but they still trade quite sensitively to the overall 5yr government bond rate. Fixed rate (straight) preferreds are another option (albeit with different rate sensitivity). Most minimum-rate guaranteed preferreds trade very expensive (e.g. PPL.PR.K).

Of course if you anticipate 5yr government rates will increase, the inverse of the above scenario applies (i.e. potential for significant capital gains).

With the US Fed anticipated to drop short term rates, there’s a good chance Canada will be following to some extent and this will continue to depress the entire yield curve. I’m not offering an opinion on future rates, but the trend clearly has been negative (i.e. bias towards lowering rates) since the beginning of the year.

Another comment I will make is that I’ve generally noticed equity presents a much more attractive risk/reward than the preferred shares in a lot of issuers. If you’re just buying for income, why not just buy equities that give out nearly the same yield with a lot more potential for upside (including dividend increases)?

Also, I have not seen another asset class that is so ripe for tax-loss selling. If you were sitting on a 45% loss on TRP.PR.B but really wanted the exposure, I’d sell it and buy something very related instead (e.g. TRP.PR.C) and this avoids the 30-day wash sale rule.

So to conclude, there appears to be quite an element of risk unless if you’re planning on holding these securities strictly for income for a considerable period of time.

Drudge on the doom of the stock market

Most times I have no idea where things are going in the macro sense – speculating is entertainment but I don’t find I have superior insights on the matter. However, it is important to read the market psychology and when non-financial media start to comment on financial happenings, more often than not it is a contrarian indication:

I find this paranoia regarding Trump, China, recessions, etc., to be very alarmist. I’m pretty sure at this stage in the economic cycle that we are due for an economic purge sometime – there’s a lot of excess out there (does anybody seriously think Beyond Meat is worth a third of Tyson Foods?). Instead, we have a very low interest environment, with short term interest rates likely to head lower over the next year, and it all brings you to the fundamental question:

What else are you going to invest in?

Clearly as real rates go negative (let’s not get into the scenario where nominal rates go negative!), institutions have found safe passage in gold.

But, as Buffett says, there isn’t much economic value to storing a bunch of yellow metal in a fort somewhere. Where are you going to find a return?

You can put money in a BBB or A-rated bond and get your 340bps, but that isn’t going to be enough.

Real estate gives a yield (on rent) but even REITs have their yields compressed, and in Canada, you have commercial property cap rates that are getting ridiculously low (mid single digits). The favourite residential REIT of most retail (TSX: CAR.UN) gives out a whopping 270bps in distribution yield. Looks expensive (unless if real estate continues to rise).

What’s left if you actually want a return?

There’s only one game in town – equities.

There’s a lot of old-school value out there that’s really getting hammered in anticipation of this recession.

Genworth MI – sold to Brookfield Business Partners

The winner of the Genworth MI auction (presumably there were multiple interested partners) was Brookfield Business Partners LP (TSX: BBU.UN) at CAD$48.86 per share, for 57% of Genworth MI shares. Brookfield Asset Management owns about 80% of Brookfield Business Partners. I’m not going to dissect more of Brookfield’s capital structure or even the LP unit, but suffice to say, they have the assets to consummate the transaction, assuming they receive regulatory approval.

The transaction, if approved, will close sometime in the first half of 2020 and apparently will receive regulatory approval by the end of 2019. I had speculated earlier that Genworth would not receive more than CAD$55/share for the unit (and my initial opinion was CAD$50) and this appears to be right on the mark. Genworth MI’s stated book value was $47.17 at the end of Q2-2019, so Brookfield is paying a very modest premium over book.

Here’s the interest part of the release:

Brookfield Business Partners has also agreed, between now and the closing of the transaction, to provide Genworth Financial, Inc. with a bridge loan of up to US$850 million that is intended to be repaid from proceeds of the sale of its interest in Genworth Canada.

Genworth Financial has some solvency matters to deal with.

The other logistical matter for Genworth MI is that they share services with Genworth Financial for some business operations. This will have to be carved out and transitioned over with the takeover. In addition, it is not clear whether the senior staff of Genworth MI will go back to Genworth Financial, or whether they will stay with the MI subsidiary. When businesses are acquired like this, there is always an element of disruption, if not handled carefully!

As for the other 43% of Genworth MI, currently Brookfield indicated they do not wish to repurchase it:

Given the short time frame available to complete this transaction, Brookfield Business Partners has no current intention to make an offer for the balance of the outstanding Shares. Brookfield Business Partners may in the future consider the appropriateness of such an offer after discussion with Genworth Canada’s shareholders and other stakeholders.

This may happen if Genworth MI starts to trade significantly under CAD$48.86. One needs to look no further than the treatment of minority shareholders of Teekay Offshore (NYSE: TOO) which are currently receiving a lowball offer for their shares.

I would suspect very limited upside for the capital value of Genworth MI shares at current market prices.