In this issue:

Next Update Edition: November 7

Next regular issue: November 28

HIGH YIELD PORTFOLIO DOES WELL

By Gordon Pape, Editor and Publisher

As we have seen on previous portfolio reviews, many income stocks took a hit in recent months after interest rates took a sudden jump in May. Our Income Investor High Yield Portfolio did not escape unscathed with three of our securities suffering losses. Fortunately, we had some big winners, which more than offset the losers.

We launched this portfolio in March 2012, stressing at the time that it was designed for investors who could tolerate risk in exchange for above-average cash flow. With one exception (Sun Life) the components of the portfolio are small to mid-size companies. Two are income trusts, six are former trusts and we own one REIT.

The goal of the portfolio is to provide above-average cash flow. It is best suited to non-registered accounts for three reasons. First, registered plans like RRIFs and RRSPs should not be exposed to as much risk as you’ll find here. Second, any capital losses in a non-registered account can be deducted from taxable capital gains. Third, a high percentage of the payments from this portfolio will receive favourable tax treatment in a non-registered account.

Here is a rundown of the securities we own and how they have performed in the six months since our last review on April 19.

The Keg Royalties Income Fund (TSX: KEG.UN, OTC: KRIUF). This fund, originally recommended by contributing editor Gavin Graham, is the leading operator and franchisor of steakhouse restaurants in Canada and has a substantial presence in select regional markets in the United States. We added it to the portfolio in April when it was trading at $15.25. We have a small capital loss to date but that was more than offset by the distributions we received, resulting in a modest profit of 2.1%.

Davis + Henderson (TSX: DH, OTC: DHIFF). This company, which used to derive most of its revenue from cheque printing, has successfully diversified its business into other areas. The stock pays a quarterly dividend of $0.32 per share ($1.28 a year). It was a powerhouse performer over the past six months with the stock price advancing almost 26% in addition to the dividends we received. That was good enough to make it the portfolio’s number one performer to date by a narrow margin.

Freehold Royalties (TSX: FRU, OTC: FRHLF). This oil and gas royalty company pays a monthly dividend of $0.14 per share ($1.68 a year). The stock price moved up a modest 4% in the six months since April 19 but when that was combined with the dividend the overall result was a good return.

Firm Capital (TSX: FC). This mortgage investment company was added in October 2012 to replace Just Energy (TSX, NYSE: JE). The move worked out fine in the first six months but Firm was among the companies hit hard when interest rates spiked. The shares are down 11.4% since April and the monthly distribution of $0.078 ($0.936 annually) wasn’t enough to offset that. As a result, we are now in a loss position on this one.

Liquor Stores (TSX: LIQ, OTC: LQSIF). This company operates retail liquor stores in Alberta, British Columbia, Alaska and Kentucky. It pays monthly dividends of $0.09 a share ($1.08 annually). Despite that attractive payout, the stock has been sliding in value, losing 11% since our last review. It too is in an overall loss position.

Morneau Shepell Inc. (TSX: MSI, OTC: MSIXF). Morneau Shepell Inc. is the largest Canadian-based firm offering benefits and pension consulting, outsourcing, as well as health management services. It has performed well and the stock is up $1.15 (8.7%) since April. The monthly dividend is $0.065 ($0.78 a year).

Pembina Pipeline Corp. (TSX: PPL, OTC: PBNPF). This pipeline company continues to be an outstanding performer for us. The share price is up 6% since our last review and in August the company increased its monthly dividend by half a cent to $0.14 a share ($1.68 a year).

Sun Life Financial (TSX, NYSE: SLF). This insurance company is the only blue-chip stock in the portfolio and it has turned out to be one of our best performers. The shares took a big jump over the past six months, rising $7.12 (26.3%). Combine that with the quarterly dividend of $0.36 ($1.44 a year) and the result is the second-best gain in the portfolio.

Chemtrade Logistics Income Fund (TSX: CHE.UN, OTC: CGIFF). Chemtrade is one of the world’s largest suppliers of sulphuric acid, liquid sulphur dioxide, and sodium chlorate. The share price is up a modest 1.6% since April. Distributions are $0.10 per unit monthly ($1.20 a year).

Pure Industrial REIT (TSX: AAR.UN). This REIT invests in a portfolio of income-producing industrial properties across Canada. All REITs were hurt by the interest rate jump and in this case we saw a drop of 12.6% in the unit price. Thanks to the monthly distribution of $0.026 per unit ($0.312 a year) we still have a modest gain but the recent results were unsatisfactory.

Here’s what the portfolio looks like now, with prices as of the close of trading on Oct. 18. The weighting is the percentage of the market value of the security in relation to the total market value of the portfolio. Sales commissions are not taken into account. Note that the original book value was $24,947.30. The return since inception is based on that amount. We received interest on our cash position of $10.50 during the latest six months.

