New Issue: CU Straight Perpetual, 5.25%

Canadian Utilities has announced:

it has entered into an agreement with a syndicate of underwriters co-led by BMO Capital Markets and RBC Capital Markets, and including TD Securities Inc., Scotiabank, CIBC, Canaccord Genuity Corp., and GMP Securities L.P. The underwriters have agreed to buy 5,000,000 5.25% Cumulative Redeemable Second Preferred Shares Series EE at a price of $25.00 per share for aggregate gross proceeds of $125,000,000. The proceeds will be used for capital expenditures, to repay indebtedness and for other general corporate purposes.

Canadian Utilities Limited has granted the underwriters an option to purchase at the offering price an additional 2,000,000 Series EE Preferred Shares exercisable in whole or in part at any time up to 7:00 AM (Calgary time) on the date that is two business days prior to closing. Should the option be fully exercised, the total gross proceeds of the Series EE Preferred Share offering will be $175,000,000.

The Series EE Preferred Shares will be issued to the public at a price of $25.00 per share and holders will be entitled to receive fixed cumulative preferential cash dividends, payable quarterly as and when declared by the Board of Directors of the Corporation at an annual rate of $1.3125 per share, to yield 5.25% annually. On or after September 1, 2020, the Corporation may redeem the Series EE Preferred Shares in whole or in part from time to time, at $26.00 per share if redeemed during the 12 months commencing September 1, 2020, at $25.75 per share if redeemed during the 12 months commencing September 1, 2021, at $25.50 per share if redeemed during the 12 months commencing September 1, 2022, at $25.25 per share if redeemed during the 12 months commencing September 1, 2023, and at $25.00 per share if redeemed on or after September 1, 2024.

The offering is being made only in the provinces of Canada by means of a prospectus supplement and the closing date of the issue is expected to be on or about August 7, 2015.

Implied Volatility theory suggests that this issue is somewhat expensive – the company has, as is often the case, priced the issue so that it yields the same as issues trading at a discount, thus assigning a value of zero to the ill effects of negative convexity.

impVol_CU_150727
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12 Responses to “New Issue: CU Straight Perpetual, 5.25%”

  1. fed says:

    I have noticed that the last few issues have been perpetuals. As interest rates cannot go down much more, unless there is deflation, why would anyone buy a perpetual at this point in time? Would you be betting that interest rates will stay low for a long time and then deflation would set in eventually.

    If interest rates rise, the value of this perpetual would drop. The company would not redeem the shares while interest rates were higher than now. So, if interest rates were to rise, and then don’t come back down to these levels, you would never get your capital back.

    Is my understanding correct?

  2. jiHymas says:

    I may suggest this issue is a rich compared to other CU Straights, but you will recall I spoke highly of the CU Straights relative to other recent new issues quite recently.

    So it’s not as if this issue is way out to lunch. It’s in the same league as its comparators, regardless of its actual placement within that league.

    When you say “interest rates”, do you mean long rates or short rates? Policy rates or market rates? Corporate rates or government rates? There is a wide variety of interest rates and they will all react differently to changes in the investment environment.

    On October 3, 2007, PerpetualDiscounts yielded 5.27%, roughly equal to what this issue yields now. At that time, five-year Canadas yielded 4.24%, long Canadas were at 4.45% and long corporates at 6.00%. If we revisit those relationships, PerpetualDiscounts will have outperformed these other fixed income classes.

    You will recall that on July 22 the Seniority Spread was at 285bp, while I mentioned on July 24 that CU Inc., a subsidiary of CU, issued long paper at 3.964% for a spread of 268bp. However well, or poorly, this issue is priced against other preferreds, they’re all very well priced against bonds.

  3. fed says:

    But bonds mature. Perpetuals don’t.

    If GOC5Y increases, which is what I meant by interest rates, over time past your 2007 value of 4.24%, this issue looses almost all of its value. It would not be called, and you would be stuck to wait and hope, that by the time rates drop enough to raise the preferred share price to the original $25, your original capital will still have purchasing power, considering the inherent inflation.

  4. jiHymas says:

    But bonds mature. Perpetuals don’t.

    See my article Perpetual Misperceptions.

    If GOC5Y increases, which is what I meant by interest rates, over time past your 2007 value of 4.24%, this issue looses almost all of its value.

    That depends on what happens to long rates. Short yields can go arbitrarily high without necessarily affecting long yields.

  5. fed says:

    Thanks or the link. I read it, but again it is a bit confusing.

    It looks like you were saying that a 5% discounted perpetual at $20 will yield close to 2% per year if interest rates increase to 5.15% in year 1 and gradually increasing to 18% after 20 years. Is that correct?

    But if the interest rates were growing so high, doesn’t that imply growing inflation, and hence a major loss of purchasing power of the money locked into the perp?

  6. jiHymas says:

    It looks like you were saying that a 5% discounted perpetual at $20 will yield close to 2% per year if interest rates increase to 5.15% in year 1 and gradually increasing to 18% after 20 years.

    That was Table 1.

