Yield chasers are going to get killed

I note that James Hymas has observed that an issue of Royal Bank preferred shares (essentially a fixed rate coupon of 6.25% that will be redeemed at par in February 2014) is trading at a yield-to-call of 2.93%. Essentially investors will be paying $28.31 to receive a cash flow of $1.5625 per year until February 24, 2014, and a payment of $25 on February 24, 2014.

Putting this another way, an investor is paying $28.31 today to receive $5.625 in preferred dividend income and taking a $3.31 capital loss in less than four years.

When you compute this at the highest marginal tax rate, it makes even less sense – trading income for future capital losses makes the proposition even worse on an after-tax basis.

The only justification I could come up with why this occurs is two-fold:

1) Unsophisticated investors do not realize that the preferred share will be called away for $25 on February 2014 and purchases the shares in the mistaken belief that their yield will be roughly 5.52% ($1.5625/$28.31 = 5.52% and this is what you would see on most typical stock quote providers as the “dividend yield”);

2) Fixed-income funds that have been swamped with investor capital just buy the preferred shares blindly without regards to any stringent valuation criteria.

Either way, when seeing action like this on the markets, it is a sign that yield chasers are paying far too much for income-oriented investments. It makes me very wary to be playing the preferred and bond markets at the moment. Individual opportunities have pretty much dried up during the last half of 2009 and the remaining issues that are trading below par all have some chronic business issues that make them less than “safe”.

My focus as of late has been on the equity side, a much more difficult world to analyze than bonds and preferreds.

Bellatrix Exploration debentures trading lesson

I own (clarification: after today, this should be “owned”) some debentures of Bellatrix Exploration (formerly True North Energy Trust). They mature in June 2011, coupon of 7.5%. They also were a relatively safe pick to be redeemed at maturity.

Today the company announced they raised money for more debentures and announced their intention to redeem the existing debentures. The debentures have an early redemption term as follows:

Subject to closing of the Offering, Bellatrix intends to give notice on or following the closing date of the Offering of its intention to redeem its currently outstanding approximately $84.9 million 7.50% Convertible Unsecured Subordinated Debentures due June 30, 2011 (the “Existing Debentures”). The Existing Debentures are redeemable for an amount of $1,050 for each $1,000 principal amount of the Existing Debentures plus accrued unpaid interest if redeemed on or prior to June 30, 2010 or an amount of $1,025 for each $1,000 principal amount of the Existing Debentures plus accrued unpaid interest if redeemed after June 30, 2010. A determination as to the redemption date will be made prior to closing of the Offering. Proceeds from the Offering will be used by Bellatrix to partially fund the redemption of the Existing Debentures and the balance of the redemption amount is intended to be funded through bank indebtedness.

Earlier this year, Bellatrix debentures were trading very close to 102.5, which was my exit price. I was actually the asking price at one point in time, but nobody bought my asking price. I had assumed the company would wait until June 2010 to mature the debt and just left my open order at 102.5, assuming they would never consider an early redemption at 105.

I was apparently wrong – the debentures today traded from 102 to 104, settling around 103.5. The people buying above 102.5 obviously are speculating that management will be redeeming earlier than the June 30, 2010 date.

The math is pretty simple – the new convertible debenture deal closes on April 20, 2010. If the company redeems early, they will pay $2.125 million more in redemption premiums if they do it immediately after the deal closing than if they did so in June 30, 2010. If they wait the 2.3 months before redeeming, they are paying $1.22 million in interest payments, and this also does not include the company’s ability to utilize the $85 million in capital during that time period. Even if they redeem today, they will be paying $1.59M in interest expenses, much less than the $2.125 million they would save by delaying the redemption.

The calculation highly suggests the debentures will be redeemed on June 30, 2010, and anybody buying Bellatrix at 103.5 is insane. When the debentures are deemed, they will receive a -3.6% annualized return on their investment.

The trading lesson here, however, is that keeping open orders in this manner exposed myself to the risk of this happening and as a result, I am short a small amount, but an amount that certainly would have paid for quite a few ribeye steaks.

I also could have avoided this issue by actually waking up at 5:30am Pacific time and reading the press release to cancel my order, but Pacific coast investors automatically face the handicap of having the financial world set on the eastern time zone (even for an Alberta corporation) and I was obviously asleep at the time.

I am happy, however, that this trade was successful in the overall scheme of things.

Canada Interest Rate Projections – March 2010 – Effect on mortgages

With all the talk about the Bank of Canada wanting to raise rates, it is instructive to look at what the futures market is saying about the issue. It should be noted that the next scheduled rate announcements are as follows:

April 20, 2010
June 1, 2010
July 20, 2010
September 8, 2010
October 19, 2010
December 7, 2010

A rate increase on or before the July 20, 2010 meeting is a guarantee. The question is how much?

