Petrobakken / Lightstream Resources bites the dust

Lightstream Resources (TSX: LTS), formerly known as Petrobakken (TSX: PBN), was formerly a subject of analysis on this website. Despite the company having excessively high yields and posting (and boasting) about huge cash flows through operations, I remained very skeptical of them. Then the oil price cratered at the end of 2014, and then all the excess leverage the company held came to bite it.

The senior unsecured creditors failed to reach an agreement with the company, and as a result they will be going into CCAA proceedings.

I have never held shares of this company. The entity, once restructured, should be mildly profitable in the current oil price environment, but they need to shed a healthy quantity of their debt. It is a classic case of using too much leverage when the times are good.

Turning down a very likely 12% annualized return

There is a catch to the title – the 12% annualized return is in the form of a 6.6% return over six and a half months.

I have mentioned this before (at much higher yields) but Pengrowth Energy debentures (TSX: PGF.DB.B) is probably the best low-risk/medium-reward opportunity in the entire Canadian debt market today. At the current price of 97 cents (plus 5.5 months of accrued interest payments), you are nearly guaranteed to receive 100 cents plus two interest payments of 3.125% each. The math is simple – for every 97 cents invested today (plus 5.5 months coupon which you’d get 6 months back at the end of September), you will get 103.4 cents on March 31, 2017, the maturity date. This is a 6.6% return or about 12% annualized.

By virtue of Pengrowth’s debt term structure, this one gets the first crack at being paid by their billion-dollar credit facility which was untapped at the last quarterly report.

The only risk of any relevance is that the company will opt to exchange the debt for shares of PGF at 95% of the 20-day volume-weighted average price, but considering that the debenture face value is $126 million vs. the current market cap of $1.1 billion, the equity would not incur too much toxicity if management decided to do a virtual secondary offering at current share prices.

The company did give plenty of warning that at June 30, 2016, current oil/gas price levels and a 75 cent Canadian dollar would result in them potentially blowing their covenants in mid-2017. But this is of little concern to the March 31, 2017 debenture holder. They will get cashed out at par, either in cash or shares.

I own some of these debentures, which I purchased earlier this year when things were murkier and much more attractively priced. Given some recent liquidations in my portfolio, I could have reinvested cash proceeds into this apparently very low risk proposition. But I did not.

So why would I want to decline such a no-brainer opportunity and instead funnel it into a short-term bond ETF (specifically the very-low yielding Vanguard Short-Term Canadian Bond Index ETF at TSX:VSB)?

The reason is liquidity.

In any sort of financial stress situation, debt of entities that are “near guarantees” are traded for cash, and you will suddenly see that 97 cent bid moved down as entities are pressured to liquidate. For securities that are precious and safe, such as government AAA bonds, there is an anti-correlation to market pricing that occurs and ETFs holding these securities will be bidded up in response.

VSB is not something that you are going to see move up or down 5% overnight in a real panic situation, but it will retain its liquidity in stressful financial moments. The selection of VSB is different than the longer-term cousin, which has more rate sensitivity, but something has changed in the marketplace where equity and longer term debt asset classes have decided to trade in lock-step: as demonstrated in last week’s trading in Japan and the Euro-zone. When equities and long-term government debt (nearly zero-yielding, if not negative) trade in the same direction, it gets me to notice and contemplate what is going on.

The tea leaves I have been reading in the market suggest something strange is going on with respect to bond yields, the negative-interest rate policies and their correlation to equities. I’m not intelligent enough to figure it out completely, but what I do know is that putting it into so-called “low risk” opportunities like Pengrowth debentures come at future liquidity costs in cash if I needed to liquidate them before maturity. Six and a half months can be a long time in a crisis situation, and we all see what is going on in the US President Election – markets are once again seriously considering Donald Trump’s election now that Hillary clearly isn’t healthy enough to be Commander-in-Chief of the US Military. The public will ask themselves: If she can’t stand up to attend a 15-year memorial of 9/11, what makes you think she will be able to stand up when the terrorists strike the homeland again?

The markets have vastly evolved since last February where things were awash in opportunities. Today, I am seeing very little that can be safely invested in, which is getting me to change what I am looking for, but also telling me that I should relax on the accelerator, raise cash, and keep it in a safe and liquid form until the seas start getting stormy again. And my gut instinct says exactly that: winter is coming.

