DBRS has announced it:
has today downgraded the Class B, Preferred Shares (the Preferred Shares) issued by Energy Split Corporation (the Corporation) from Pfd-2 (low) to Pfd-3 (high) with a Stable trend and has removed the Preferred Shares from Under Review with Developing Implications where the rating was placed on November 8, 2006.
The net asset value (NAV) of the Corporation decreased significantly shortly after its reorganization. The quick decline can be attributed to the Canadian government’s October 31, 2006, announcement relating to the change in taxation on income trusts and to the sensitivity of the Royalty Trust Portfolio, consisting of oil and gas income trusts, relative to the price of oil. Downside protection decreased from 54% at reorganization to 42% on November 2, 2006. Since then, the downside protection fluctuated in a band from 35% to 45% before falling to 34% on August 30, 2007, the low point since reorganization.
…
The redemption date for both classes of shares will be September 16, 2011.
Asset coverage is 1.52:1 as of August 30, according to Scotia Managed Companies. Thus, the underlying portfolio can lose 34% of its value before eating into the value set aside on the balance sheet for preferred shareholders, which is what DBRS means by “downside protection”.
ES.PR.B is not tracked by HIMIPref™.
Now here is an issue (ES.PR.B) that should not even get an investment grade rating. Being based on oil & gas royalty trusts, one EXPECTS the trust unit value to decline over time in an environment of stable oil prices (should one ever arrive). This is because production and reserves PER UNIT decline over time due to depletion by about 5-12% per year. That’s why a 16% oil & gas yield can’t equate to more than about 8% long run return (roughly 16% minus 8% annual fall in production per unit per year).
Despite reserves and production PER UNIT being the most critical metric of an oil & gas trust, I’ve never seen it reported by any issuer or analyst! Firms love to point out that they have replaced their produced reserves (by acquisition, usually), but it came at either a dollar cost or a unit dilution cost that almost always has no effect on the reserves and production per unit, which still decline.
So, in an environment of constant oil prices, one should expect the trust unit price to decline annually in proportion to falls in production and/or reserves (which, by the way, usually preserves the Reserve Life Index as cash generation ability falls).
Anyway, if you understand this dynamic, you understand how delightfully risky a security like ES.PR.B is. At maturity in 2011 (4 years from now) I would expect that (at flat oil prices), the 34% downside protection will fall to zero +/- 15%. One could be more precise by studying the reserve and production per unit trends of the underlying investments, but changes in the oil price would also have an effect.
Net, net, there is no way I want to bet on oil staying at $70+ for four years and a greater than 50% chance of a principal haircut at maturity for a measly 5%.
P.S.
I see now that ES.PR.B is trading at 19 and has a par redemption price of $21. Therefore the current yield is 5%, and the yield to $21 would be 7.5%, if realized. Alternatively, you could argue the market already expects a redemption price of $19. Either way, these attributes are those of a Pfd-4 or -5 issue.
That ain’t nuthin. The NAV for the capital units is $11.01 as of August 30, according to Scotia … and they’re quoted at $16.87-80. That’s a short candidate no matter what you think of the underlying!
P.S. What you are describing with respect to the ES.PR.B is a Credit Anticipation play.
DBRS should not be analyzing the underlying portfolio in the degree of detail which you are doing; nor should they be setting target prices for the underlying and performing calculations based on coverage at the time the target prices are reached. That’s going way too far for a ratings agency.
The underlying portfolio is traded on the market. Rightly or (I agree with you that it’s probably) wrongly, the market is putting prices on the underlying royalty trusts and backing up their bets with actual dollars. I would be more nervous about ratings in general if DBRS were to say ‘No, the market’s wrong’ as a matter of routine.
What they can do is, essentially, what they have done: pointed out that the underlying is highly exposed to the price of a particular commodity and that there is a return of capital implicit in the amounts distributed and discounted the coverage based on these particular factors.
If the underlying was, say, 50 different financial stocks, I suspect that the credit rating would still be Pfd-2(low).
I get your points, and did more research today. The underlying portfolio has a distribution yield of about 12.8%, but is subject to a MER of 1.2% for a net 11.6%. Based on this morning’s prices, the capital shares look leveraged (at NAV anyway) at 3.0X. The distribution on capital shares is $2.92 per year, payable quarterly (73 cents goes ex Sep 11) and is supported by the underlying trust distributions less the pref share distributions.
