TA.PR.F To Reset At 4.027%

TransAlta Corporation has announced:

that it does not intend to exercise its right to redeem all or any part of the currently outstanding Cumulative Redeemable Rate Reset First Preferred Shares, Series C (“Series C Shares”) (TSX: TA.PR.F) on June 30, 2017 (the “Conversion Date”).

As a result and subject to certain conditions set out in the prospectus supplement dated November 23, 2011 relating to the issuance of the Series C Shares, the holders of the Series C Shares will have the right to elect to convert all or any of their Series C Shares into Cumulative Redeemable First Preferred Shares, Series D of the Company (“Series D Shares”) on the basis of one Series D Share for each Series C Share on the Conversion Date.

With respect to any Series C Shares that remain outstanding after June 30, 2017, holders thereof will be entitled to receive quarterly fixed cumulative preferential cash dividends, if, as and when declared by the Board of Directors of TransAlta. The annual dividend rate for the Series C Shares for the five-year period from and including June 30, 2017 to but excluding June 30, 2022, will be 4.027%, being equal to the five-year Government of Canada bond yield of 0.927% determined as of today plus 3.10%, in accordance with the terms of the Series C Shares.

With respect to any Series D Shares that may be issued on June 30, 2017, holders thereof will be entitled to receive quarterly floating rate cumulative preferential cash dividends, if, as and when declared by the Board of Directors of TransAlta. The annual dividend rate for the 3-month floating rate period from and including June 30, 2017 to but excluding September 30, 2017 will be 3.629%, being equal to the annual rate for the most recent auction of 90-day Government of Canada Treasury Bills of 0.529% plus 3.10%, in accordance with the terms of the Series D Shares (the “Floating Quarterly Dividend Rate”). The Floating Quarterly Dividend Rate will be reset every quarter.

As provided in the share conditions of the Series C Shares: (i) if TransAlta determines that there would remain outstanding on June 30, 2017, less than 1,000,000 Series C Shares, all remaining Series C Shares shall be converted automatically into Series D Shares on a one-for one basis effective June 30, 2017; or (ii) if TransAlta determines that there would remain outstanding after June 30, 2017, less than 1,000,000 Series D Shares, Series C Shares shall not be entitled to convert their shares into Series D Shares effective June 30, 2017. There are currently 11,000,000 Series C Shares outstanding.

The Series C Shares are issued in “book entry only” form and must be purchased or transferred through a participant in the CDS depository service (“CDS Participant”). All rights of holders of Series C Shares must be exercised through CDS or the CDS Participant through which the Series C Shares are held. The deadline for the registered shareholder to provide notice of exercise of the right to convert Series C Shares into Series D Shares is 3:00 p.m. (MST) / 5:00 p.m. (EST) on June 15, 2017. Any notices received after this deadline will not be valid. As such, holders of Series C Shares who wish to exercise their right to convert their shares should contact their broker or other intermediary for more information and it is recommended that this be done well in advance of the deadline in order to provide the broker or other intermediary with time to complete the necessary steps.

If TransAlta does not receive an election notice from a holder of Series C Shares during the time fixed therefor, then the Series C Shares shall be deemed not to have been converted (except in the case of an automatic conversion). Holders of the Series C Shares and the Series D Shares will have the opportunity to convert their shares again on June 30, 2022, and every five years thereafter as long as the shares remain outstanding.

The Toronto Stock Exchange (TSX) has conditionally approved the listing of the Series D Shares effective upon conversion. Listing of the Series D Shares is subject to TransAlta fulfilling all the listing requirements of the TSX.

TA.PR.F is a FixedReset 4.60%+310 that commenced trading 2011-11-30 after being announced 2011-11-22. It has been relegated to the Scraps subindex since inception on credit concerns.

The most logical way to analyze the question of whether or not to convert is through the theory of Preferred Pairs, for which a calculator is available. Briefly, a Strong Pair is defined as a pair of securities that can be interconverted in the future (e.g., IAG.PR.G and the FloatingReset that will exist if enough holders convert). Since they will be interconvertible on this future date, it may be assumed that they will be priced identically on this date (if they aren’t then holders will simply convert en masse to the higher-priced issue). And since they will be priced identically on a given date in the future, any current difference in price must be offset by expectations of an equal and opposite value of dividends to be received in the interim. And since the dividend rate on one element of the pair is both fixed and known, the implied average rate of the other, floating rate, instrument can be determined. Finally, we say, we may compare these average rates and take a view regarding the actual future course of that rate relative to the implied rate, which will provide us with guidance on which element of the pair is likely to outperform the other until the next interconversion date, at which time the process will be repeated.

We can show the break-even rates for each FixedReset / FloatingReset Strong Pair graphically by plotting the implied average 3-month bill rate against the next Exchange Date (which is the date to which the average will be calculated).

pairs_fr_170601
Click for Big

The market appears to have a distaste at the moment for floating rate product; most of the implied rates until the next interconversion are lower than the current 3-month bill rate and the averages for investment-grade and junk issues are both well below current market rates, at +0.07% and -0.33%, respectively! Whatever might be the result of the next few Bank of Canada overnight rate decisions, I suggest that it is unlikely that the average rate over the next five years will be lower than current – but if you disagree, of course, you may interpret the data any way you like.

Since credit quality of each element of the pair is equal to the other element, it should not make any difference whether the pair examined is investment-grade or junk, although we might expect greater variation of implied rates between junk issues on grounds of lower liquidity, and this is just what we see.

If we plug in the current bid price of the TA.PR.F FixedReset, we may construct the following table showing consistent prices for its soon-may-be-issued FloatingReset counterpart given a variety of Implied Breakeven yields consistent with issues currently trading:

Estimate of FloatingReset TA.PR.? (received in exchange for TA.PR.F) Trading Price In Current Conditions
  Assumed FloatingReset
Price if Implied Bill
is equal to
FixedReset Bid Price Spread 0.50% 0.00% -0.50%
TA.PR.F 16.67 310bp 16.26 15.78 15.30

Based on current market conditions, I suggest that the FloatingResets that will result from conversion are likely to be cheap and trading below the price of their FixedReset counterparts. Therefore, it seems likely that I will recommend that holders of TA.PR.F continue to hold the issue and not to convert, but I will wait until it’s closer to the June 15 notification deadline before making a final pronouncement. I will note that, given the apparent cheapness of the FloatingResets, it may be a good trade to swap the FixedReset for the FloatingReset in the market once both elements of each pair are trading and you can – presumably, according to this analysis – do it with a reasonably good take-out in price, rather than doing it through the company on a 1:1 basis. But that, of course, will depend on the prices at that time and your forecast for the path of policy rates over the next five years. There are no guarantees – my recommendation is based on the assumption that current market conditions with respect to the pairs will continue until the FloatingResets commence trading and that the relative pricing of the two new pairs will reflect these conditions.

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