In this issue:

Next Update Edition: February 13

Next regular issue: February 27

SEARCHING FOR GREENBACKS

By Gordon Pape, Editor and Publisher

Many income investors spend at least part of the winter in the south, which in most cases means the Sunbelt of the U.S. The precipitous fall in the value of the loonie has left them scrambling. Everything now costs about 10% more than it did at the same time last year, putting a strain on some budgets.

Fortunately, there is something you can do about it. Invest a portion of your portfolio in securities that pay dividends/distributions in U.S. dollars. This will provide steady U.S. cash flow without the expense of converting Canadian dollars at an unfavourable rate.

There are several securities on our Recommended List that qualify and some even come with tax breaks if they are held in a non-registered account. Here are some suggestions. The figures are all in U.S. dollars unless otherwise stated.

Diageo plc (NYSE: DEO). This global beverage alcohol distributor is based in London but trades on the New York Stock Exchange as an American Depository Receipt. That means the dividends are received as U.S. dollars. The stock has come off a little recently but is still trading well above our original recommended price of $81.25. The dividend is paid twice yearly and is tied directly to profits. In 2013, investors received $2.92 per share, which translates to a yield of 2.3% at the current price. Today, the company announced an interim dividend increase to 19.7 pence per share, up 9% from last year. That’s a positive signal to buy.

Ensco plc (NYSE: ESV). The share price of this offshore oil and gas drilling company is off a little since contributing editor Gavin Graham recommended it last October. But the yield is a juicy 5.8% based on the big dividend increase announced in October, bringing the quarterly payment to $0.75 ($3 annually). That works out to 55% of Ensco’s trailing 12-month earnings per share, so the payout appears safe. The company will release fourth-quarter and year-end results on Feb. 20.

FLY Leasing Ltd. (NYSE: FLY). You’ll find an update on FLY elsewhere in this issue so I won’t go into detail here. Suffice to say that the company just increased its dividend by 13% and now yields 6.4%.

Unilever plc (NYSE: UL). The share price hasn’t moved much since our last update in October but the company just released solid year-end results and announced the March dividend would be 0.269, which works out to almost US$0.37 a share. On an annual basis, that would be $1.48 for a yield of 3.6%.

Potash Corporation of Saskatchewan (TSX, NYSE: POT). Here’s something a little different: a Canadian company that pays its dividend in U.S. currency. That means you get the best of both worlds: U.S. cash flow plus eligibility for the dividend tax credit. POT currently pays a quarterly dividend of $0.35 a share ($1.40 annually) to yield 4.4%.

Brookfield Infrastructure Limited Partnership (TSX: BIP.UN, NYSE: BIP). This Bermuda-based LP has an excellent record of increasing its dividend each year, often by a significant amount. The payout in 2013 was $0.43 a quarter or $1.72 for the year, which works out to a yield of 4.6% at the current price. However, fourth-quarter and year-end results are due out in early February and I expect we will see a dividend increase at that time that will push the yield close to 5%. This one also comes with a tax break: a portion of the income (about 42% in 2012) is treated as return of capital for tax purposes.

Brookfield Renewable Energy Partners Limited Partnership (TSX: BEP.UN, NYSE: BEP). This LP has a similar structure to that of its Infrastructure sibling. The current dividend level is $0.362 per quarter (about $1.45 annually) to yield 5.7%. But look for an increase when the financial results are released on Feb. 6. There are also some tax breaks with this one.

Johnson & Johnson (NYSE: JNJ). This pharmaceutical giant has been very good to us since it was recommended by contributing editor Gavin Graham in October 2010 at $63.81. It is now trading in the $90 range and pays a quarterly dividend of $0.66 a share ($2.64 a year) to yield 2.9%. Based on the company’s history, expect the dividend to be increased with the May payment, perhaps to as much as $0.70 a share.

TAL International Group (NYSE: TAL). The payout is very attractive at $0.70 per quarter ($2.80 annually) for a yield of 6.3% but be cautious on this one. See the Updates section for details.

As you can see, there are many options available to create a section of your portfolio to provide U.S. cash flow. Just be sure the securities you select meet your fundamental investment goals.

Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, can be pre-ordered now at 28% off the suggested retail price. Go to http://astore.amazon.ca/buildicaquizm-20

 

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INTEREST RATES LIKELY TO INCH UP IN 2014

By Tom Slee, Contributing Editor

North American bond markets are slowly but surely stabilizing. After a rollercoaster ride in 2013, prices are less volatile. We are seeing more predictable trading pattern thanks in part to Fed Chairman Ben Bernanke’s decision to taper quantitative easing. The central bank is going to reduce its long bond-buying program but keep a tight lid on short-term interest rates. That removes a lot of uncertainty and I think we are going to see an orderly bond market with relatively little price movement this year. Rates are bound to inch higher in the long end as the Fed traders start to back away but most of the adjustment is already in the market. It’s all very encouraging. To quote Bank of Japan Governor Kuroda, “a stable debt market is highly desirable.”

As far as Canadian income investors are concerned, the more rational outlook gives us a chance to fine-tune our portfolios. It’s also an opportunity to factor in a new bond bear market that emerged last year. In 2014 and beyond, we will have to deal with a fundamental and gradual upward trend in interest rates. This is a seismic shift that is going to persist. Underlying bond market trends are prolonged. For example, interest rates started rising in 1946 and kept climbing until 1979 when, with 10-year U.S. Treasuries yielding 15% and inflation rampant, the bond bear market came to an abrupt end. It seems almost certain that last May, 34 years later, the ensuing bond bull ended with interest rates at record lows. Of course, there are going to be fluctuations but from now on interest rates on balance are likely to trend higher. We have to build that bias into our income strategy. The trick is not to overcompensate.

There has already been an overreaction. Normally fundamental bond market changes take place gradually. There is no dramatic event and analysts can only identify a turning point in retrospect, long after it occurs. This time around though, because of the Fed’s high-profile, bond-buying program and the economic turmoil people were looking for an end to the bull market. When it came in May they stampeded, dumping bonds and REITs. Interest rates jumped but then fell away again as investors realized that the U.S. government was going to remain a major player in the market. However, prices remained volatile as nervous investors grappled with a bear market and a lot of pundits have been predicting much higher rates by the end of 2014. I disagree, but believe we will see a sharper yield curve – a wider gap between short- and long-term yields.

As usual, the U.S. Federal Reserve is going to dictate our Canadian interest rates because our two financial systems are joined at the hip. Trendsetting Canadian government yields move in lockstep with their American counterparts even during periods when it makes little sense. The average difference between Canadian and U.S. 10-year rates is a miniscule 26 basis points over the last 20 years despite periods when the respective economies were growing at vastly different speeds. So as Canadian income investors, we need to study Mr. Bernanke’s announcement on Dec. 18 carefully.

First and foremost, the Fed is going to continue using open market activity to orchestrate interest rates. The plan is to keep short-term rates “exceptionally low” until at least 2015, more likely 2016. There is to be a “modest reduction” of $10 billion in the monthly long bond-buying program. We are going to monetary stimulus for years to come and economists expect incoming Fed Chair Barbara Yellen to quickly jump in and drive down long rates if mortgages start becoming expensive. Mr. Bernanke was extremely cautious in his comments. He did not unleash the market. The traders are not off and running although the Dow soared 300 points because his announcement was a vote of confidence in the economy.

