Category: Debt

Debt investing advice

The reason why debt is valued more highly than equity, thus giving off a smaller yield, is because of its higher ranking in the seniority chain. If the company fails to pay interest and principal according to the terms of the debt agreement, then the debtors will usually be able to take some equity stake in the firm after a bankruptcy proceeding.

The tip of the day is not to invest in an entity where it is mandatory for the existing equity owners to maintain control of an organization in order for it to operate. The leverage the debtholders have in such a situation is precisely none – if they force the organization into bankruptcy, they will be left with nothing, while if they do not, they will still be left with nothing except a promise to be paid.

A debtholder needs more than a promise to be paid – they need the ability to force the company into bankruptcy or liquidation if a default occurs.

Harvest Energy debenture liquidation

I noticed in my accounts today that the “D” series of Harvest Energy (6.4% coupon, maturity October 31, 2012) has been sold at 1.015 on the dollar. I set the order about a month after the takeover announcement.

At this price, the debentures have a current yield of 6.31% and an implied capital gain of -0.51%.

There is a floor price of 1.01 on the dollar because of the obligation of KNOC to purchase all debentures at this price; my sense of risk suggests that I should be liquidating them on the open market higher than the 1.01 repurchase price. I don’t want to wait two and three-quarters years to collect my money since I can probably reinvest the proceeds at a rate better than 5.8%.

The “E” series of trust units is a little trickier; its coupon is 7.25%, maturity on September 30, 2013. Right now it is at 1.0175 which is implying a current yield of 7.13% and a capital gain of -0.46%. It is priced relatively lower than the D series. If you assume the same yield valuation on the E series, you get a price of 1.045 on the debentures (current yield 6.94%, capital gain -1.15%) but the debentures will never trade that high. My liquidation point for the E series is between 1.015 and 1.045 and we will see if it gets there.

Harvest “G” is the longest duration and highest coupon (7.5%, maturity May 31, 2015) and it is trading at 1.026 currently. This is an implied current yield of 7.31% and a capital gain of -0.67%.

I will be happy to receive a premium over the 1.01 floor price and be rid myself of the debentures, preferably in the new tax year. I don’t like liquidating gains at the end of a tax year, but the price offered was too attractive. Fortunately, this liquidation also included my TFSA, which is now sitting at $13,000 for the end of this year.

I am also relatively pleased I can liquidate these things for a premium on the open market, mainly because if I had to submit instructions to my broker (in this case, Questrade), I have a sinking feeling that they would screw up the tendering or otherwise cause me to lose liquidity.

Harvest Energy Trust takeover by KNOC approved

The takeover of Harvest Energy Trust, for $10/unit and acquisition of debt by the Korean National Oil Company (KNOC), has been approved by Harvest Energy unitholders. The vote was 90.2% in favour. They required 66.7% for approval.

One particular note of amusement is the Harvest Energy Yahoo message board that was dominated by trolls were screaming about voting against the merger. If you believed that the message board was a representative sample of the unitholders, you would have received the impression that the takeover vote would have failed 90% against, instead of in favour! Message boards for most companies are worse than useless – the information that travels through them should be regarded with the same credibility of that of supermarket tabloids.

Retail investors generally do not matter in terms of corporate governance – it is the institutional investors, primarily mutual, pension and hedge fund owners that control most of the votes in publicly held corporations. The market had priced in Harvest units as if the takeover vote was a done deal, and indeed, the market was correct on this projection.

Once the takeover is finally cleared, with an expected date of December 22, 2009, Harvest will be delisted. My guess why they do this at the end of the year, opposed to the beginning of January is because so many people have accrued losses on Harvest Units that management decided it was worth crystallizing the capital losses for the 2009 tax filing, rather than deferring capital gains for 2010.