    What it says is, that if you start with a PerpetualDiscount paying $1, yielding 5%, and priced at $20 then:

    i) Total realized return after one year will be 2% even if yields have increased to 5.15% (and the price of the issue has gone down accordingly to 19.42)

    ii) Total realized return after two years will be 2% p.a., even if yields have increased to 5.32% (and the price of the issue has gone down accordingly to 18.80)

    iii) Total realized return after three years will be 2% p.a., even if yields have increased to 5.50% (and the price of the issue has gone down accordingly to 18.19)

    iv) Total realized return after twenty years will be 2% p.a., even if yields have increased to 17.98% (and the price of the issue has gone down accordingly to 5.56)

    The point of all this is that if we are comparing a 5% PerpetualDiscount to a 2% bond of certain term, we can
    a) Calculate in advance what the price of the PerpetualDiscount must be at the time the bond matures in order that the total returns until bond maturity are the same.
    b) Therefore calculate the yield of perpetuals at this future time that will result in equal total returns. If the actual yield after this passage of time is lower, then the PerpetualDiscount will have outperformed; if the actual yield is higher, then the bond will have outperformed.

    The point is … if you’re getting a significantly higher annual yield from the perpetual, then the end-value doesn’t matter very much. The longer the term and the higher the spread, the less the end-value matters.

    You will recall from above:

    I mentioned on July 24 that CU Inc., a subsidiary of CU, issued long paper at 3.964% for a spread of 268bp.

    So here’s what I want you to do: assume that you can make only one of two investments, the thirty-year CIU bond paying 3.964%, or the CU Straight paying 5.25% DIVIDEND, which is equivalent to 6.825% INTEREST.

    Make yourself an Excel Spreadsheet. List all the cash flow dates for the next thirty years in one column (I will permit you to cheat and assume that the preferred pays semi-annually). List all the cash flows for the bond in the second column. List all the interest-equivalent cash flows for the preferred in the third column. The end price for the bond will, of course, be its maturity value of $100. Stick in any end-price you like for the preferred.

    Now use the Excel XIRR() function to determine the Internal Rate of Return for each of these possible investments. Play around with the end-price of preferred. What is the endprice of the preferred that results in the total returns through the entire period of the two investments being equal? What does this imply the perpetual will be yielding at that time (don’t forget to convert back to dividends)?

    Do you believe that perpetual yields will be that high in thirty years? Do you really?

    Send your spreadsheet to me by eMail and I’ll check it for you. Let me know if I can publish it.

    But if the interest rates were growing so high, doesn’t that imply growing inflation, and hence a major loss of purchasing power of the money locked into the perp

    Higher inflation actually makes the perp look better, since its higher coupon payments will be reinvested along the way at higher yields. At 5%, only one-quarter of the value of the perp is covered by the end-value; three-quarters of what you are paying is for the coupon stream.

    At 2.5%, roughly half the value of the thirty-year bond is represented by its end-value.

    Therefore, changes in investment environment due to increasing inflation actually hurt the bond-holder more. So much for the benefits of maturity! You pay one helluva big price for that benefit in terms of lower income!

  7. broke says:

    Is there a difference between user jiHymas and user fjiHymas?

  8. jiHymas says:

    Nope. That was just a mouse-slip when I was editing the post.

    Sorry about that, I’ve fixed it.

  9. fed says:

    This is how I understand what you are saying:

    Bond income comes at maturity, pref dividends come quarterly.
    Dividends can then be reinvested at higher yields if interest rates go up. This moderates the interest rate risk.
    Dividends are taxed better, so are worth more than bonds of the same yield.
    Worst case is that the pref principle is fully lost to inflation, but even then, you are much better off than with bonds, where principle and yield can all be lost to inflation.

    This all makes sense to me. Thank you. I am working on the spreadsheet.

    But my concern is if inflation, and then interest rates, increase quickly, as they did in the 70s. Sure you get some early dividends with the perpetual, and recoup money there, but the principal is virtually locked in, and future dividends become less and less valuable as inflation erodes its purchasing power. Sure bonds would be much worse, but fixed resets and floating prefs would be much better.

    That is why I was asking – are you betting against (I am now adding) high inflation by buying perpetuals?

  10. jiHymas says:

    Well, Assiduous Reader fed accepted his assignment and sent me the
    spreadsheet I requested (which I am providing here as a PDF).

    I would have done the dates differently and there is one error (the principal repayment, or endprice, is dated 30.5 years hence) but the results are clear: the CU perpetual will outperform the CIU bond over thirty years, provided its endprice is more than 3% of par. Since this is less than six month’s coupon, we can translate this to: the preferred will outperform unless conditions have changed such that it yields more than 200% p.a.

    To me, this sounds like a pretty good bet!

    A lot is left out of this analysis, of course. First, the preferred should yield a little more because there is slightly higher default risk, which in this case is exacerbated by the fact that it’s issued by the holding company while the bond is from the operating company. And there’s tax risk, in that we don’t know for sure whether the 1.3x equivalency factor will remain constant for the next thirty years. And there should be another yield premium due to liquidity concerns. So performing this comparison straight-up should not be the end of relative value analysis but that’s not the point.

