First Uranium will be an interestnig story

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.

Debt and confidence

John Mauldin summarizes a part of the book This Time is Different by repeating that a sudden drop in confidence is what drives economic crises. A lack of confidence is more pronounced in debt crises because if the market collapses for debt renewals, you will have to default, which triggers a worse cascade of events.

It is also difficult to predict when the confidence is lost, but when it does occur, it is usually sudden, as witnessed in the 2008 financial crisis.

Whether another financial-type crash will occur in North American markets is up for debate, but whenever such a crash happens, one is best to brace for impact in terms of one’s portfolio and personal financial situation – high debt leverage is the big killer.

Frontera Copper Note Exchange

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.

Fixed income comparisons

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!

Handbook of Fixed Income Securities

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.