The real message is that the Fed is going to try and keep a lid on rates. We should not underestimate its power. Mr. Bernanke broke a lot of rules with his quantitative easing program. The Fed is now printing money to buy bonds from the U.S. Treasury. This was unimaginable a few short years ago. Moreover, observers feel that Ms. Yellen is even more of an interventionist than Mr. Bernanke. She has spoken about the need to spur employment and housing and showed less concern about the need for free markets. That is why there was a lot of opposition to her appointment.

Here’s another reason why interest rate increases are likely to be gradual. Inflation remains very low. This is a crucial factor in the bond market where investors often see their capital locked into long-term issues and lose its purchasing power before repayment. Instead, there is talk of deflation, a situation where prices actually spiral downward. This is already happening in parts of Europe. Lenders are benefitting in Latvia, Greece and Cyprus as the cost of living falls and their repayments increase in value. The European Central Bank has slashed its refinancing rate to 0.25%. I am not suggesting that we are going to see deflation in North America but U.S. inflation could hover around 1.25% in 2014. In Canada it’s running at 1%. There is an outside possibility that the Bank of Canada will cut interest rates to stimulate business activity.

What does it all add up to? Benchmark 10-year U.S. Treasury Notes, a guide for mortgage rates, are currently yielding 2.95%. I expect to see them paying about 3.5% by the end of the year. With current inflation close to 1.5% that represents a 2% real return. In Canada 10-year Government of Canada issues are paying 2.75%. My feeling is they will remain relatively unchanged for most of 2014 and then gradually increase to approximately 3.25% by December.

In the short end, central banks are going to keep providing cheap money. The Bank of Canada’s 1% overnight rate is unlikely to change until the middle of 2015. Similarly, the 0.13% U.S. Federal funds rate should remain the same for the foreseeable future.

As you can see, it’s a business-as-usual forecast. There is no sign of an interest rate surge. As a matter of fact, long rates may move sideways if the Fed sees the house market losing steam and decides to intervene. In short, bonds are going to remain unattractive this year. The yields are poor and now that we have a bear market there is little chance of capital growth.

For investors seeking reliable, above-average income, preferred shares are a much better prospect. This market sold off in 2013 as pundits became alarmed and predicted rocketing rates. The S&P /TSX Preferred Share Index slipped 2.8% in the third quarter, an even-worse performance than the DEX Corporate Bond Index that showed a 0.7% return. As a result, Canadian preferred shares are already reflecting the Fed’s new policy and some of the issues are oversold. A recent CIBC survey showed the following average median returns.

• Retractable Preferreds: 5.12%
• Perpetual Preferreds: 5.41%
• Fixed-Reset Rate Preferreds 5.06%
• Floating Rate Preferreds 3.25%

Keep in mind that unlike bond interest income, these dividends qualify for the dividend tax credit in unregistered accounts. Of course, bonds are usually more secure but many Canadian preferred shares now provide a sufficient income spread to compensate for this risk. Ten-year corporate bonds pay about 3% while top quality perpetuals yield 5%, equivalent to about 7.5% with the tax credit, a 450 basis point spread. That’s why I think that perpetual issues offer the best value. See my recommendations in this issue’s updates section.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed income securities.

 

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TIME TO BUY INTEREST-SENSITIVE STOCKS?

By Tom Slee, Contributing Editor

As Gordon has pointed out in his review of 2013, it was not a good year for those investments that are sensitive to interest-rate moves. While defensive income-producing sectors such as utilities, pipelines and real estate investment trusts (REITs) did well in the bull market that began in March 2009, in most cases, that came to an abrupt end last May.

When former U.S. Federal Reserve Chairman Ben Bernanke made public the fact that the Fed was looking at phasing out its Quantitative Easing (QE) program, markets sold off sharply, with bonds and interest-sensitive sectors hit the worst. The yield on the benchmark 10-year U.S. Treasury bond rose by almost 1% to over 3% within three months, resulting in a 10% price decline and the iShares S&P/TSX Capped REIT Index ETF (TSX: XRE) fell 17% between the end of April and the end of August.

Over the last 12 months, the REIT Index is off 10.5%, the DEX Long Bond Index is down 6.1%, and individual income stocks such as Canadian Utilities and TransCanada are down 3% and 1.5%, respectively. Other defensive sectors such as pipelines, power companies and telecommunications are lagging the 9.2% return from the S&P/TSX Composite by 3% to 6%. This does not include the income being generated by these companies, which reduces the under performance somewhat. But it is fair to say that these sectors are looking more attractive than the general market.

Of course, investors need to be comfortable that interest rates do not go up more than has been factored into the falls in share prices. On that front, new Fed Chair Janet Yellen is regarded as even less willing than Ben Bernanke to begin raising interest rates before the tentative recovery in the U.S. is well established. Besides, tapering has already begun, with the amount of monthly QE reduced by US$10 billion in December 2013. Long-term interest rates have actually eased a little.

Meanwhile, in the October statement, new Bank of Canada Governor Stephen Poloz suggested the central bank might raise interest rates. The result? The loonie slid 6.2% against the US dollar in the last three months, acting as an effective interest rate reduction, as exports are stimulated.

Therefore, I would suggest higher longer-term rates are already reflected in today’s share prices. But there are still underperformers to consider. Check out my Top Pick.

Gavin Graham is president of Graham Investment Strategy Ltd., which provides macro economic investment analysis and recommendations on asset classes.

 

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JANUARY’S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on Monday, Jan. 27 unless otherwise indicated.

Capital Power Corporation (TSX: CPX, OTC: CPXWF)

Type: Common stock
Trading symbol: CPX, CPXWF
Exchanges: TSX, Grey Market
Current price: C$22.60, US$19.32
Entry price: Current price
Payout: $1.26
Yield: 5.6%
Risk Rating: Moderate risk
Recommended by: Gavin Graham
Website: www.capitalpower.com

The business: Capital Power is an independent North American power producer, owning 2,510 MW (megawatts) of power generation capacity at 13 facilities across Canada and the U.S. and the rights to an additional 371 MW through its interest in the Sundance Power Purchase Agreement (PPA). An additional 595 MW of capacity are under construction or development in Alberta and Ontario. Capital Power generates its power from a wide range of sources including coal, solid fuels, natural gas and wind. It has a market capitalization of $1.9 billion and in 2009 was spun off from its former parent company EPCOR, whose roots go back to 1891.

For the nine months ending Sept. 30, Capital Power had revenues of $1.07 billion, virtually flat with $1.03 billion in the same period in 2012, but Earnings Before Interest, Tax, Depreciation & Amortization (EBITDA) rose 6% to $390 million from $368 million while Funds From Operations (FFO) rose 4% to $310 million.

The company’s net income has more than doubled to $98 million ($1.19 per share) in 2013 versus $47 million ($0.65 per share) in 2012. Normalized income was also higher in 2013 at $95 million ($1.35 per share) compared to $70 million in 2012 ($1.06 per share). These higher earnings are due to better-than-expected Alberta electricity prices, averaging $82 per MWh (megawatt hour) through the first three quarters of 2013.