De-leveraging

Leverage is great – only when everything is appreciating. Indeed, if things appreciate, the leverage ratio goes down since the loan-to-equity ratio goes lower. A simple example is taking a $100 portfolio, borrowing $100, which gives you a 50% loan-to-equity ratio. If your portfolio appreciates 10%, the loan-to-equity goes down to 45%, and suddenly you’re feeling more comfortable again.

This basically explains the real estate market – you buy a house, take a mortgage for 80% of the house value (paying 20% down), and when the real estate market goes up 40% (like it has in the Vancouver area), suddenly your loan-to-value ratio goes down to 57% – let’s suck more money out of the house and get that back to 75%! This means borrowing another 25% of your original house value.

This all works, until the underlying asset value falls and you have to pay back your loans. In the instance of an initial 80% loan-to-value, a price drop of 10% means the loan-to-value goes up to 89%.

The same dynamics go for portfolio management – leverage is painful in the down direction because your loan-to-equity ratio becomes more concentrated.

Clearly, the best time to de-leverage is when you’ve made your anticipated gains.

I’ve started to take some money off the table. Specifically, Genworth (NYSE: GNW) and most US insurers have gotten hot because of the probability of the federal reserve increasing interest rates again.

After raising cash, the most difficult part of investing is to wait. The easiest way to lose money is to do something with cash just because it is earning zero yield in the brokerage account.

Genworth MI – Despite housing slowdown, still undervalued

mic

Genworth MI (TSX: MIC) has gone nowhere in the past three months, despite the corporation lowering losses from insurance claims and the housing market being relatively stable to date. The company trades at a 10% discount to book value, and also at a P/E of 9 (realizing that these two metrics are not the only ones that insurance companies should be valued by, but suffice to say, unless if the insurance written is completely bad, it is difficult to lose money when buying something under book and under a P/E of 10).

There are a few cautionary flags – the reduction of their portfolio insurance business (which allows third-party financing firms to securitize and sell their lower loan-to-value mortgages with portfolio insurance) and also the slowdown in housing sale volumes, combined with the attempts by the BC Government to quell foreign ownership with a 15% transfer tax for non-permanent residents or citizens.

In particular, the transfer tax has caused quite a quenching of the roaring housing fire that was occurring in the southwestern BC housing market. This in turn has spooked the various markets linked to residential real estate. However, it is my assessment that as it relates to mortgage insurance, the market has continually over-estimated the impact of the short-term gyrations in Canadian real estate.

What would cause issues is mortgage serviceability and this is a function of employment, not housing prices. Although there is correlation between housing prices and construction-related employment, if there is not mass unemployment it is difficult to see how somewhat lower housing prices would cause difficulties in the mortgage insurance space. Indeed, the $300 billion ceiling for private insurance in Canada seems to be more of a daunting barrier than the state of the actual insurance market.

It is worthy to note that during the depths of the 2008-2009 financial crisis that the loss ratio peaked out at 46% (June 30, 2009) and this still resulted in a profitable book for the firm. The subsequent combined ratio peaked at 62%, which means that for every dollar of revenue booked that the firm recorded a gross profit of 38 cents.

Also, the corporate has increased its quarterly dividend every year for the past 5 years – it is currently 42 cents and if prior patterns continue they will likely raise it to 45 cents per share. Although the yield is not important (cash generation is), there are various market participants out there that only care about yield and this would serve to boost the stock price.

Bombardier debt trading like it is investment grade again

What a difference a year makes for Bombardier’s (TSX: BBD.A, BBD.B) credit profile:

bbd

Their credit profile over the last year has improved considerably – they can now tap debt capital from the market at reasonable rates. Right now the closest comparable is the 8.5 year maturity for 8.5% yield.

The market is clearly believing that their solvency concerns are over. This would likely get cemented (and yields will compress even further) on successful deliveries of CS100/CS300 jets to their customers, of which two are already delivered and 356 are currently in the pipeline.

The more junior preferred share (TSX: BBD.PR.C) with a 6.25% coupon is trading at a current yield of 9% (eligible dividends), which should continue to go lower as confidence increases in the firm’s ability to be financially sustainable with the C-series. The rumours of the pending Learjet sale would also be an injection of capital if it did occur, but it does not appear that this is necessary, nor is the rumoured injection of capital by the Government of Canada (although this might occur to give future customers the impression that the government will not let the company fail).

The common equity remains pinned around CAD$2/share, and there is considerable overhang from the warrants issued from the two Quebec financings. I doubt that there will be cash dividends on the common shares until the turn of the next decade.