Category: Debt

Fixed income and rising interest rates

The public perception is that the value of fixed income securities goes down when interest rates rise.

In a sense, this is true, but how it get reflected in the marketplace is different than what the common “retail” perception is. A better way of phrasing this is that the value of fixed income securities go lower when the there is a perception of interest rates rising.

Even though the whole planet knows that the Bank of Canada overnight rate target is 0.25%, the whole world also knows that this will increase by an amount coming June. This expectation has already been baked into the marketplace, and thus in most circumstances it should be baked into the prices of fixed income securities.

Reading the comments on some Garth Turner articles, where Turner is generally pushing preferred shares over GICs, readers are giving “blowback” stating that the price of those securities will drop when rates rise.

In the eyes of the marketplace, rates are going to rise. You can see this in the 5-year Canadian bond rate.

The question is whether the market prices for preferred securities is going to reflect this or not. In any market, you have to ask yourself about the participants, and a lot of preferred issues are dominated by retail traders. In this event, and assuming retail traders think prices are going to go down because of a flawed notion of a price impact with a rate increase, it would suggest there is a dislocation of information that can be exploited.

Preferred shares require a bit extra research than standard equities or bonds simply because they contain varying provisions which gives the holders and company certain rights that have dramatic effects on their risk profile.

Also, the intent of owning preferred shares is to provide income, rather than capital appreciation and this should always be taken into consideration – it is an alternative to putting money in a savings account, rather than a replacement for an equity (growth) component of a portfolio.

Trimming the long-term corporate debt position

Although not a huge fraction of my portfolio, I have trimmed some of my long-term corporate debt position in Limited Brands 2033 bonds, at a yield to maturity of 7.8%. I will be trimming more if the yield goes down to around 7.6%, and eliminate it entirely if the yield goes down to around 7.4%.

The risk-free rate (US government treasuries) for a 23-year maturity is about 4.5%, so the yield spread of 3.3% is not sufficient compensation in my eyes for the level of risk taken.

Limited Brands is a company that is in excellent shape after the 2008-2009 recession. They have about $2.7 billion in debt, compared to $1.8 billion cash on the balance sheet, and yearly free cash flow of about $900 million. Their “big name” store is Victoria’s Secret and they also operate Bath and Body Works. Although they have excellent prospects looking forward in terms of liquidity and solvency (and they have announced they will be giving out a $323M special dividend and a share buyback program, which is not good for bondholders although it speaks to the financial capability of the company to make such a move), I will lower my exposure to their debt as prices continue to rise and look elsewhere to get a better risk/reward ratio for my capital.

I think there is a good a chance as any of US bond yields rising considerably over the next few years, so this trade is also an adjustment with respect to my macroeconomic view of the world. It does lower the yield of my portfolio, but I am happy to keep the cash. It will stay as cash until such a time where I can determine where to deploy it in an efficient manner. Given what I see out of the markets, I don’t anticipate this will be a quick process.

Garth Turner on Variable/Fixed mortgages – bad advice

On Garth Turner’s “Bingo” post on March 29, 2010, he states:

But the big question I was asked today: what should you do about your mortgage?

The bankers will be on the phone to you soon ‘suggesting’ you lock in, ‘for your own protection.’ Have none of it, if you are in a cheap VRM. We know why the lenders are saying that, since they count on scores of people now rushing in to voluntarily increase their payments. Once again, they play the emotional card, consistently suggesting actions counter to the best interests of Canadians.

A prime-minus VRM is a gift. Keep it. The Bank of Canada rate would have to soar by more than 200 basis points (2%) by Christmas for you even to consider locking in. And even then you would be saving money staying variable. In fact, the typical prime minus one half borrower would be better off staying put until the prime mushroomed almost 4% above current levels. You’d still be paying less a month.

And a prime rate of 6.25% is not going to happen for two, three or perhaps four years. Any sooner and you could mop up the economy with a Swiffer.

Right now, a 5-year variable rate mortgage is prime minus 0.5%, and if you shop around, the 5-year fixed rate is 3.79%.