What the market seems to be saying with a market value for the capital units that is 45% higher than NAV is two things:
1. The current yield of 16-17% on the capital units is “comparable” to the underlying trusts. Due to the leverage, if ES traded at NAV, its yield would be nearly 25%.
2. The Capital units have some properties of a call option on the underlying, so Market – NAV is a measure of time premium.
By the way, the 45% premium to NAV is a record high — it has been increasing gradually from nearly zero a year ago and was once a discount. Partly contributing to this would be the corresponding fall in oil & gas trust prices which is lowering the NAV and increasing the time premium of the option.
Also, I observe that with ES.PR.B trading at a $2.00 discount to NAV, the total discount on the unit (ES + ES.PR.B) is a lower $4 or 13% or so.
Finally, a quick look at the underlying income trusts shows an average payout ratio of 67% in the first half of 2007, so DIPU “yield” on the portfolio is 19% (12.8%/0.67); if depletion/unit is 10% per year (10 year Reserve Life Index ASSUMED), then the long run expected return is (very approximately) 9% less 12.8% paid out in cash or -4% per year on the unit price at fixed oil prices. If true, the pref may still pay out the expected $21 par value in 4 years — an interesting speculation on oil prices.
Anyway, as an experimental imperfect arbitrage trade I shorted 1000 ES at $17.50 (I call it $16.77 due to the upcoming distribution; this is about 1/3 of the daily average trading) and bought $35K of 5 (out of 20 underlying) oil & gas trusts (I need 3.0X leverage on NAV to hedge and these also pay the shorted cash flow). If I get a very gradual 4-year return to NAV on the ES, I would expect a gross return of 19-11% annually after costs (on my $35K put up). If I get a quick drop in the ES premium to NAV (e.g. to 20%, I will probably take my quick 10% profit and run). Aside from the imperfect hedge, this position has nearly zero exposure to commodity prices (unless they fall a lot and the time premium of the ES call option goes up). One way to look at it is that I have written a covered call option that is 33% in the money.
Anyway, it is an experiment and I am always looking for arbitrage trades with fatter than usual premiums!
I’ll keep you posted.
prefHound … you’re a player!
Playing with your note that got me going after all…
P.S. I see a typo in my last post. My expected gross return is 9-11% NOT 19-11% — mis-strike there.
[…] Ratings agency employees shouldn’t be able to jump to investment banks they have helped to structure transactions.: This suggestion came up in the September 4 commentary. No! A thousand times, no! In the first place, there is no indication that this is, in fact, a problem. Secondly, it will enforce draconian restrictions on the career choices of analysts. And thirdly, it is inappropriate because agency analysts have no power to force anybody to do anything; they give advice. Full stop. This sort of restriction is appropriate for regulators but is not even applied to them. Regulation Services trumpetted the fact that their employees were jumping to the banks for fat paycheques as evidence of the impressive skill of their employees; let’s fix up this aspect of revolving-door regulation before going after mere advisors! I will, perhaps, give a certain amount of additional credence to a particular agency if they tell me that each analyst has “gardening leave” in their contracts; to give such a matter of judgement the full force of law would be abuse of regulatory authority. I would be much more impressed if the agencies reacted in the same way every single brokerage firm in the world reacts when an employee leaves: devote a lot of time to reviewing the employee’s work. In the brokerage’s case, this is in order to retain the clients for the firm; in an agency’s case, it should be to double-check the ratings assigned to the instruments reviewed by that employee. The ratings should never be the responsibility of a single employee in any event. I recently reported the DBRS downgrade of little rinky-dink ES.PR.B – that report has two names on it. […]
OK, it is time to close out the discussion on ES.
Today I closed my arbitrage trade, buying to cover ES at $14, and selling off my five oil and gas trusts (which had hardly moved). Net profit after all costs was about $3K or 8.1% of the $35K initial capital — not bad for 32 days. I left another $1K on the table because there must be better things to do with one’s money (and time — having to monitor the damn thing on a nearly daily basis once it was clear I was getting close to target).
Besides, the future outlook for potential returns from this trade is less exciting. I figure the PennWest takeover by TAQA cost me about $1 grand — it boosted the shorted ES NAV, but (unfortunately) I didn’t own it.
Always on the lookout for more enticing arbitrage plays.
Cheeerio from the Prefhound…..
Cheeerio, indeed! Well done!
[…] was last mentioned on PrefBlog in connection with DBRS’s downgrade to Pfd-3(high) at this time last year, when asset coverage was 1.52:1. Asset coverage is 1.92:1 as of August 28 […]