The security: Capital Power trades as a common stock on the Toronto Stock Exchange, and the over-the-counter Grey Market in the U.S.

Why we like it: Capital Power has underperformed both the TSX and its sector over the last three years. This is due to the overhang of shares from its former parent, EPCOR, which initially floated 28% of Capital Power in 2009. EPCOR has subsequently carried out three sales of its holding in the market, most recently the October sale of 9.6 million shares (10% of the company) priced at $21 a share. That raised $201.6 million for EPCOR, reducing its holding to 19%. When combined with an 18.8-million-share primary equity issue by Capital Power in 2011, the share price has understandably marked time, especially as the dividend has not been raised for the last four years.

However, the company has been refocusing itself on the Alberta market, where it owns three long-life and low-emission, coal-fired power plants with 1,365 MW in capacity. Demonstrating its widely diversified range of power sources, it also has the 371 MW coal-fired Sundance PPA, a 192 MW gas-fired plant in Joffre and, in Halkirk, the largest wind farm in the province. In addition, Capital Power is building an 800 MW gas-fired plant in a 50/50 joint venture with ENMAX on the eastern edge of Calgary, due to start up in 2015.

Alberta’s forecast demand for power is among the best in North America, due to its strong economy, inward migration and the growing demand from the energy sector. In 2018-2020, Capital Power intends to build two more gas-fired plants with up to 900 MW capacity in Genesee to meet future demand. It also has two wind farms due this year and next year with 375 MW capacity in Ontario with long-life PPAs.

Financial highlights: Capital Power is rated BBB- by S&P and BBB by DBRS (both investment grade). Assets of $5.1 billion support $1.6 billion of debt, giving the company a debt-to-capital ratio of 34%. Debt maturities are well spread out over the next decade. Although EPCOR’s shareholding falling below 20% allows it to demand early repayment of its $340 million in debt this year, Capital Power regards this as a chance to lower its interest cost and extend its maturities should this occur. The company raised $200 million in 4.5% 2018 preferred shares rated P-3 last year. The company sells for a P/E ratio of 15.6 times, a price/book ratio of 0.5 and a low price/cash flow of 2.7 times.

Risks: Capital Power is an independent power producer, meaning that much of its output is sold on the open (merchant) market, with all of the exposure to fluctuating power prices that implies. However, it has locked in the output from its Alberta baseload power plants, with 92% sold in the high $50s per MWh in 2014 and 77% at mid $50s for 2015 until its Shepard plant is built. Its 375 MW Ontario wind farms have 20-year PPAs at $135 per MWh, which Capital estimates will produce an extra $80 to $85 million per annum of cash flow, worth $0.90 to $0.95 per share and $0.35 to $0.40 of earnings per share. Two of its power plants in North Carolina (134 MW) have eight-year PPAs and another three (457 MW) in Ontario and BC have PPAs expiring between 2022 and 2037. In October, it sold three Northeast U.S. power plants (1089 MW) to Emera for $541 million (all following numbers in U.S. dollars), taking a $6 million loss, but reducing its exposure to merchant activities. It also closed down most of its power-trading operations, which together with other staff reductions, will reduce its employees by 160 and save it an estimated $30 million per annum.

Distribution policy: Dividends are paid quarterly in March, June, September and December and the yield is a respectable 5.6%. With discretionary cash flow equaling 35% to 40% of its $310 million, and capital expenditure halving from $950 million to $475 million in 2013, it is reasonable to expect an increase in the dividend at some stage in the next 18 months.

Tax implications: Capital Power dividends are considered qualifying dividends for Canadian tax purposes, and are taxed at two-thirds of the investor’s top marginal rate in a non-registered account. For U.S. investors, the dividends are taxed at the lower dividend tax rate.

Who it’s for: Capital Power is for investors looking for a reasonable and sustainable absolute yield from a company, which is conservatively financed. The company is coming to the end of a major capital expenditure cycle and has underperformed due to consistent selling by its former parent. It has upside from its concentrated exposure to the Alberta power market, which has good long-term fundamentals.

How to buy: Capital Power trades on the TSX and its $2 billion market capitalization and 80% free float allows investors to buy any amount within reason.

Summing up: Capital Power is an underperformer within its sector. It has specific factors that should enable it to deliver a competitive total return while providing a reasonable yield. – G.G.

 

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JANUARY UPDATES

Here are this month’s updates. All prices are as of the close of trading on Monday, Jan. 27 unless otherwise indicated.

FLY Leasing Ltd. (NYSE: FLY)

Type: American Depository Receipt (ADR)
Trading symbol: FLY
Exchange: NYSE
Current price: US$15.03
Originally recommended: Oct. 10/13 at US$13.40
Annual payout: US$1.00
Yield: 6.7%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.flyleasing.com

Investors in this Dublin-based aircraft leasing company got some good news this month when the directors approved a 13% increase in the dividend to $0.25 per quarter or $1 per year (all figures in U.S. currency). The first enhanced dividend will be paid on Feb. 20 to shareholders of record as of Jan. 31.

“FLY achieved strong growth in 2013, adding 14 aircraft to its fleet, which has increased our earnings per share and provided us with the ability to raise our quarterly dividend and return further value to our shareholders,” said CEO Colm Barrington in announcing the increase.

The announcement comes in advance of the company’s fourth-quarter and year-end results, which are expected in late February or early March. The early dividend increase appears to signal strong performance numbers at that time.

If it plays out that way, it will be welcome news for investors. Third-quarter figures were disappointing with the company reporting adjusted net income of only $2.7 million ($0.07 per share), down from $5.4 million ($0.21 per share) in the same period last year. For the first nine months of the 2013 fiscal year, FLY reported adjusted net income of $52.5 million ($1.65 a share) compared to $63.1 million ($2.43 a share) in 2012.

“During the third quarter we added five aircraft, increasing our portfolio to 107 aircraft at quarter end,” said Mr. Barrington. “So far in the fourth quarter we have added two more aircraft, including a new Boeing 787 on a long-term lease to a top credit airline. This year we have added aircraft worth more than $560 million to our fleet, achieving our growth target for the year and putting us on track to add more than $600 million worth of aircraft by year-end. FLY has the capital to maintain this strong growth in 2014 and we continue to see attractive acquisition opportunities.

“All of our aircraft are now on lease or committed to leases. The global airline industry is strong with air traffic and airline load factors at or near all-time highs. Demand for leased aircraft remains strong and we are seeing improvements in lease rates. As we look ahead to 2014, FLY is well positioned to benefit from its strong financial position, its growing fleet and improving industry conditions.”

Action now: FLY remains a Buy for investors who can tolerate above average risk. – G.P.

TAL International Group (NYSE: TAL)

Type: Common stock
Trading symbol: TAL
Exchange: NYSE
Current price: US$44.10
Originally recommended: Jan. 9/13 at US$37.11
Annual payout: $2.80
Yield: 6.3%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.talinternational.com

Comments: TAL has increased its dividend in every quarter since the start of 2012 but the stock has been in a slide recently that has taken it down from $57.28 in late November to the current level. That suggests that investors are concerned that growth is slowing and that fourth-quarter and year-end results may disappoint.