    The point is: as long as we want an investment that will provide income for thirty years, the perpetual issue is just fine. We don’t give a damn whether it maintains its value over the period … the extra yield and the long time horizon covers off the end-price risk just fine.

    Bond income comes at maturity, pref dividends come quarterly.

    I know what you’re getting at, but I wouldn’t put it that way. I would simply say that the higher the yield and the longer the time horizon, the less the end-price matters, in terms of total return through the entire period.

    In the example worked out in the spreadsheet print-out linked above, the end-price of the perpetual doesn’t really matter at all.

    But my concern is if inflation, and then interest rates, increase quickly, as they did in the 70s. … That is why I was asking – are you betting against (I am now adding) high inflation by buying perpetuals?

    I wouldn’t put it that way, but perhaps I’m just quibbling.

    Yes, Straight Perpetuals will perform poorly if inflation picks up significantly but – as we see in the spreadsheet – no worse than bonds (as long as we keep our examples within range of the current market).

    And yes, FixedResets and Floaters will perform better relative to Straights if inflation picks up significantly (note that they might still underperform Straights on a 30-year total return basis. It will depend on how soon and how much inflation picks up, and how the underlying index for these issues responds to this inflation. You can play around with this with a spreadsheet).

    So my quibble? I don’t like the phrase ‘betting against inflation’. It can be justified, sure, I have problems with the concept based on portfolio management considerations.

    Every portfolio has a purpose and that portfolio is most definitely not ‘outperform this other portfolio’. That concept completely misses the point. The purpose of a retiree’s portfolio might be ‘keep me at a decent and predictable standard of living for as long as I live’. Or it might be ‘yes, do that, but in addition I want to leave a significant amount of money to the Home For Abandoned Cats’. For a middle-aged guy, it might be ‘Lay the foundation for retirement if things work out, but mainly make sure I can pay the bills if I’m unemployed for a year’.

    Whatever. Every portfolio has a purpose and that purpose has only an incidental relationship to performance.

    So, assuming the investor is rational (which is usually not the case), you start off with a fairly generic portfolio that will meet your goals if the investment environment is unchanged throughout your time horizon … and sometimes this will mean you have to change your goals once you take a hard look at the numbers!

    Well, that’s nice, but you are assuming that the investment environment is unchanged. So then, our imaginary rational investor will start throwing rocks at his portfolio. “What if inflation moves permanently to 6%?” “What if I die halfway through?” “What if I live twice as long?” “What if technological change destroys all existing industrial stocks?” “What if there’s another Great Depression?”

    It’s a bit of a frustrating game, because you can always think of something that will mean your portfolio will not succeed in accomplishing its objectives, but it’s a useful exercise.

    So maybe you’re at the stage where you’re throwing the inflation rock at your portfolio plan. I certainly agree that holding Straight Perpetuals increase the vulnerability of your portfolio to this risk, but I have grave doubts as to whether the answer is Floating Rate or FixedReset preferreds. In an inflationary environment, no fixed income is going to do particularly well. To address inflation risk, I would make sure that my portfolio included commodity-based equities. Also foreign currency denominated investments, in case the inflation is local.

    But increasing your commodity-based equities increases your vulnerability to deflation. One way you could address that risk is by adding Straight Perpetuals.

    The name of the game is diversification. Higher inflation is only one scenario out of many.

  11. fed says:

    Thank you for that. Much clearer now. I assume my spreadsheet was fine other than the one date error. In that case, I really don’t understand what XIRR does. I expected the value to be the yield of the investment.

    You are right, I am indeed throwing large rocks. I’m considering the following:

    1) perpetuals and cash (including GICs) for deflation risk
    2) commodity equities for inflation risk (especially since they are cheap right now, I will consider solid equities after the next correction)
    3) property, solid equities, and commodities for hyperinflation risk
    4) preferred shares for retirement income should (hopefully) none of the above risks occur and all goes well for all of us.

    I’m not looking for spectacular gains, but rather security. I hope I’m not too off target.

  12. Nestor says:

    sorry to jump in here at the end.

    fed,

    hyperinflation. you need to take a look at other economies that have suffered or are suffering extremely high, or hyperinflation. we are talking about inflation rates that are astronomical. there is pretty much nothing that will save you but owning your own farm, where you can live and produce your own food, have potable water, etc etc. and probably physical gold or diamonds or something else along those lines (swiss francs)

    hyperinflation is generally the total collapse of the economic system. i wouldn’t bet on that happening any time soon in the developed economies. banana republics, sure. venezuela comes to mind. they’re more worried about toilet paper….

    we’re likely to see a pickup in inflation over the next few years. not anything like the 1970s though.

    many eastern european countries, and southern ones, (greece, italy, yugoslavia, romania etc) before they moved to the Euro, had continued high inflation. take a look there as an example of how people lived and made due if you’re worried about those things.

    sorry. just my opinion.

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