The markets currently say the following:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AL 0.000 0.000 0.000 99.480 0.000 0
+ 10 MA 0.000 0.000 0.000 99.440 0.000 0
+ 10 JN 0.000 99.320 99.325 99.360 -0.040 21736
+ 10 SE 0.000 98.870 98.880 98.910 -0.040 33614
+ 10 DE 0.000 98.400 98.410 98.450 -0.050 19923
+ 11 MR 0.000 97.980 97.990 98.030 -0.040 6402
+ 11 JN 0.000 97.630 97.640 97.690 -0.050 3215
+ 11 SE 0.000 97.320 97.350 97.410 -0.080 1445
+ 11 DE 0.000 97.040 97.060 97.140 -0.090 707
+ 12 MR 0.000 96.810 96.840 96.910 -0.080 50

The three-month interest rate will be:

June 2010: 0.68%
September 2010: 1.13%
December 2010: 1.60%
March 2011: 2.01%
June 2011: 2.37%

Reading my tea leaves, this would suggest that the Bank of Canada will raise per the following schedule:

April 20, 2010 (No change – 0.25%)
June 1, 2010 (No change – 0.25%)
July 20, 2010 (+0.75% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

It is also likely that by June 2011 that interest rates will be around 2.5%.

The only effect these rate increases will have on mortgages are for floating rate mortgages (ING Direct offers them at prime minus 0.4%). This would mean that rates would go up from 1.85% to 3.35% by the end of the year and roughly to 4.1% by the middle of 2011. For most borrowers on floating rate mortgages, they will likely see their interest payments at least double over the course of the year. As an example, for somebody borrowing $300,000, their interest payments will increase from roughly $450/month to roughly $1000/month by the middle of 2011.

In terms of fixed rate mortgages, rates are essentially set by the bond market, and the bond market has already “baked” in these projected rate increases. The best available 5-year fixed rate mortgage is 3.69% currently. Given a choice between these two options, it is a rare time where taking the 5-year rate would be the prudent option.

It is likely once interest rates start to increase that banks will increase the “prime minus” spread from a typical 0.4% currently to around 0.8% – the peak discount which was seen in the last housing rush.

Either way, the lack of ultra-cheap credit will have an effect of slowing down the housing market considerably.

Canadian Taxes – Waiting for the T3

Anybody invested in income trusts should know that the T3 slip, a statement of income from trusts, is required for applicable trust holders by March 31 of every year. This is usually the last tax form to come in, and it will explain how much income (and what type of income) you received over the year.

The reason why the T3 slip comes so late is to give trusts sufficient time to finalize (and audit) their financial statements for the fiscal year.

Impatient investors that want to get cracking at their personal income taxes, however, can go to CDS Innovations’ website and get a sneak preview of most publicly traded entities’ allocation of income. T3 statements for the 2009 tax year can be found here. Just note, in theory, a trust can change the reported allocation on March 30, 2010 and one should never submit their income tax return using the preliminary data.

First Uranium raises expensive capital

The financial soap opera continues at First Uranium. On Friday morning they announced they have agreed to a private placement of between $125 to $150 million of senior secured notes. There are a bunch of stakeholders that are getting into this offer, including the major shareholder, Simmer and Jack, and also Gold Wheaton, who has a stake in the gold production of First Uranium.

The notes are convertible at $1.30/share and this will represent a substantial amount of dilution for existing equity holders, assuming conversion – about 48% dilution.

I was informed that the notes will have a 7% coupon attached to them.

Also in the announcement is that the CEO, Gordon Miller, will depart and be replaced by another CEO, Deon van der Mescht, who is currently the CEO of Simmer and Jack.

A relevant quotation is the following:

In addition, the Company is relying upon exemptions from the minority approval and valuation requirements of Multilateral Instrument 61-101 – Protection of Minority Security Holders in Special Transactions, on the basis of financial hardship. The Company’s current payables do not, in the Company’s estimation provide comfort to wait for 21 days to begin closing the Offering. As previously announced, the Company’s financial situation has been severely compromised by the termination of discussions regarding certain financing options as a result of the decision to withdraw and subsequently reinstate the Company’s environmental authorization for the new Tailings Storage Facility designed to accommodate future tailings deposition at the Company’s Mine Waste Solutions tailings recovery project.

First Uranium, therefore, is very close to bankruptcy. If this deal falls through, then bankruptcy is guaranteed. There would be a process where creditors (including the debentureholders) will be able to make their claim on the assets in accordance with Canadian law. Simmer and Jack’s investment would have been completely destroyed in the process, which is why they had to take this very unpalatable deal in order to save their interest in the company – which by all means should be able to produce a substantial amount of revenues once the core operation commences.

If you are holding equity in First Uranium, you have virtually lost most of your value over the past couple years. This deal should probably stop most of the blood-letting, but it is at a huge cost to shareholders.

The market, seeing certainty on the horizon, bidded up First Uranium shares 13% to $1.68. This also provides a substantial conversion cushion for the private placement component of the convertible offering to succeed.

The convertible debentures also rose 12% to 77 cents on the dollar with this news. The convertible debentures are a $150M issue, with a 4.25% coupon and maturing on June 2012. I happen to own some of these and am not afraid of dilution – in fact, I prefer dilution.

If this deal succeeds, it is more likely that I will receive payback on my investment, especially since the maturity date of this new deal is later than the existing convertibles. It is not clear, without reading some sort of prospectus statement, whether the secured nature of these new notes would interfere with the payment of the unsecured debentures.

Of note in this press release is no quotations from any officers in question – probably because this deal was entirely organized without the management of First Uranium consenting to it.