There was no sign of any problems in the third-quarter numbers, which came out in late October. The container leasing company reported adjusted net income of $1.60 a share, fully diluted, up 8.1% from the same period in 2012. Leasing revenue totalled $143.9 million, an increase of 6.4% from the previous year.

“TAL continued to deliver strong operational and financial results in the third quarter of 2013,” commented CEO Brian M. Sondey. “Our strong performance continues to be driven by high equipment utilization. Our utilization averaged 97.3% for the third quarter and currently stands at 96.9%. We also continue to benefit from the debt refinancing we completed in the first half of the year. Our average effective interest rate dropped to 3.8% in the third quarter of 2013, down almost a full percentage point from the same period last year.”

However, some analysts are predicting some rough waters for the company. A widely-circulated article on the popular investing website Seeking Alpha goes so far as to predict TAL could experience lower leasing prices, declining sales gains, and higher interest costs which combined could force the company to eliminate its dividend and drive the share price down to below $20.

This is an extreme view from a writer who discloses he is shorting the stock. The 11 analysts surveyed by Thomson/First Call are basically neutral on the company with a median target price of $50 on the shares.

Reassuring as that may be, the big drop in the share price is a real concern. I don’t want to dump this one yet because of the very attractive U.S. dollar yield, but put it in your watch list. If the price drops below $40, get out.

Action now: Hold. Sell below $40. – G.P.

Canexus Corp. (TSX: CUS, OTC: CXUSF)

Type: Common stock
Trading symbols: CUS, CXUSF
Exchanges: TSX, Grey Market
Current price: C$5.80, US$5.22 (Jan. 23)
Originally recommended: Feb. 20/13 at C$9.08, US$9
Annual payout: $0.55
Yield: 9.5%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.canexus.ca

Comments: This stock has taken a beating since I recommended it almost a year ago. I did stress at the time that it was suitable for aggressive investors only, but the downside has been worse than I expected.

A big part of the reason for the drop in the share price is a 40% cost overrun in the construction of the company’s pipeline connected unit train expansion at the North American Terminal Operations at Bruderheim, Alberta. Instead of the initial $225 million estimate, the final cost is now expected to be in the $315 million range.

CEO Gary Kubera said he was “disappointed” with the revised projection. Investors would likely use stronger language – a 40% overrun suggests bad planning and/or execution and for a project this size, that is inexcusable.

The good news is that the company expects to begin loading 14 unit trains per day in February, which represents about 30,000 barrels of oil. Unit trains are dedicated carriers, transporting oil to a single destination.

The full project is scheduled for completion in mid-year.

The cost overrun prompted the company to dilute the stock by agreeing to a bought deal with a syndicate led by National Bank Financial, CIBC World Markets, Scotia Capital and BMO Nesbitt Burns. Canexus raised $150 million by issuing 26.8 million shares at $5.60. The money has been earmarked to fund the completion of the Bruderheim project.

Apart from the stock dilution, investors are now faced with the reality of the cash flow restraints imposed by the cost overrun. The company has said it intends to retain its dividend at the current level but analysts note this would imply a payout ratio of more than 100% through 2014. If anything more goes wrong, the company may have no choice but to reduce the dividend.

My inclination is to hang in and continue to collect the handsome yield, always keeping the risk factor in mind. But if the shares drop below $5, take the loss and exit.

Action now: Hold. – G.P.

Bank of Nova Scotia 5.6% Series 17 Preferreds (TSX: BNS.PR.O)

Type: Straight preferred shares
Trading symbol: BNS.PR.O
Exchange: TSX
Current price: $26.10
Originally recommended: Dec. 21/11 at $26.98
Annual payout: $1.40
Yield: 5.4%
Credit Rating: DBRS: Pfd 1
Risk Rating: Conservative
Recommended by: Tom Slee
Website: www.scotiabank.com/ca/en/0,,4158,00.html

Comments: These preferreds are equivalent to about 7.5% from a bond in an unregistered account. The dividends are non-cumulative, which means that in the unlikely event a distribution is missed or only partially made, Scotiabank is not required to make up the shortfall.

As Canada’s third largest bank with a market capital of $72 billion and 3,100 branches, BNS is one of the safest stocks on the board. Sporting a Double A (stable) rating from Dominion Bond Rating Service, the bank earned $5.17 a share in fiscal 2013 and is expected to make $5.50 or more this year.

My only slight reservation is that Scotiabank can redeem the Series O shares at a price of $25.75 on and after April 26 and later at descending prices to $25 on or after April 26, 2017. Normally I would consider the risk of redemption as extremely low. However, new international rules governing bank capital calculations disqualify preferred shares. Banks are disputing this change and in any event the phasing-in provisions are generous. Nevertheless, at some time in the future, Canadian banks may retire their preferred shares. There were no new issues in 2013.

Action now: Buy for above-average, safe income. – T.S.

Canadian General Investments 4.65% Class A Series 2 Preferreds (TSX: CGI.PR.B)

Type: Cumulative, redeemable, retractable preferred shares
Symbol: CGI.PR.B
Exchange: TSX
Current price: $25 (May 29)
Risk rating: Conservative
Recommended by: Tom Slee
Website:
www.mmainvestments.com/index.cfm?Section=CGI&Page=CGI_Preferred

Comments: The Canadian General Investments 4.65% Class A Series 2 Preferred Shares have been redeemed at a price of $25, slightly below our original recommendation at $25.27. At that time we advised investors not to chase the shares up and expose themselves to a possible capital loss. Unfortunately, the redemption was unexpected and funded by a short-term bank loan. It highlights the danger of buying preferred shares at prices above the redemption provision.

Action now: Redeemed. – T.S.

 

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YOUR QUESTIONS

Convertible debentures and interest rates

Q – How are convertible debentures likely to react to rising interest rates?

A – Convertible debentures are the ultimate hybrid – part bonds and part stocks. As a result they respond to both markets. My own experience, however, is that they are a law unto themselves with the underlying stock as a driving force. To give you an example, in May 2012, when rates were at rock bottom, we recommended the Chemtrade Logistics 5.75% Convertible Debentures (TSX: CHE.DB.A) at $102.50 to yield 5.25%. The stock (TSX: CHE.UN) was at $15.82. Interest rates have climbed in the interim and you would expect these convertibles to drop in price and the yield increase. Instead, they are priced at $108.50 and yielding 3.84% because the stock has performed well and is trading at $19.89.

The fact is, although convertible debentures are fixed income securities, institutions use them to play the stock market. They have no intention of converting and almost always take their capital gain when the debenture moves up. If the stock fails to perform they might hold the convertible to maturity but performance-minded managers are more likely to take any loss and move on. Therefore, convertible debentures are unlikely to drop very much when interest rates are rising, especially those underwritten by growth stocks. – T.S.

 

That’s all for this issue. Look for your next Update Edition on Feb. 13. The next regular issue will be published on Feb. 27.

