Wednesday, 27 January 2016

Morguard REIT 10/31/17 Convertible Debentures

As I continue scouring the North American investment universe for possible ideas, unrelated to alpha or beta or gamma or whatever, I've begun looking into cracks and crevices that I feel are not ordinarily looked at by the ordinary Joe or Jane retail investor, either due to unfamiliarity or oversight.  One of these areas is convertible debentures.

You can find a full listing of TSX traded convertible debentures here.  My thoughts are that the universe of convertible debentures is like the wild west.  The majority of the issues are absolute crap. There's a reason why issuers have to offer sweeteners such as imbedded call options in addition to juicier coupons in order to float issues: because the majority of issuers here are junk issuers.

I sorted the listing in excel.  Of the 151 issues listed for trading, a whopping 9 issues are in the money. Thinking about this, 6% of trading issues are trading based on the imbedded call option feature being in the money.  The remainder are trading out of the money, meaning, these issues should straight like straight bonds as the imbedded calls have zero value.  The farther away the strike price, the more the issue will trade like a straight bond.

I stumbled across the following issue which I thought was interesting:

These debentures trade at just under par and are convertible into underlying MRT.UN units at a strike price of $24.60 up until maturity.  As the REIT unit price has tanked, the call feature is basically worthless and the debentures should trade like straight bonds of equivalent coupon and maturity, but they don't!

Here's the equity performance over the last 5 years weekly, as compared to the BMO equal weight REIT index (on a price performance and correlation basis):

You can see that the units pretty closely track the overall BMO REIT universe on both a price performance and on a correlation basis.  I'm not sure why though.

Here's the debenture vs. the REIT:

Here's what's interesting about this debenture:

  1. The entire amount of the convertible issue is a tiny fraction of Morguard REIT’s overall debt.  They could redeem the entire issue without making a meaningful difference to their balance sheet.  It’s only about $147M on the balance sheet (see below)
  2. Morguard REIT is 48% owned by Morguard (the parent company), which actively buys shares of Morguard REIT in the open market.  I would hazard a guess that depending on how cheap Morguard REIT gets, Morguard could very well take Morguard REIT private in the best case, and in the worst case, continue to buy units in the market.  You can see that Morguard REIT has performed extremely badly since last January! It’s down almost 40%, and I suspect this is a function of Alberta industrial and commercial exposure and exposure to Target leases
  3. The convertibles trade at $.99 on the $1, but yield 4.85%.  The maturity date is October 31st, 2017, so there’s about 1 ¾ years left to maturity at almost 5%.  The concern is that Morguard REIT has the option to settle the $1,000 maturity obligation by issuing units instead of redeeming the units at par of $1,000.  I don’t think this is such a bad trade off though.  The cheaper the units get, the more units you would eventually get for $1,000 par, and see 2) above, Morguard owns 48% of the units and is an active buyer.  If the units got cheap enough, my guess is that Morguard would take the REIT private.  The net value of the real estate (carried less total debt) is around $1.47B.  The units have a total capitalization of $775M, so I think there’s a margin of safety here in buying the debentures
  4. The conversion price is way above current price, $24 or so, vs $12 currently, with no real chance of the stock getting there before 10/31/17, so it should trade like a straight bond, but it’s not because of the optionality in 3) above, re: Morguard REIT having the option to pay the debenture issue off in units instead of cash.  But I wonder if this is such a bad thing?  You’d be receiving units where total cap is $775M vs. net value of real estate of $1.47B and a ready buyer in the parent company willing to continue buying units?  Compare this to Riocan, with a capitalization of $7.74B vs. net value of real estate of $7B?

Here's an excerpt from the most recent quarterly with details surrounding the issuer's option to redeem the debentures in units.

If maturity was tomorrow, I would receive the equivalent of $1,000 worth of units calculated as:

$1,000 / avg trading price for previous 20 days x 95% = $1,000 / (avg ($13.80,$12.57) x 95% = 80 units (I haven't used VWAP here, I've used closing price, but close enough for interest's sake).

Concluding Thoughts

I bought $3K face value of these debentures.  I figure that the following set of possibilities can happen:

  1. They go lower and they get redeemed at par ($1,000) in cash on Oct 31, 2017.  Between now and Oct 31, 2017 I collect 4.85% x $3,000 per year
  2. They stay where they are and they get redeemed at par ($1,000) in cash on Oct 31, 2017.  Between now and Oct 31, 2017 I collect 4.85% x $3,000 per year
  3. They go lower and they get redeemed in units of Morguard REIT on Oct 31, 2017.  Between now and Oct 31, 2017 I collect 4.85% x $3,000 per year.  If the price per unit gets low enough, my margin of safety improves.  

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