Category: Debt

Unloading some more long term debt

One of my corporate long-term debt holdings in R.R. Donnelley (NYSE: RRD) has been trading significantly higher since my purchase point in 2009. I had invested in the 6.625% October 2029 debenture, via a trust preferred security (NYSE: PYS), which has a coupon of 6.3%.

Although I had been sitting on large unrealized gains on the issue and was intending to dispose of it in 2011, the trading above 24 proved to be too tempting so I unloaded it and realized gains. Although it’s entirely possible the bonds will continue trading this high in a couple months, I didn’t want to take the gamble.

Mathematically, assuming a continuous yield (which the trust preferreds do not trade as; they trade “as-is”), the PYS security would have a pre-tax current yield of 6.5% and an implied capital gain over 18.9 years of 0.2%. This is below what you can get with some shorter duration fixed income securities, so disposing of this will be a good decision assuming I can deploy capital more efficiently in the future.

The equity in RR Donnelley at this moment appears to look like a better investment than its long-term debt – the company’s cash generation is significant and its debt is termed out properly and has been managed well, so there is unlikely to be a liquidity risk with the operation. Even if you assume they do absolutely nothing but earn income at the rate they have been doing in the past 9 months (a false assumption due to seasonality in their business), the equity will be yielding a minimum of 7.6% at present prices – a compensation of about 1% over debt. When you factor some very conservative growth assumptions, it skews significantly in favour toward the equity relative to the debt.

In terms of overall portfolio movement, my long-term debt holdings have shrunk again and cash has increased. If/when long-term government bond yields start to rise this should prove to be a good move.

Clearwater Seafoods debenture refinancing

This is slightly old news, but on October 7, 2010 the management of Clearwater Seafoods Income Fund are trying to get $45 million in debentures, due at the end of the year, out of the way without excessive cost.

The terms they offered are the following:

– Higher Interest rate: The proposed amendments provide Debentureholders with an interest rate that will be increased by 3.5% from 7.0% to 10.5%.
– Lower Conversion Price: The conversion price will be reduced from $12.25 per Fund unit (“Fund Unit”) to $3.25 per Fund Unit.
– Extended Term: The maturity date will be extended from December 31, 2010 to December 31, 2013, and the amended debentures will not be redeemable prior to June 30, 2011. As such, Debentureholders will have a longer period of time to receive a higher interest rate and potential to exchange their debenture for equity in an entity that is poised to create significant value for unitholders.

The higher interest rate is the only appealing sweetener for the holders – the conversion price decrease is insignificant when compared to the present unit price of 86 cents per unit; the extension of the maturity is also not beneficial when considering that it puts them behind in order with a series of term loans and a bond maturing on August 2013.

If I was holding the debentures (which I am not), I would walk away this deal.

If they dropped the conversion price to $1.00/unit, I would consider it. $3.25/unit, however, is a ridiculously high conversion rate.

Even if the debenture holders were stupid enough to approve this deal, they will not be collecting their coupons for too long since the company actually has to generate cash to pay out. It will not be long before this whole company has to give out a lot of equity to get rid of the high debt on their books. It would be one thing if the company were operationally running well but was financially leveraged too highly, but it just appears that this company is not particularly profitable, but management talks like it is.

When management has to use language like “potential to exchange their debenture for equity in an entity that is poised to create significant value for unitholders” in a pitch to debt holders, I have my doubts the right people are running the company as they are taking their owners and creditors like idiots.

The public will find out on November 12, 2010 whether this proposal goes through or not.

As I have previously disclosed, I have no holdings in Clearwater Seafoods equity or debt.

Get ready for the next soverign debt crisis

It appears that Ireland’s ability to borrow money is becoming much more impaired in the past three months, looking at the 10-year yield on their notes (note that the chart is the spread between the German and Irish 10-year sovereign debt, not the absolute yield to maturity of the Irish 10-year note; Germany’s 10-year debt yields roughly 2.4% at present):

The absolute yield to maturity is here:

Observers should note that during the Greek bond crisis (which peaked in early May 2010) that yield spreads on the same Irish notes went up from roughly 1.3% to 3.0% before trading at a range of roughly 1.6% to 4.5% before this wave of relative selling hit. This corresponds to a yield to maturity on Irish debt of roughly 4.4% to 5.9% and 4.6% to 6.7% after the Greek debt crisis.

Something else to note was that US treasuries were recipients of capital inflows during the Greek debt crisis, which apparently is not happening right now.

I have no further insight other than what is making the news right now, which means it is not tradable information. But it is something to be aware of – there may be another European sovereign debt crisis coming down the pipeline. If a yield spike hit the US government debt market, it would make major financial headlines. There is no telling whether the 50 basis point run-up in the last month is the start of a 5% rise in yield, or whether it is market noise.

