This article was first published to Trade With Beta members on October 02, 2022.
In all our future articles, we will have a small intro presenting the returns of the different asset classes so that the the reader gets an idea of what is normal in the current environment. This includes the Treasury Yield Curve, Mortgage Rates, Corporate Bonds, Fixed Rate Preferred Shares and a number of instruments that we find interesting and representative at this time. We call this “the big picture”. After the overview, we present our income idea in the shortest way possible, hopefully without any fluff.
The big picture
As we all know, over the past few weeks, US Treasury yields have risen to their highest levels in a decade. The curve is now inverted:
Federal funds rate
The federal funds rate is currently 3.25%. Fed officials have signaled their intention to continue raising interest rates as much as necessary to fight inflation. Market expectations can be viewed below:
The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to each other in the international interbank market for short-term loans. The current 3-month LIBOR rate is 3.75%, whereas at the start of the year it was around 0.2-0.3%. It is highly likely that LIBOR will continue to outperform Fed Funds, as it makes sense
What will happen to LIBOR
This question is asked after almost every article that includes the good old benchmark. In our last article, DS Leach & CE Leach were helpful enough to post the following link and comment:
The FED text is as follows:
Most likely, 3-month LIBOR will be SOFR +0.26%
The average interest rate on a 30-year fixed mortgage is 6.83%, down from 3.3% at the start of the year. The average rate for a 15-year loan is 6% at the time of writing.
Here we will again use the BAC “A-” corporate bond yield curve:
Yields are around 4% to 6% depending on duration and liquidity.
Fixed Rate Preferred Shares
We have over 100 fixed rate preferred stocks with investment grade credit ratings from S&P or Moody’s. Some of them qualify for lower tax rates, some don’t, but typically their yields range between 5.7% and 6.8% depending on the specifics of the business.
CEF Preferred Shares
From a credit perspective, they are the safest preferred stocks on the exchange, and their yields range between 5.25% and 6.4% depending on the issuer and certain tax differences.
Our recent articles
Allstate Baby Bond interest rate protection with a potential return of 16% (NYSE:ALL)
idea of the day
The stock that caught our attention was Enbridge, 6.375% Fixed/Float Subordinated Notes Series 2018-B due 4/15/2078 (NYSE:NYSE: ENBA). We believe this is an appropriate fixed income investment from both a credit risk and an interest rate risk perspective. It is rated BBB- by S&P and in April 2023 it will be floating, which is supposed to combat interest rate risk.
Before looking at the corporate bond, we need to shed some light on the corporation itself, represented by its common stock. At the time of writing, the dividend yield of Enbridge Inc. (NYSE: ENB) is 7.26% and the company’s forward P/E ratio is around 20.70, with a forward P/E of around 12. This corresponds to an earnings yield of around 8.5% . Historically, the company has been able to generate approximately 8.4% per year over the past 15 years:
and has outperformed its peers over the long term:
The company has an outstanding track record of increasing dividends per share:
On top of that, ENB’s management has been consistent enough to meet its own expectations, which builds confidence among investors and rating agencies:
At a time when the world is preoccupied primarily with energy for obvious reasons, this BBB+ rated company is well positioned to take full advantage of its diverse asset base, as its latest financial outlook shows:
The company aims to maintain debt at levels of 4.5-5x EBITDA with a DCF/s dividend payout ratio of 60-70%. The company is targeting a 7% CAGR on its adjusted EBITDA and discounted cash flow (“DCF”) per share, while it expects a 3% CAGR for dividends per share.
The investor has every reason to believe in the company’s growth prospectus based on past performance and simple financial logic. As markets are currently a bit more volatile than the average investor enjoys, we try to focus on larger companies with good balance sheets and seek even higher value in the capital structure so that our credit risk be as low as possible. Over the past year, ENB’s price behavior has roughly correlated with the broader market:
On top of that, interest rate risk has been the main topic for many investors. Even though ENB has a clear CAGR target of 7%, one is not in a position to buy ENB at book value today to take full advantage of it, even if the company meets its targets (which is very probably based on his performance so far). Being invested in a large company such as ENB does not only mean buying the capital of the company. One can take full advantage of the high credit quality of the company by being invested in bonds for example. At the time of writing, the company is rated BBB+ by all major rating agencies:
By buying the company today, one can expect to earn a perpetual “DCF yield” of 13.63% according to the company’s projections. That sure sounds like a tough number to beat. It is still necessary to ensure that he understands the risks of being invested in the price and not in the fundamentals of the company. Once the big picture of the business is clear, it’s time to take a look at our idea today
Description of ENBA
ENBA is a subordinated fixed/floating note issued by Enbridge. This exchange-traded debt security pays a fixed dividend of $1.59 per year until it becomes a floating rate security on 04/15/2023 and matures on 04/15/2078. At the time of writing, the stock is trading at around $23.60. This security is rated BBB- by S&P and Baa3 by Moody’s. The particularity of this fixed-floating baby bond is that in the years to come the fixed part of its variable rate will increase. After its call date from 04/15/2023 to 04/15/2028, the interest rate on the Notes will be equal to 3-month LIBOR plus 3.593%. From 04/15/2028 to 04/15/2043 the rate will be LIBOR plus 3.843%. From 04/15/2043 to 04/15/2078 the rate will be LIBOR plus 4.593%.
The first possible scenario for the ENBA is to be redeemed. We believe that the probability of redemption is quite high, given the LIBOR rate. Let’s see the numbers in the graph below.
ENBA priced at $23.60 has a call yield of 18.07%. That’s a huge return even in the current environment, so it’s the best possible scenario for an investor in ENBA.
The second scenario for ENBA after its call date of 04/15/2023 is not to be reimbursed. This means that ENBA will become floating and its coupon rate will be 3.593% + 3 month LIBOR until 04/15/2028. The 3-month LIBOR is currently at 3.75%, and as the Fed continues to raise rates, it is expected to rise as well. We will take a rate of 4% for the 3 month LIBOR on the call date (giving our idea a lower rate than expected). Thus, the baseline expectation for ENBA, if not redeemed, is to have a floating nominal rate of approximately 7.6% (4.00% + 3.593%) until 04/15/2028 . As long as ENBA’s buy price is below par, a possible buyback will always be positive, so the worst you can get right now is 7.6% free float, which is around 8% if one buys at around $23.60.
ENB’s Corporate Obligations can be viewed here:
These bonds are 2 notches higher than ENBA and it is up to the reader to decide if a 2% yield spread is fair, bearing in mind that ENBA is a floating instrument with built-in protection. against rising yields. For us the comparison is very simple and we believe that ENBA is far superior to anything presented in the article
The liquidation of fixed rate instruments is only a pure curve shift, which is expected and logical. The passive nature of fixed income exchange-traded funds (“ETFs”) also puts selling pressure on floating-rate instruments. The ENBA is an example that has been mistreated by the market. Its worst case scenario (excluding credit shocks) is an 8% floating rate which is higher than almost anything fixed income can be found on primary exchanges. With such a large company, it’s hard to believe this bond will become exceptional and the projected redemption yield of 18% makes the bond the best investment in the entire BNB capital structure.