Best regards,
Gordon Pape, editor-in-chief

In this issue:

Next Update Edition: February 13

Next regular issue: February 27

SEARCHING FOR GREENBACKS

By Gordon Pape, Editor and Publisher

Many income investors spend at least part of the winter in the south, which in most cases means the Sunbelt of the U.S. The precipitous fall in the value of the loonie has left them scrambling. Everything now costs about 10% more than it did at the same time last year, putting a strain on some budgets.

Fortunately, there is something you can do about it. Invest a portion of your portfolio in securities that pay dividends/distributions in U.S. dollars. This will provide steady U.S. cash flow without the expense of converting Canadian dollars at an unfavourable rate.

There are several securities on our Recommended List that qualify and some even come with tax breaks if they are held in a non-registered account. Here are some suggestions. The figures are all in U.S. dollars unless otherwise stated.

Diageo plc (NYSE: DEO). This global beverage alcohol distributor is based in London but trades on the New York Stock Exchange as an American Depository Receipt. That means the dividends are received as U.S. dollars. The stock has come off a little recently but is still trading well above our original recommended price of $81.25. The dividend is paid twice yearly and is tied directly to profits. In 2013, investors received $2.92 per share, which translates to a yield of 2.3% at the current price. Today, the company announced an interim dividend increase to 19.7 pence per share, up 9% from last year. That’s a positive signal to buy.

Ensco plc (NYSE: ESV). The share price of this offshore oil and gas drilling company is off a little since contributing editor Gavin Graham recommended it last October. But the yield is a juicy 5.8% based on the big dividend increase announced in October, bringing the quarterly payment to $0.75 ($3 annually). That works out to 55% of Ensco’s trailing 12-month earnings per share, so the payout appears safe. The company will release fourth-quarter and year-end results on Feb. 20.

FLY Leasing Ltd. (NYSE: FLY). You’ll find an update on FLY elsewhere in this issue so I won’t go into detail here. Suffice to say that the company just increased its dividend by 13% and now yields 6.4%.

Unilever plc (NYSE: UL). The share price hasn’t moved much since our last update in October but the company just released solid year-end results and announced the March dividend would be 0.269, which works out to almost US$0.37 a share. On an annual basis, that would be $1.48 for a yield of 3.6%.

Potash Corporation of Saskatchewan (TSX, NYSE: POT). Here’s something a little different: a Canadian company that pays its dividend in U.S. currency. That means you get the best of both worlds: U.S. cash flow plus eligibility for the dividend tax credit. POT currently pays a quarterly dividend of $0.35 a share ($1.40 annually) to yield 4.4%.

Brookfield Infrastructure Limited Partnership (TSX: BIP.UN, NYSE: BIP). This Bermuda-based LP has an excellent record of increasing its dividend each year, often by a significant amount. The payout in 2013 was $0.43 a quarter or $1.72 for the year, which works out to a yield of 4.6% at the current price. However, fourth-quarter and year-end results are due out in early February and I expect we will see a dividend increase at that time that will push the yield close to 5%. This one also comes with a tax break: a portion of the income (about 42% in 2012) is treated as return of capital for tax purposes.

Brookfield Renewable Energy Partners Limited Partnership (TSX: BEP.UN, NYSE: BEP). This LP has a similar structure to that of its Infrastructure sibling. The current dividend level is $0.362 per quarter (about $1.45 annually) to yield 5.7%. But look for an increase when the financial results are released on Feb. 6. There are also some tax breaks with this one.

Johnson & Johnson (NYSE: JNJ). This pharmaceutical giant has been very good to us since it was recommended by contributing editor Gavin Graham in October 2010 at $63.81. It is now trading in the $90 range and pays a quarterly dividend of $0.66 a share ($2.64 a year) to yield 2.9%. Based on the company’s history, expect the dividend to be increased with the May payment, perhaps to as much as $0.70 a share.

TAL International Group (NYSE: TAL). The payout is very attractive at $0.70 per quarter ($2.80 annually) for a yield of 6.3% but be cautious on this one. See the Updates section for details.

As you can see, there are many options available to create a section of your portfolio to provide U.S. cash flow. Just be sure the securities you select meet your fundamental investment goals.

Gordon Pape’s new book, RRSPs: The Ultimate Wealth Builder, can be pre-ordered now at 28% off the suggested retail price. Go to http://astore.amazon.ca/buildicaquizm-20

 

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INTEREST RATES LIKELY TO INCH UP IN 2014

By Tom Slee, Contributing Editor

North American bond markets are slowly but surely stabilizing. After a rollercoaster ride in 2013, prices are less volatile. We are seeing more predictable trading pattern thanks in part to Fed Chairman Ben Bernanke’s decision to taper quantitative easing. The central bank is going to reduce its long bond-buying program but keep a tight lid on short-term interest rates. That removes a lot of uncertainty and I think we are going to see an orderly bond market with relatively little price movement this year. Rates are bound to inch higher in the long end as the Fed traders start to back away but most of the adjustment is already in the market. It’s all very encouraging. To quote Bank of Japan Governor Kuroda, “a stable debt market is highly desirable.”

As far as Canadian income investors are concerned, the more rational outlook gives us a chance to fine-tune our portfolios. It’s also an opportunity to factor in a new bond bear market that emerged last year. In 2014 and beyond, we will have to deal with a fundamental and gradual upward trend in interest rates. This is a seismic shift that is going to persist. Underlying bond market trends are prolonged. For example, interest rates started rising in 1946 and kept climbing until 1979 when, with 10-year U.S. Treasuries yielding 15% and inflation rampant, the bond bear market came to an abrupt end. It seems almost certain that last May, 34 years later, the ensuing bond bull ended with interest rates at record lows. Of course, there are going to be fluctuations but from now on interest rates on balance are likely to trend higher. We have to build that bias into our income strategy. The trick is not to overcompensate.

There has already been an overreaction. Normally fundamental bond market changes take place gradually. There is no dramatic event and analysts can only identify a turning point in retrospect, long after it occurs. This time around though, because of the Fed’s high-profile, bond-buying program and the economic turmoil people were looking for an end to the bull market. When it came in May they stampeded, dumping bonds and REITs. Interest rates jumped but then fell away again as investors realized that the U.S. government was going to remain a major player in the market. However, prices remained volatile as nervous investors grappled with a bear market and a lot of pundits have been predicting much higher rates by the end of 2014. I disagree, but believe we will see a sharper yield curve – a wider gap between short- and long-term yields.

As usual, the U.S. Federal Reserve is going to dictate our Canadian interest rates because our two financial systems are joined at the hip. Trendsetting Canadian government yields move in lockstep with their American counterparts even during periods when it makes little sense. The average difference between Canadian and U.S. 10-year rates is a miniscule 26 basis points over the last 20 years despite periods when the respective economies were growing at vastly different speeds. So as Canadian income investors, we need to study Mr. Bernanke’s announcement on Dec. 18 carefully.

First and foremost, the Fed is going to continue using open market activity to orchestrate interest rates. The plan is to keep short-term rates “exceptionally low” until at least 2015, more likely 2016. There is to be a “modest reduction” of $10 billion in the monthly long bond-buying program. We are going to monetary stimulus for years to come and economists expect incoming Fed Chair Barbara Yellen to quickly jump in and drive down long rates if mortgages start becoming expensive. Mr. Bernanke was extremely cautious in his comments. He did not unleash the market. The traders are not off and running although the Dow soared 300 points because his announcement was a vote of confidence in the economy.