Rising bond yields

The chart of the 30-year treasury bond clearly shows an increasing yield since roughly early October:

Yield is up from roughly 3.65% to 4.25% presently. Will this trend continue? It seems the market is starting to price in long-run inflation, especially when contrasted with the 10-year yield:

Yields from early October is up from 2.50% to 2.66% presently.

It is very difficult to trade a bond market when the environment is so explicitly manipulated by large players (the Federal Reserve being one) – there is a lot of money to be made predicting their next move, but from the retail end it is very difficult to judge since there are a lot more informed participants in the bond market.

One consequence of increasing bond rates is that the price of obtaining long term corporate debt will rise. On the 10-year the rise doesn’t appear to be much above ambient noise levels, but there is clearly something going on in the 30-year.

Historically, however, 10-year yields are trading at relative lows.

Trading credit principal for quality – TFSA update

As readers here may remember, my TFSA investment (which I am trying to compound as quickly as possible) was in First Uranium debentures (TSX: FIU.DB), unsecured senior debt, coupon 4.25%, maturing June 2012.

This has been one of my lesser performing investments, due to a horrible entry point (the company announced some adverse news shortly after my investment), which I had an opportunity to see the writing on the wall and liquidate (which I could have received a very acceptable price), but unfortunately my worst decision in the year was to not.

Anyhow, my TFSA is currently sitting about $600 below the end of December 2009 mark (netting out the $5,000 deposit), which is not too good since my other (fixed income) investment candidates at the time would have resulted in an actual increase on investment, which is the whole point of the TFSA. If I was planning on losing money, I would have prefered to do it in the RRSP or in the non-registered account so I could deduct the loss. C’est la vie – that’s how things work sometimes. The question is now, how to get back on track?

The first thing to look at is whether the underlying securities are still worth keeping based on new information that has been received in the interim. First Uranium went through a recapitalization which saw common shareholders be diluted in the form of a convertible notes offering (senior, secured by all assets minus what Gold Wheaton is entitled to, maturing March 31, 2013, convertible at $1.30/share, 7% coupon, TSX:FIU.NT) and a 14 million share settlement to Gold Wheaton (TSX: GLW) since FIU did not finish constructing a mine module in time. The company itself remains active in the gold mining industry (despite the company’s name, Uranium is a small part of the business), having two mines operating – Mine Waste Solutions (which is operating well and is profitable) and Ezulwini (which has been a basket case operationally and has been losing money). After firing most of the board and management, it appears there are hints that the company is coming back to financial life again, especially with gold prices at the high prices they are at today.

The company’s financials, once they stop spending big cash on capital expenditures, should be cash generating and healthily profitable even if you believe they will moderately underperform the economic projections in the technical reports. So it becomes a matter of whether the market believes the management can deliver operationally, and whether the management is credible. Given the history of the company, they are not and the common stock and debentures trade as if this is the case.

Thus, this is a high risk, high reward scenario. I have only gone superficially into one of the risks in this post, but there are other risks that I have mentally dissected.

While I do not think this investment is a slam dunk, when you adjust it for risk/return, there is a compelling investment thesis on the debt of First Uranium, and possibly the equity, which appears to be somewhat undervalued. There is a huge amount of default risk for the equity holders, and some risk for the unsecured debenture holders, and limited risk for the secured note holders.

The TFSA transaction that I recently performed was to sell half the debentures ($12k face) at 70 cents on the dollar, and then use the proceeds to purchase $10k face of notes, which I subsequently purchased at 88.5 cents on the dollar.

Why would I trade lower priced unsecured notes, maturing earlier (and a better annual compounded yield at existing trading prices) for more expensive, secure notes with a later maturity and less yield? The quick answer is that I am trading yield for quality.

The longer answer is that I am reasonably confident that the secured note holders would be able to receive the full principal amount in a bankruptcy liquidation of First Uranium. There is $150M outstanding and the company is likely to fetch more than this from Mine Waste Solutions alone. The upside for the noteholders (beyond a payout at maturity) is the $1.30 strike price, 2.5 year call option embedded in the notes, which provides a mild amount of equity participation without actually having to own the equity. The equity is currently about 67% out of the money as of this writing.

If FIU does get its act together, it is likely that the equity will increase higher than 67%. However, the equity is far too risky in the TFSA – it is better suited to a non-registered account where you can at least book capital losses if it tanks.

Finally, there is the scenario of what happens to the unsecured debenture holders when their maturity hits (June 2012) – the company will either likely make an offer to extend the maturity or give the debenture holders a sweeter deal (higher coupon and lower conversion rate) while the company tries to make its mining operations profitable. I do not think the unsecured debenture holders will force the company into bankruptcy simply because of their rank – they have relatively less negotiating power.

I will emphasize that equity in First Uranium is a highly risky investment, and the debentures are a risky investment, but the notes appear to be less risky, and are priced to represent the lower risk.

The notes are also better positioned in the TFSA (since you will likely see your money back), while debentures are better positioned in the RRSP (income is tax-deferred, but you can still benefit if you have a loss of prinicpal), and equity is positioned in the non-registered account.