Overlooked Short-Term Convertible Debentures: A Great Opportunity!
Paul Borisoff - Feb 11, 2019
Overlooked Short-Term Convertible Debentures: A Great Opportunity!
The Canadian Convertible Debenture market is one of my favorite “asset classes” in which to hunt for compelling investment opportunities for our discretionary Diversified Income Portfolio which is currently ~ 38% exposed to this asset class.
A convertible debenture is a hybrid security which has some of the features of both bonds and equities. It is essentially an issuer unsecured debt obligation which comes with a set maturity date, maturity value, and a built-in conversion option to equity that can provide significant upside potential.
Our May 18th, 2017 report: The Canadian Convertible Debenture Market: Exploiting Opportunities in an Overlooked Asset Class goes into detail explaining how the conversion features works – and the significant upside beyond the “face value” or “par value” a convertible debenture can potentially deliver – with specific examples. The same report also discusses “Worst Case Scenarios” and how convertible debenture holders typically have a “2nd chance” at recovering their capital if a company gets into trouble.
Key Point: A convertible debenture is almost always a safer way for an investor to be exposed to a particular company compared to buying its common or preferred shares directly.
However, if you do not like the nature of a firm’s business (i.e. a highly cyclical resource company), the state of the firm’s balance sheet, or have questions about the firm’s expected profitability, overall direction and/or management quality you should probably stay away its convertible debentures as well.
While recent market weakness and volatility has been stressful for most investors – it has allowed us to pick-up some absolute bargains in the convertible debenture space. The expected returns highlighted below are the “yield-to-maturity” or “the expected average annual return” these investments will provide from the prices and dates referenced. The referenced returns are also not dependent on what the stock market or the bond market does in the future. The only thing these referenced returns are dependent on is that the issuing company remains in business and solvent – in which case these fixed income investments mature at par value (100 cents on the dollar) on the maturity date - or sooner if called (and possibly at a premium in this situation).
I have often found that investing in convertible debentures issued by good quality companies at opportune times provides a much higher degree of “return certainty” than relying on the future value of a stock or the stock market.
A Few Recent Examples
On December 14th we bought a new position in a Chemtrade Logistics 5.25% 30JUN21 convertible debenture at a price of 91.07. A $9,107 investment in this debenture at the time was therefore scheduled to mature at $10,000 in 2 ½ years – and pay $525 in “coupon interest” each year. The semi-annual yield-to-maturity on this investment was 9.3% - which can be thought of as the “average implied return each year.” Note, this debenture closed at 95.00 on January 31st, up 4.3% from where recently bought it – and from this level it still offers an attractive return of 7.6% each year.
Also in December we increased our Chemtrade Logistics 4.75% 31MAY24 convertible debenture to 4.7% of the portfolio from 2.8% at an average price of 81.06 – which coincidently was also equivalent to a 9.3% semi-annual yield-to-maturity – but for 5 ½ years in this case. This debenture closed at 84.00 on January 31st, up 3.6% from where we last bought it – and from this level the return offered is 8.5% each year – still very attractive in my opinion.
For investors contemplating investing in these debentures the most important questions are: Do we expect Chemtrade Logistics Income Fund to remain in business over the next 5 ½ years? How healthy is the company? Are there any pending or expected developments which we think may negatively impact the company? A little background on Chemtrade Logistics Income Fund:
Chemtrade Logistics Income Fund is listed on the TSX and trades under the symbol CHE.UN. Based on its closing price on January 31st of $10.60 the company’s current market capitalization is approximately $1 billion – and the company currently distributes $1.20 per year of cash via monthly distributions (11.3% yield). Chemtrade Logistics Income Fund is a leading processor of spent acid from the petroleum refining industry and is the largest producer of ultra-pure sulfuric acid used in the electronics industry in North America. The company owns 64 production facilities in North America that can be broadly classified as either:
- Sulfuric acid/ regen acid / ultrapure acid / sodium bisulphate / liquid SO2
- Inorganic coagulants plants – for water and wastewater treatment
- Sodium chlorate plants
- Individual specialty chemical plants
- Plants providing customers with specialized services
For more information please see the company’s website: www.chemtradelogistics.com.
As far as the sustainability of the company’s current distributions management commented last November that “it will not only maintain the distribution but will also consider increases tied to GDP/CPI” – which was reported in a National Bank of Canada Financial Markets report on November 25th (ranked “Outperform” with a “Target Price” of $16.50). Note, there is currently one “Neutral” recommendation on the company, one “Sector Perform” and six “Buy”, “Outperform” or “Sector Outperform” recommendations on the company as of January 31st, 2019 – with an average consensus twelve-month price target of $16.00 per unit.