The real message is that the Fed is going to try and keep a lid on rates. We should not underestimate its power. Mr. Bernanke broke a lot of rules with his quantitative easing program. The Fed is now printing money to buy bonds from the U.S. Treasury. This was unimaginable a few short years ago. Moreover, observers feel that Ms. Yellen is even more of an interventionist than Mr. Bernanke. She has spoken about the need to spur employment and housing and showed less concern about the need for free markets. That is why there was a lot of opposition to her appointment.

Here’s another reason why interest rate increases are likely to be gradual. Inflation remains very low. This is a crucial factor in the bond market where investors often see their capital locked into long-term issues and lose its purchasing power before repayment. Instead, there is talk of deflation, a situation where prices actually spiral downward. This is already happening in parts of Europe. Lenders are benefitting in Latvia, Greece and Cyprus as the cost of living falls and their repayments increase in value. The European Central Bank has slashed its refinancing rate to 0.25%. I am not suggesting that we are going to see deflation in North America but U.S. inflation could hover around 1.25% in 2014. In Canada it’s running at 1%. There is an outside possibility that the Bank of Canada will cut interest rates to stimulate business activity.

What does it all add up to? Benchmark 10-year U.S. Treasury Notes, a guide for mortgage rates, are currently yielding 2.95%. I expect to see them paying about 3.5% by the end of the year. With current inflation close to 1.5% that represents a 2% real return. In Canada 10-year Government of Canada issues are paying 2.75%. My feeling is they will remain relatively unchanged for most of 2014 and then gradually increase to approximately 3.25% by December.

In the short end, central banks are going to keep providing cheap money. The Bank of Canada’s 1% overnight rate is unlikely to change until the middle of 2015. Similarly, the 0.13% U.S. Federal funds rate should remain the same for the foreseeable future.

As you can see, it’s a business-as-usual forecast. There is no sign of an interest rate surge. As a matter of fact, long rates may move sideways if the Fed sees the house market losing steam and decides to intervene. In short, bonds are going to remain unattractive this year. The yields are poor and now that we have a bear market there is little chance of capital growth.

For investors seeking reliable, above-average income, preferred shares are a much better prospect. This market sold off in 2013 as pundits became alarmed and predicted rocketing rates. The S&P /TSX Preferred Share Index slipped 2.8% in the third quarter, an even-worse performance than the DEX Corporate Bond Index that showed a 0.7% return. As a result, Canadian preferred shares are already reflecting the Fed’s new policy and some of the issues are oversold. A recent CIBC survey showed the following average median returns.

• Retractable Preferreds: 5.12%
• Perpetual Preferreds: 5.41%
• Fixed-Reset Rate Preferreds 5.06%
• Floating Rate Preferreds 3.25%

Keep in mind that unlike bond interest income, these dividends qualify for the dividend tax credit in unregistered accounts. Of course, bonds are usually more secure but many Canadian preferred shares now provide a sufficient income spread to compensate for this risk. Ten-year corporate bonds pay about 3% while top quality perpetuals yield 5%, equivalent to about 7.5% with the tax credit, a 450 basis point spread. That’s why I think that perpetual issues offer the best value. See my recommendations in this issue’s updates section.

Tom Slee managed millions of dollars in pension money during his career and is an expert in fixed income securities.

 

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TIME TO BUY INTEREST-SENSITIVE STOCKS?

By Tom Slee, Contributing Editor

As Gordon has pointed out in his review of 2013, it was not a good year for those investments that are sensitive to interest-rate moves. While defensive income-producing sectors such as utilities, pipelines and real estate investment trusts (REITs) did well in the bull market that began in March 2009, in most cases, that came to an abrupt end last May.

When former U.S. Federal Reserve Chairman Ben Bernanke made public the fact that the Fed was looking at phasing out its Quantitative Easing (QE) program, markets sold off sharply, with bonds and interest-sensitive sectors hit the worst. The yield on the benchmark 10-year U.S. Treasury bond rose by almost 1% to over 3% within three months, resulting in a 10% price decline and the iShares S&P/TSX Capped REIT Index ETF (TSX: XRE) fell 17% between the end of April and the end of August.

Over the last 12 months, the REIT Index is off 10.5%, the DEX Long Bond Index is down 6.1%, and individual income stocks such as Canadian Utilities and TransCanada are down 3% and 1.5%, respectively. Other defensive sectors such as pipelines, power companies and telecommunications are lagging the 9.2% return from the S&P/TSX Composite by 3% to 6%. This does not include the income being generated by these companies, which reduces the under performance somewhat. But it is fair to say that these sectors are looking more attractive than the general market.

Of course, investors need to be comfortable that interest rates do not go up more than has been factored into the falls in share prices. On that front, new Fed Chair Janet Yellen is regarded as even less willing than Ben Bernanke to begin raising interest rates before the tentative recovery in the U.S. is well established. Besides, tapering has already begun, with the amount of monthly QE reduced by US$10 billion in December 2013. Long-term interest rates have actually eased a little.

Meanwhile, in the October statement, new Bank of Canada Governor Stephen Poloz suggested the central bank might raise interest rates. The result? The loonie slid 6.2% against the US dollar in the last three months, acting as an effective interest rate reduction, as exports are stimulated.

Therefore, I would suggest higher longer-term rates are already reflected in today’s share prices. But there are still underperformers to consider. Check out my Top Pick.

Gavin Graham is president of Graham Investment Strategy Ltd., which provides macro economic investment analysis and recommendations on asset classes.

 

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JANUARY’S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on Monday, Jan. 27 unless otherwise indicated.

Capital Power Corporation (TSX: CPX, OTC: CPXWF)

Type: Common stock
Trading symbol: CPX, CPXWF
Exchanges: TSX, Grey Market
Current price: C$22.60, US$19.32
Entry price: Current price
Payout: $1.26
Yield: 5.6%
Risk Rating: Moderate risk
Recommended by: Gavin Graham
Website: www.capitalpower.com

The business: Capital Power is an independent North American power producer, owning 2,510 MW (megawatts) of power generation capacity at 13 facilities across Canada and the U.S. and the rights to an additional 371 MW through its interest in the Sundance Power Purchase Agreement (PPA). An additional 595 MW of capacity are under construction or development in Alberta and Ontario. Capital Power generates its power from a wide range of sources including coal, solid fuels, natural gas and wind. It has a market capitalization of $1.9 billion and in 2009 was spun off from its former parent company EPCOR, whose roots go back to 1891.

For the nine months ending Sept. 30, Capital Power had revenues of $1.07 billion, virtually flat with $1.03 billion in the same period in 2012, but Earnings Before Interest, Tax, Depreciation & Amortization (EBITDA) rose 6% to $390 million from $368 million while Funds From Operations (FFO) rose 4% to $310 million.

The company’s net income has more than doubled to $98 million ($1.19 per share) in 2013 versus $47 million ($0.65 per share) in 2012. Normalized income was also higher in 2013 at $95 million ($1.35 per share) compared to $70 million in 2012 ($1.06 per share). These higher earnings are due to better-than-expected Alberta electricity prices, averaging $82 per MWh (megawatt hour) through the first three quarters of 2013.