Income Investor High Yield Portfolio – a/o Oct. 18/13

Security Weight
%		 Total
Shares		 Average
Price		 Book
Value		 Current
Price		 Market
Value		 Dividends Gain/Loss
%
KEG.UN
8.3
150
$15.25
$2,287.50
$15.09
$2,263.50
$ 72.00
+ 2.1
DH
13.2
135
$18.45
$2,490.75
$26.99
$3,643.65
$256.50
+56.6
FRU
11.1
125
$20.24
$2,530.00
$24.48
$3,060.00
$332.50
+34.1
FC
6.6
150
$13.54
$2,031.00
$12.08
$1,812.00
$148.50
– 3.5
LIQ
7.9
140
$17.77
$2,487.80
$15.58
$2,181.20
$259.40
– 1.9
MSI
10.8
210
$11.80
$2,478.00
$14.17
$2,975.70
$239.35
+30.6
PPL
11.0
90
$28.23
$2,540.70
$33.68
$3,031.20
$231.75
+28.4
SLF
13.0
105
$23.44
$2,461.20
$34.23
$3,594.15
$226.80
+55.2
CHE.UN
9.3
150
$16.66
$2,499.00
$17.05
$2,557.50
$285.00
+13.7
AAR.UN
8.7
540
$4.64
$2,505.60
$4.43
$2,392.20
$262.44
+ 5.9
Cash
0.1
$40.34
$50.84
Total
100.0
$24,351.89
$27,561.94
$2,314.24
+22.7
Inception
$24,947.30
+16.5

Comments: The total value of the portfolio, including distributions, now stands at $29,876.18. That’s a gain of almost $2,000 or 7.2% since April, which is a very good result. Since inception, the portfolio has gained 16.5% which works out to an annualized rate of return of 12.1%. I’m sure that most income investors would be quite content with that result. However, I believe we can do better.

Changes: We are going to sell three of our positions, not because they are bad companies but because they have the greatest vulnerability to future increases in interest rates. They are:

Firm Capital. We will sell our position at $12.08 for a capital loss of 10.8%. With accumulated dividends we will realize a total of $1,960.50.

Liquor Stores. We are down 12.3% on this one, although the overall loss is only 1.9% when the dividends are factored in. The total value of this position is $2,440.60.

Pure Industrial REIT. Our capital loss here is very small, only 4.5%, and with distributions included we have a modest profit overall. But there doesn’t appear to be much upside potential at present. We will receive $2,654.64 for this one.

This gives us a total amount to reinvest of $7,055.74. Here are the new positions.

TAL International Group (NYSE: TAL). This shipping container company has done very well for us since I recommended it last January at US$37.11. The stock is now trading at US$49.99, for a gain of almost 35% since the recommendation. However, it is still yielding 5.2% based on the trailing 12-month dividend. It’s important to understand that TAL’s dividends are tied directly to profits so they will vary from one quarter to the next. The good news is that since November 2011, every dividend has been higher than the previous one. We will buy 50 shares at the current price for an investment of $2,499.50. (Note that for purposes of this portfolio the U.S. and Canadian dollars will be treated as being at par.)

FLY Leasing (NYSE: FLY). This Irish-based airplane leasing firm was added to our Recommended List in this month’s Update Edition and it is off to a good start. I recommended it at US$13.40 and it is now trading at US$14.39 for an advance of 7.4% in two weeks. Despite the price rise, the yield is still attractive at 6.1% based on a quarterly dividend of $0.22 a share. We will buy 150 shares for a total of $2,158.50.

Premium Brands Holding Corp. (TSX: PBH, OTC: PRBZF). This stock hasn’t done much since I recommended it in July at $19.49. It closed on Oct. 18 at $19.30, down a modest 1%. However, the yield is a very appealing 6.5% based on a quarterly dividend of $0.3125 per share. We will buy 125 shares for an investment of $2,412.50.

The total value of the new positions is $7,070.50. That’s $14.76 more than we received from our sales so we will take the balance from our cash position. The remaining cash plus dividends will be invested in a high-interest savings account paying 1.35%.

Here is the revised portfolio.

Income Investor High Yield Portfolio – revised Oct. 18/13

Security
Weight
%
Total
Shares
Average
Price
Book
Value
Current
Price
Market
Value
Dividends
KEG.UN
8.1
150
$15.25
$2,287.50
$15.09
$2,263.50
$ 72.00
DH
12.9
135
$18.45
$2,490.75
$26.99
$3,643.65
$256.50
FRU
10.8
125
$20.24
$2,530.00
$24.48
$3,060.00
$332.50
TAL
8.9
50
$49.99
$2,499.50
$49.99
$2,499.50
0
FLY
7.6
150
$14.39
$2,158.50
$14.39
$2,158.50
0
MSI
10.6
210
$11.80
$2,478.00
$14.17
$2,975.70
$239.35
PPL
10.7
90
$28.23
$2,540.70
$33.68
$3,031.20
$231.75
SLF
12.7
105
$23.44
$2,461.20
$34.23
$3,594.15
$226.80
CHE.UN
9.1
150
$16.66
$2,499.00
$17.05
$2,557.50
$285.00
PBH
8.5
125
$19.30
$2,412.50
$19.30
$2,412.50
0
Cash
0.1
$36.08
$36.08
Total
100.0
$24,393.73
$28,232.28
$1,643.90