After taking a little closer look at the firm’s balance sheet, and some of the expectations around the business as per the various analyst comments, Chemtrade does look interesting to us as a possible equity investment. From our due diligence we did not detect even the slightest hint that Chemtrade is at risk of going out of business at some point over the next few years. We are therefore confident that Chemtrade will redeem our debentures on their respective maturity dates at their face value (100 cents on the dollar) – and that these investments will perform as expected until they mature. We have no reason to expect that these investments will not deliver the expected 9.3% average return each year.
Another recent example: Last November we doubled our exposure to the Invesque Inc. 5.00% USD 31JAN22 convertible debenture to 1.8% of the Diversified Income Portfolio at a price of 79.48 – which equated to a 13.1% yield-to-maturity. On December 21st we increased our position by 50% to ~2.7% at a price of 77.00 - which equated to a 14.5% yield-to-maturity – or average implied return each year – for the next three years! Invesque owns a portfolio of 99 senior housing, skilled nursing facilities and medical office buildings across North America – located in 19 U.S. states and two Canadian provinces which contain 9,100+ Beds/Suites: www.invesque.com. On December 21st, 2018, Invesque announced that the company had signed a new US$400 million unsecured credit facility (expandable to $750 million with an accordion feature) which offered improved pricing (lower rates) compared to the facility it replaced – and can be viewed as a validation of the company’s growth and diversification strategy from the company’s credit providers. Invesque had a market capitalization of ~$410 million USD as of its January 31st closing price of $7.76 USD per unit (9.5% dividend yield). Incidentally, there are six firms currently providing research coverage on the company – with a current consensus twelve-month price target of $8.65 USD (One “Sector Perform”, two “Outperform”, two “Buys” and one “Strong Buy”.
As Invesque is a company which we would consider buying direct equity exposure to via their units – we were very comfortable increasing our exposure to the company’s three-year convertible debenture at a yield-to-maturity in the 13.2% to 14.5% range. Note, this debenture closed on January 31st at 83.50 – up 8.4% from where we last bought it – and from this level the return on offer is still a highly attractive 11.7% each year – for the next three years.
And finally, one last example. Last November we increased our exposure to the Just Energy 6.75% 31DEC21 convertible debenture at a price of 93.81 - a yield-to-maturity of 9.1% per year – for 3 years. Just Energy is an “energy management solutions provider” engaged in electricity, natural gas, solar and other forms of “green” energy: www.justenergy.com. The company’s two largest shareholders are billionaire’s Jim Pattison and Ron Joyce (Tim Horton’s – deceased on Jan 31/19) – and with the company’s CEO Rebecca MacDonald included the trio owns ~1/3rd of the company’s current $720 million of shareholder equity – which would likely have to be wiped-out prior to our convertible debenture position being at risk (not likely in any realistic scenario over the next three years in my opinion). Just Energy’s share price closed on January 31st at $4.83 per share (10.4% yield) and the current consensus twelve-month price target is $6.50 (there are two “Neutral” or “Hold” recommendations, two “Sector Performs”, one “Speculative Buy” and four “Buys” on the company).
While we are not interested in direct equity exposure to Just Energy at this time – we are very confident that our convertible debenture is not at risk – and will therefore deliver the expected return. Note, this debenture closed on January 31st at 96.00 – up 2.3% from our last purchase – and from this level the yield-to-maturity is still an attractive 8.3% per year – for just under three-years.
So, what is the “catch” you might ask? The answer: Limited liquidity at certain times. The very fact that we can buy these debentures at the prices referenced above – implies that someone is selling at those prices. However, that is the opportunity for those prepared to buy and hold these investments to the maturity dates. Again, if you are comfortable being exposed to the issuing company until the convertible debentures maturity date - the return opportunities offered in many situations are some of the most attractive and reliable in the market today in my opinion.
If you would like to see our recent Diversified Income Portfolio comments - including details on recent changes to our convertible debenture positions, please let me know. I spend a great deal of time monitoring this asset class – and would be happy to discuss any current opportunities which we see.
As always please do not hesitate to contract me directly if you any questions – or would like to discuss our current portfolio and investment strategy.
Paul J. Borisoff, BBA, CIM, FCSI, AIFPTM, RIAC
Senior Vice President, Portfolio Manager
Senior Investment Advisor
Canaccord Genuity Wealth Management
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The comments and opinions expressed in this blog post are solely the work of Paul Borisoff, not an official publication of Canaccord Genuity Corp., and may differ from the opinion of Canaccord Genuity Corp’s. Research Department. Accordingly, they should not be considered as representative of Canaccord Genuity Corp’s. beliefs, opinions or recommendations. All information is given as of the date appearing in this newsletter, is for general information only, does not constitute legal or tax advice, and Paul Borisoff does not assume any obligation to update it or to advise on further developments related. All information included herein has been compiled from sources believed to be reliable, but its accuracy and completeness is not guaranteed, nor in providing it do the author or Canaccord Genuity Corp. assume any liability. Past performance may not be repeated.