Prime is currently 2.25%, and should rise to 3.50% by the end of the year. Markets currently suggest the prime rate will be 4.75-5.00% at the end of 2011.

Thus, a variable rate mortgage, locked at prime minus 0.5%, should have a higher rate than a fixed rate mortgage sometime in the second half of 2011.

If prime stayed at 4.25% for the rest of the 5-year term, then a variable rate mortgage is still a cheaper option. However, the differential between the two is close enough that for most everyday people, I would still suggest a 5-year fixed rate if you can get 3.79% for it. It is highly likely over the 5-year period you will outperform the variable option, especially if the yield curve starts to invert (which will happen if the economic recovery runs out of steam).

The crystal ball becomes considerably more fuzzy if you use a 4.39% 5-year fixed rate (which is currently what is ING Direct’s posted rate). If rate increases in 2012-2014 moderate, then taking the variable rate option will be a winner. However, this is exceedingly difficult to predict.

Either way, the lack of ultra-cheap credit will have the effect of slowing down demand in the housing market. Whether that will translate into lower prices remains to be seen. Personally, I have long since thought the housing market was irrational beyond belief, but have come to accept it could be that way for longer than my lifespan.

Ultimately, the only time that housing will become “cheap” in Vancouver is likely when people don’t want to buy houses when mortgages are so expensive that GICs start to become an attractive investment option. Just imagine living back in 1982 when you had a choice of buying some Vancouver special for $150,000 on an 18% 5-year fixed-rate mortgage or renting and putting your would-be down payment in a GIC earning 15% and not having to worry about making those $27k/year interest payments… in situations like that, the cost of capital becomes so high that renting becomes a much more viable alternative.

If we ever see those days again, where buying a house is very difficult because you have such more financially attractive (and accessible) options elsewhere, I would suspect valuations are ripe for buying. We are a long way away from this, even if mortgage credit is given out at 5%.

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.

Paying attention to debt call features

Rogers Sugar Income Fund announced yesterday a bought deal – they were issuing $50M in convertible debt. The salient part of their press release was the following:

The net proceeds of the offering will be used to redeem all of the outstanding $50 million principal amount 6.0% convertible unsecured subordinated debentures of the Fund due June 29, 2012. The redemption is intended to take place on or about June 29, 2010.

The $50M currently outstanding trades as RSI.DB.A. It had a maturity of June 2012, coupon of 6% and a conversion feature at $5.30/unit – before this announcement, the debt was trading very thinly at a price of 103-104. This implies a 4.1-4.5% yield, plus the option premium on conversion. The proper valuation of the debt actually is not a trivial issue considering you have to make some complex calculations with respect to the convertible option – Black Scholes will not cut it in this case.

In any event, Rogers Sugar refinanced the debt. The June 2012 debt also contains a call option, where the company can call the debt, as per the prospectus:

On or after June 29, 2010, the Debentures will be redeemable prior to Maturity in whole or in part from time to time at the option of the Fund on not more than 60 days and not less than 30 days prior notice at a price equal to the principal amount thereof plus accrued and unpaid interest.

So in other words, debt that was trading between 103-104 on March 18, 2010 will be redeemed at a price of 100 by the company on June 29, 2010.

Not surprisingly, the debt now is trading with a bid/ask of 101.75/102.00 and the only reason why this is above 100 is purely due to the value of a three month option with a strike price of $5.30/unit embedded in the debt. Debt purchased at 102 actually has a negative 0.5% yield when you factor in the call that will occur on June 29, 2010.

Investors would be very well to take note of any embedded call features in the debentures they purchase – especially if they are purchasing the debt for over par value.

The new debt issue of Rogers Sugar has a 7 year maturity and is 2.7% above government bond rates (coupon 5.7%; government 7-year benchmark is 2.96%), which is represents a rather cheap medium-term financing for the company. The $6.50/unit call premium is about 35% above market value and thus would minimize any dilution in the unlikely event that Rogers Sugar actually trades that high and thus the coupon cost is lower. I would have preferred that management lower the conversion rate to about $6.00/unit and have a smaller coupon on the debt, however.