The security: Capital Power trades as a common stock on the Toronto Stock Exchange, and the over-the-counter Grey Market in the U.S.

Why we like it: Capital Power has underperformed both the TSX and its sector over the last three years. This is due to the overhang of shares from its former parent, EPCOR, which initially floated 28% of Capital Power in 2009. EPCOR has subsequently carried out three sales of its holding in the market, most recently the October sale of 9.6 million shares (10% of the company) priced at $21 a share. That raised $201.6 million for EPCOR, reducing its holding to 19%. When combined with an 18.8-million-share primary equity issue by Capital Power in 2011, the share price has understandably marked time, especially as the dividend has not been raised for the last four years.

However, the company has been refocusing itself on the Alberta market, where it owns three long-life and low-emission, coal-fired power plants with 1,365 MW in capacity. Demonstrating its widely diversified range of power sources, it also has the 371 MW coal-fired Sundance PPA, a 192 MW gas-fired plant in Joffre and, in Halkirk, the largest wind farm in the province. In addition, Capital Power is building an 800 MW gas-fired plant in a 50/50 joint venture with ENMAX on the eastern edge of Calgary, due to start up in 2015.

Alberta’s forecast demand for power is among the best in North America, due to its strong economy, inward migration and the growing demand from the energy sector. In 2018-2020, Capital Power intends to build two more gas-fired plants with up to 900 MW capacity in Genesee to meet future demand. It also has two wind farms due this year and next year with 375 MW capacity in Ontario with long-life PPAs.

Financial highlights: Capital Power is rated BBB- by S&P and BBB by DBRS (both investment grade). Assets of $5.1 billion support $1.6 billion of debt, giving the company a debt-to-capital ratio of 34%. Debt maturities are well spread out over the next decade. Although EPCOR’s shareholding falling below 20% allows it to demand early repayment of its $340 million in debt this year, Capital Power regards this as a chance to lower its interest cost and extend its maturities should this occur. The company raised $200 million in 4.5% 2018 preferred shares rated P-3 last year. The company sells for a P/E ratio of 15.6 times, a price/book ratio of 0.5 and a low price/cash flow of 2.7 times.

Risks: Capital Power is an independent power producer, meaning that much of its output is sold on the open (merchant) market, with all of the exposure to fluctuating power prices that implies. However, it has locked in the output from its Alberta baseload power plants, with 92% sold in the high $50s per MWh in 2014 and 77% at mid $50s for 2015 until its Shepard plant is built. Its 375 MW Ontario wind farms have 20-year PPAs at $135 per MWh, which Capital estimates will produce an extra $80 to $85 million per annum of cash flow, worth $0.90 to $0.95 per share and $0.35 to $0.40 of earnings per share. Two of its power plants in North Carolina (134 MW) have eight-year PPAs and another three (457 MW) in Ontario and BC have PPAs expiring between 2022 and 2037. In October, it sold three Northeast U.S. power plants (1089 MW) to Emera for $541 million (all following numbers in U.S. dollars), taking a $6 million loss, but reducing its exposure to merchant activities. It also closed down most of its power-trading operations, which together with other staff reductions, will reduce its employees by 160 and save it an estimated $30 million per annum.

Distribution policy: Dividends are paid quarterly in March, June, September and December and the yield is a respectable 5.6%. With discretionary cash flow equaling 35% to 40% of its $310 million, and capital expenditure halving from $950 million to $475 million in 2013, it is reasonable to expect an increase in the dividend at some stage in the next 18 months.

Tax implications: Capital Power dividends are considered qualifying dividends for Canadian tax purposes, and are taxed at two-thirds of the investor’s top marginal rate in a non-registered account. For U.S. investors, the dividends are taxed at the lower dividend tax rate.

Who it’s for: Capital Power is for investors looking for a reasonable and sustainable absolute yield from a company, which is conservatively financed. The company is coming to the end of a major capital expenditure cycle and has underperformed due to consistent selling by its former parent. It has upside from its concentrated exposure to the Alberta power market, which has good long-term fundamentals.

How to buy: Capital Power trades on the TSX and its $2 billion market capitalization and 80% free float allows investors to buy any amount within reason.

Summing up: Capital Power is an underperformer within its sector. It has specific factors that should enable it to deliver a competitive total return while providing a reasonable yield. – G.G.

 

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JANUARY UPDATES

Here are this month’s updates. All prices are as of the close of trading on Monday, Jan. 27 unless otherwise indicated.

FLY Leasing Ltd. (NYSE: FLY)

Type: American Depository Receipt (ADR)
Trading symbol: FLY
Exchange: NYSE
Current price: US$15.03
Originally recommended: Oct. 10/13 at US$13.40
Annual payout: US$1.00
Yield: 6.7%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.flyleasing.com

Investors in this Dublin-based aircraft leasing company got some good news this month when the directors approved a 13% increase in the dividend to $0.25 per quarter or $1 per year (all figures in U.S. currency). The first enhanced dividend will be paid on Feb. 20 to shareholders of record as of Jan. 31.

“FLY achieved strong growth in 2013, adding 14 aircraft to its fleet, which has increased our earnings per share and provided us with the ability to raise our quarterly dividend and return further value to our shareholders,” said CEO Colm Barrington in announcing the increase.

The announcement comes in advance of the company’s fourth-quarter and year-end results, which are expected in late February or early March. The early dividend increase appears to signal strong performance numbers at that time.

If it plays out that way, it will be welcome news for investors. Third-quarter figures were disappointing with the company reporting adjusted net income of only $2.7 million ($0.07 per share), down from $5.4 million ($0.21 per share) in the same period last year. For the first nine months of the 2013 fiscal year, FLY reported adjusted net income of $52.5 million ($1.65 a share) compared to $63.1 million ($2.43 a share) in 2012.

“During the third quarter we added five aircraft, increasing our portfolio to 107 aircraft at quarter end,” said Mr. Barrington. “So far in the fourth quarter we have added two more aircraft, including a new Boeing 787 on a long-term lease to a top credit airline. This year we have added aircraft worth more than $560 million to our fleet, achieving our growth target for the year and putting us on track to add more than $600 million worth of aircraft by year-end. FLY has the capital to maintain this strong growth in 2014 and we continue to see attractive acquisition opportunities.

“All of our aircraft are now on lease or committed to leases. The global airline industry is strong with air traffic and airline load factors at or near all-time highs. Demand for leased aircraft remains strong and we are seeing improvements in lease rates. As we look ahead to 2014, FLY is well positioned to benefit from its strong financial position, its growing fleet and improving industry conditions.”

Action now: FLY remains a Buy for investors who can tolerate above average risk. – G.P.

TAL International Group (NYSE: TAL)

Type: Common stock
Trading symbol: TAL
Exchange: NYSE
Current price: US$44.10
Originally recommended: Jan. 9/13 at US$37.11
Annual payout: $2.80
Yield: 6.3%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.talinternational.com

Comments: TAL has increased its dividend in every quarter since the start of 2012 but the stock has been in a slide recently that has taken it down from $57.28 in late November to the current level. That suggests that investors are concerned that growth is slowing and that fourth-quarter and year-end results may disappoint.

