PrefBlog

The Brookfield Infrastructure new issue closed today without a formal announcement from the company.

BIP.PR.F is a FixedReset, 5.10%+292M510, announced 2018-09-05. It has been assigned to the FixedReset-Discount subindex.

There are two non-standard elements to this issue, as we can specify when examining the prospectus (see SEDAR, “Brookfield Infrastructure Partners L.P. Sep 5 2018 22:59:56 ET Prospectus (non pricing) supplement – English PDF 913 K”). I regret that the Canadian Securities Administrators have made direct links to this public document illegal.

First, distributions are not dividends: they are Return of Capital and (potentially fully taxable) other things:

For Canadian federal income tax purposes, holders of Series 11 Preferred Units and Series 12 Preferred Units will be allocated a portion of the taxable income of the Partnership based on their proportionate share of distributions received on their units. The allocation of taxable income to such holders may be less than the distributions received and this difference is commonly referred to as a tax deferred return of capital (i.e., returns that are initially non-taxable but which reduce the adjusted cost base of the holder’s units). See “Certain Canadian Federal Income Tax Considerations” for further details. The below table reflects certain information regarding the taxable income allocation for the 2013 through 2017 period, with all periods updated to reflect the three-for-two unit split that occurred during September 2016. As shown in the table below, the historical 5 year average per unit return of capital (i.e., excess of distributions over allocated taxable income) expressed as a percentage of the annual distributions in respect of units of the Partnership for the period 2013 through 2017 was approximately 45%. Management anticipates a 6 year average per unit return of capital percentage of 50% for the period 2018 through 2023; however, no assurance can be provided this will occur.

	2017	2016	2015	2014	2013
Total distribution	C$2.2320	C$2.0313	C$1.8511	C$1.4252	C$1.1922
Total taxable income	C$0.7661	C$1.0552	C$1.0228	C$1.4024	C$0.4638
Return of capital	C$1.4660	C$0.9761	C$0.8283	C$0.0228	C$0.7284
Income %	30.77%	51.62%	55.25%	98.40%	38.9%
Return of capital %	69.23%	48.38%	44.75%	1.60%	61.1%

Second, it is likely, although not certain, that conversion of this issue into a FloatingReset when the time comes may be a Deemed Disposition and therefore trigger a capital gain or loss:

The reclassification of a Series 11 Preferred Unit into a Series 12 Preferred Unit or a Series 12 Preferred Unit into a Series 11 Preferred Unit, whether pursuant to an election made by the Resident Holder or pursuant to an automatic reclassification, may be considered to be a disposition of the Series 11 Preferred Unit or Series 12 Preferred Unit by the Resident Holder. The CRA’s position is that the conversion of an interest in a partnership into another interest in the partnership may result in a disposition of the partnership interest by the holder if the conversion results in a significant change in the rights and obligations of the holder in respect of the converted interest, including a significant change in the percentage interest in the profits of the partnership. Whether or not the reclassification of Series 11 Preferred Units into Series 12 Preferred Units or Series 12 Preferred Units into Series 11 Preferred Units would result in a significant change in the percentage interest of a Resident Holder in the profits of the Partnership is a question of fact that depends upon the facts and circumstances that exist at the time of the reclassification.

BIP.PR.F traded 414,753 shares today in a range of 24.70-89 before settling at 24.88-89. Vital statistics are:

The new issue is extremely expensive according to Implied Volatility Analysis:

Click for Big

According to this analysis, the fair value of the new issue on September 12 is 23.30, but note that it appears that the issue would be closer to the regression line if Implied Volatility was permitted to exceed the arbitrary limit of 40%. It is the level of Implied Volatility that is the real problem with this issue, not the distance to the fitted line.

The ludicrously high figure of Implied Volatility is something I take to mean that the underlying assumption of the Black-Scholes model, that of no directionality of prices, is not accepted by the market; the market seems to be taking the view that since things seem rosy now, they will always be rosy and everything will trade near par in the future.

I balk at ascribing a 100% probability to the ‘all issues will be called, or at least exhibit price stability’ hypothesis. There may still be a few old geezers amongst the Assiduous Readers of this blog who can still (faintly) remember the Great Bear Market of 2014-16, in which quite a few similar assumptions made earlier turned out to be slightly inaccurate. The extra cushion implied by an Issue Reset Spread that is well over the market spread is worth something, even if nothing gets called.

Part of the problem may be that all but one of the BIP FixedReset series have minimum reset guarantees. There are many naifs out there (many of them stockbrokers; many others egged on by their stockbrokers) who consider this to be an effective guarantee that the issues will always trade near par. They have evidently forgotten that spread widening is a very common cause of price declines.

Or, to put it another way, one can buy a whole lot of downside protection for very little extra money, relative to this issue. For instance, BIP.PR.D, FixedReset, 5.00%+378M500, ROC + Interest, is bid at 25.01 (theoretical fair value of 25.25, according to the above analysis, which ignores the interim dividend shortfall). You’re giving up about $0.025 p.a. in dividends until it resets 2022-03-31, sure, but that’s hardly a big deal and you’re getting a significant amount of protection in the event of a market downturn, and a bit more dividend afterwards. Is it worth it? Well, that will depend a lot on your aversion to loss … I’m just saying that buying the same amount of protection costs more in most other series of FixedResets.

It will be recalled that AX.PR.E will reset at 5.472% effective October 1.

AX.PR.E is a FixedReset, 4.75%+330, that commenced trading 2013-3-31 after being announced 2013-3-12. It must be remembered that these are not actually preferred shares, as the term is usually used; they are preferred units and the distributions will be characterized in the same manner as distributions to the Capital units. The company publishes the characterization of the distributions on its website. Because of the company’s structure, conversion between the FixedReset and FloatingReset is probably (!) a taxable event; i.e., investors will take a capital gain or loss for tax purposes on conversion and reset the Adjusted Cost Base on their new position.

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., AX.PR.E 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).

Click for Big

The market appears to be relatively uninterested in floating rate product; most of the implied rates until the next interconversion are scattered around the current 3-month bill rate although the averages for investment-grade and junk issues are have diverged slightly, at +1.73% and +1.46%, respectively – pretty close to the market rate. 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 AX.PR.E 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:

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, I recommend that holders of AX.PR.E continue to hold the issue and not to convert.

If you do wish to convert, note that the deadline for notifying the company is 5:00 p.m. (Toronto time) on September 17, 2018.. Brokerages and other intermediaries will normally set their internal deadlines a few days prior to this, so if you want to convert don’t waste any time! Such intermediaries may accept instructions after their internal deadline (but prior to the company deadline, of course) if you grovel in a sufficiently entertaining fashion, but this will only be done on a ‘best efforts’ basis.

I will note that once the FloatingResets commence trading (if, in fact, they do) 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.