Within 30 days of the takeover, KNOC is obligated to make an offer to the debenture holders for the cash repurchase of debt at 101% of par value; I will be tendering my debt (or selling it on the open market above 101%, whatever the case may be) simply because of uncertainty of being able to be paid out. While I have glossed over KNOC’s financials, and believe them to be a very solvent and viable corporate entity, the information I have on them is not timely, they do not report to SEC or SEDAR, and I don’t want to have to deal with a Dubai-like situation where Harvest Energy defaults on its debentures, and KNOC will not guarantee the debt.

I am quite happy to tender the debt in 2010 as this way I can defer capital gains until I file my taxes in April 2011.

Dubai gets bailed out… sort of

Abi Dhabi decided to bail out Dubai, by providing a $10 billion equity injection. This was presumably after the insiders bought back a ton of Dubai debt (which was trading below 50 cents on the dollar and post-announcement is around 70 cents). About $4.1 billion of the equity injection is earmarked for repayment of maturing Islamic debt, while the other $5.9 billion is going toward paying contractors and other working capital needs.

My quick guess is that the Islamic debt gets paid off first to avoid any judicial inquiry on what happens to investors in such debt – i.e. whether they will get a stake in a reorganized company. The conventional debtholders (where there is an active secondary market) are going to be at the mercy of the Dubai courts; I doubt they will be getting any favourable treatment. Maintaining the perception of confidence in the Dubai debt system is crucial for Dubai if they are to retain any foreign institutional investors, and inevitably whatever settlement coming out of the Dubai debt default will be precedent-setting.

I decided to look up what Islamic Debt was, and the Wikipedia entry on Sukuk was rather enlightening – it seems that it has characteristics of zero-coupon debt. That said, I have no idea who would ever want to invest in such financial instruments – at least when investing in Canadian or US debt instruments, you would likely have a better chance in bankruptcy court than you will in Dubai (General Motors notwithstanding!).

(Update: Apparently this is not an equity injection, it is debt.)

Taiga Building Products notes

I was doing some research on Taiga Building Products subordinated notes (TBL.NT, coupon 14%, due September 2020). The amount outstanding is $129 million face value. They are trading around 49 cents on the dollar so this is obviously in the distressed debt category – the yield to maturity calculation is an irrelevant figure (32%). The debt traded as low as 17 cents (if it did so today, the yield to maturity would be 103%). Yield to maturity is a misleading figure because it assumes coupons can be reinvested at a rate that is at the YTM. This will obviously not be the case.

In early 2008 the notes were trading very close to par value. Around October 2008 they went below 90 cents and never came back.

The first thing that struck out at me is that any company willing to shell out debt at 14% is a high credit risk. They issued the notes in September 2005.

The equity is around 41 cents, at 32.4 million shares outstanding this is a market capitalization of $13.3 million. This would rule out any debt-for-equity swaps, at least outside the context of bankruptcy proceedings.

The other salient detail is that they deferred interest payments up until September 1, 2010. This is also conveniently the date where their revolving credit facility ($53 million) becomes due. This essentially means that the credit facility gets paid off first (as it is secured by various assets of the company) and then the noteholders will get the second stab at the company.

Looking at their financials, Taiga is a profitable company, but they are not generating net income nearly as quickly as they need to in order to pay off the debt by September 2010. They generated about $11 million in free cash flow for the first 6 months of their fiscal year, but this will likely moderate for the rest of the fiscal year. Their balance sheet is in rough shape, with equity at negative 82 million and a significant chunk of debt due in less than a year. If I was a creditor to Taiga I would be somewhat concerned as the September 2010 debt payment date comes closer.

The value of the notes strongly depends on whether they can refinance their credit facility. Presumably the company would be in better financial shape if they paid off their 14% notes and refinanced the amount for a lower rate of interest.

That said, the market right now is not going to let the company do that.

It is essentially a gamble to decide whether Taiga will be able to refinance. My bet is that they will not be able to without giving some sort of concession on the interest rate, plus an equity stake in the company. It will be very expensive for shareholders and the company in general. It is clear that Taiga can be a sustainably profitable company, but it has simply taken on too much debt – my unprofessional estimation would be that it needs to go down to about half of existing levels.

As such, I wouldn’t touch the notes at current values.