There was no sign of any problems in the third-quarter numbers, which came out in late October. The container leasing company reported adjusted net income of $1.60 a share, fully diluted, up 8.1% from the same period in 2012. Leasing revenue totalled $143.9 million, an increase of 6.4% from the previous year.

“TAL continued to deliver strong operational and financial results in the third quarter of 2013,” commented CEO Brian M. Sondey. “Our strong performance continues to be driven by high equipment utilization. Our utilization averaged 97.3% for the third quarter and currently stands at 96.9%. We also continue to benefit from the debt refinancing we completed in the first half of the year. Our average effective interest rate dropped to 3.8% in the third quarter of 2013, down almost a full percentage point from the same period last year.”

However, some analysts are predicting some rough waters for the company. A widely-circulated article on the popular investing website Seeking Alpha goes so far as to predict TAL could experience lower leasing prices, declining sales gains, and higher interest costs which combined could force the company to eliminate its dividend and drive the share price down to below $20.

This is an extreme view from a writer who discloses he is shorting the stock. The 11 analysts surveyed by Thomson/First Call are basically neutral on the company with a median target price of $50 on the shares.

Reassuring as that may be, the big drop in the share price is a real concern. I don’t want to dump this one yet because of the very attractive U.S. dollar yield, but put it in your watch list. If the price drops below $40, get out.

Action now: Hold. Sell below $40. – G.P.

Canexus Corp. (TSX: CUS, OTC: CXUSF)

Type: Common stock
Trading symbols: CUS, CXUSF
Exchanges: TSX, Grey Market
Current price: C$5.80, US$5.22 (Jan. 23)
Originally recommended: Feb. 20/13 at C$9.08, US$9
Annual payout: $0.55
Yield: 9.5%
Risk Rating: Higher risk
Recommended by: Gordon Pape
Website: www.canexus.ca

Comments: This stock has taken a beating since I recommended it almost a year ago. I did stress at the time that it was suitable for aggressive investors only, but the downside has been worse than I expected.

A big part of the reason for the drop in the share price is a 40% cost overrun in the construction of the company’s pipeline connected unit train expansion at the North American Terminal Operations at Bruderheim, Alberta. Instead of the initial $225 million estimate, the final cost is now expected to be in the $315 million range.

CEO Gary Kubera said he was “disappointed” with the revised projection. Investors would likely use stronger language – a 40% overrun suggests bad planning and/or execution and for a project this size, that is inexcusable.

The good news is that the company expects to begin loading 14 unit trains per day in February, which represents about 30,000 barrels of oil. Unit trains are dedicated carriers, transporting oil to a single destination.

The full project is scheduled for completion in mid-year.

The cost overrun prompted the company to dilute the stock by agreeing to a bought deal with a syndicate led by National Bank Financial, CIBC World Markets, Scotia Capital and BMO Nesbitt Burns. Canexus raised $150 million by issuing 26.8 million shares at $5.60. The money has been earmarked to fund the completion of the Bruderheim project.

Apart from the stock dilution, investors are now faced with the reality of the cash flow restraints imposed by the cost overrun. The company has said it intends to retain its dividend at the current level but analysts note this would imply a payout ratio of more than 100% through 2014. If anything more goes wrong, the company may have no choice but to reduce the dividend.

My inclination is to hang in and continue to collect the handsome yield, always keeping the risk factor in mind. But if the shares drop below $5, take the loss and exit.

Action now: Hold. – G.P.

Bank of Nova Scotia 5.6% Series 17 Preferreds (TSX: BNS.PR.O)

Type: Straight preferred shares
Trading symbol: BNS.PR.O
Exchange: TSX
Current price: $26.10
Originally recommended: Dec. 21/11 at $26.98
Annual payout: $1.40
Yield: 5.4%
Credit Rating: DBRS: Pfd 1
Risk Rating: Conservative
Recommended by: Tom Slee
Website: www.scotiabank.com/ca/en/0,,4158,00.html

Comments: These preferreds are equivalent to about 7.5% from a bond in an unregistered account. The dividends are non-cumulative, which means that in the unlikely event a distribution is missed or only partially made, Scotiabank is not required to make up the shortfall.

As Canada’s third largest bank with a market capital of $72 billion and 3,100 branches, BNS is one of the safest stocks on the board. Sporting a Double A (stable) rating from Dominion Bond Rating Service, the bank earned $5.17 a share in fiscal 2013 and is expected to make $5.50 or more this year.

My only slight reservation is that Scotiabank can redeem the Series O shares at a price of $25.75 on and after April 26 and later at descending prices to $25 on or after April 26, 2017. Normally I would consider the risk of redemption as extremely low. However, new international rules governing bank capital calculations disqualify preferred shares. Banks are disputing this change and in any event the phasing-in provisions are generous. Nevertheless, at some time in the future, Canadian banks may retire their preferred shares. There were no new issues in 2013.

Action now: Buy for above-average, safe income. – T.S.

Canadian General Investments 4.65% Class A Series 2 Preferreds (TSX: CGI.PR.B)

Type: Cumulative, redeemable, retractable preferred shares
Symbol: CGI.PR.B
Exchange: TSX
Current price: $25 (May 29)
Risk rating: Conservative
Recommended by: Tom Slee
Website:
www.mmainvestments.com/index.cfm?Section=CGI&Page=CGI_Preferred

Comments: The Canadian General Investments 4.65% Class A Series 2 Preferred Shares have been redeemed at a price of $25, slightly below our original recommendation at $25.27. At that time we advised investors not to chase the shares up and expose themselves to a possible capital loss. Unfortunately, the redemption was unexpected and funded by a short-term bank loan. It highlights the danger of buying preferred shares at prices above the redemption provision.

Action now: Redeemed. – T.S.

 

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YOUR QUESTIONS

Convertible debentures and interest rates

Q – How are convertible debentures likely to react to rising interest rates?

A – Convertible debentures are the ultimate hybrid – part bonds and part stocks. As a result they respond to both markets. My own experience, however, is that they are a law unto themselves with the underlying stock as a driving force. To give you an example, in May 2012, when rates were at rock bottom, we recommended the Chemtrade Logistics 5.75% Convertible Debentures (TSX: CHE.DB.A) at $102.50 to yield 5.25%. The stock (TSX: CHE.UN) was at $15.82. Interest rates have climbed in the interim and you would expect these convertibles to drop in price and the yield increase. Instead, they are priced at $108.50 and yielding 3.84% because the stock has performed well and is trading at $19.89.

The fact is, although convertible debentures are fixed income securities, institutions use them to play the stock market. They have no intention of converting and almost always take their capital gain when the debenture moves up. If the stock fails to perform they might hold the convertible to maturity but performance-minded managers are more likely to take any loss and move on. Therefore, convertible debentures are unlikely to drop very much when interest rates are rising, especially those underwritten by growth stocks. – T.S.

 

That’s all for this issue. Look for your next Update Edition on Feb. 13. The next regular issue will be published on Feb. 27.

Best regards,
Gordon Pape, editor-in-chief