Gordon Pape’s on Twitter: http://twitter.com/GPUpdates

 

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THE FED’S CREDIBILITY IS IN TATTERS

By Tom Slee, Contributing Editor

The U.S. Federal Reserve has often been described as the most powerful single actor in the economy. It certainly has awesome power and responsibilities. The Fed’s Governors control inflation, protect consumers, monitor banks and stabilize markets. It’s a full plate by any standard and yet, until recently, the arrangement worked well. We all confidently relied on the Fed’s guidance and directives. But the Fed Chairman’s devastating about face last month undermined his credibility. Fixed income markets had been a roller coaster all summer. Now they are a mess.

To recap briefly, on April 3 Federal Reserve Governor John Williams announced that the government’s bond buying stimulus was coming to an end. This was the message investors were waiting for and interest rates surged. A few weeks later, Fed Chairman Ben Bernanke poured cold water on the rally. He denied plans to taper quantitative easing. Investors were puzzled and interest rates churned, then moved sideways. Economists began to question whether Mr. Bernanke had a grip on the situation. It became apparent that the Fed’s governors were divided over whether to ease the stimulus. They kept issued conflicting signals.

As we mentioned at the time it would have been much better if the Fed had remained silent until there was a decision about the stimulus. Instead, Mr. Bernanke continued to hedge his bets throughout the summer. Gradually, it became apparent the stimulus was coming to an end. The Fed seemed to confirm this and long-term interest rates moved higher. Analysts started revising corporate earnings forecasts to allow for increased debt costs. Then, in recent weeks, the Fed Chairman prepared markets for a tapering in quantitative easing. As you know, here at Income Investor we were expecting a 33% reduction in October, another 50% in January and a halt to the program in March. This was the consensus forecast. Richmond’s Fed Governor Jeffrey Lacker said, “We must make our exit from the bond buying program quick.”

We were all wrong. On September 18, Mr. Bernanke announced that quantitative easing would continue full bore. Short-term interest rates are to remain near zero. There is no relief for investors who depend on fixed interest income. Markets were stunned. Bond prices jumped, gold soared. Yield on the benchmark 10-year Treasury notes, which reached a two-year high of 3%, slumped to 2.65%. On the plus side, income stock prices recovered some of their recent losses. There was the biggest single day move in fixed income securities for two years. By comparison, when the U.S. government shut down two weeks later these markets hardly moved.

There was an immediate response. Economists and market analysts blasted Chairman Bernanke for the chaos. University of Michigan economist Justin Wolfers called the entire exercise “the result of a needless miscommunication, the whole taper debate should never have happened. Bernanke can’t just rewrite the past three months.” Chris Low, chief economist at FTR Financial, a division of First Tennessee Bank, said: “It’s almost as though Bernanke got up this week and said, ‘do not believe everything you have heard’ – his communications credibility is shredded.”

This is not just an academic debate. The Fed Chairman’s latest bombshell affects us all. Normally professional money managers would make their own investment decisions based on economic fundamentals. Since the crash in 2008, however, the Fed has become an overriding factor in the bond market. Arguably it has distorted rates and created a bond bubble. As a result, the Fed’s traders dictate rates and now the feeling is they could change direction at any time.

It’s an unhappy scene. Nevertheless, as investors we have to have a strategy. My own feeling is this new turn of events underscores the need to stop market timing. Instead of trying to guess where interest rates are going, we should deal with the here and now. The Fed is likely to remain a major player. Therefore, rates are likely going to remain close to their present levels for the foreseeable future. Despite all the excitement about rising yields, there has been relatively little movement, certainly not enough for most income investors to buy long bonds.

Here are some typical Canadian quotes as I write. Best Canadian one-year GIC rate, annual pay, is 2.03% at Bridgewater Bank. One-year Government of Canada bonds yield about 1.05% and the Canada five-year issues pay about 1.8%. On the corporate side, Bank of Montreal’s 6.17% debentures due March 28, 2018, are trading at $113.32 to yield 2.98%. Further out in the 10-year range, Province of Ontario’s 8.1% debentures maturing September 8, 2023, are priced at $138.40 to yield 3.5%. As you can see, these are relatively unattractive returns. Keep in mind that a lot of the initial rate surge in this cycle is probably behind us. Moreover, the market remains directionless now that institutions have lost confidence in Mr. Bernanke.

Incidentally, I am not recommending any of the bonds quoted, merely showing the top quality returns available.

My suggestion: investors needing reliable income should take a look at preferred shares or REITs even though they are out of favour at the moment. Any of the names on our Buy list are a better bet than bonds at this time. I would make market timing a secondary consideration. Funds that you park in cash awaiting significantly higher bond interest rates could be there for a long time.

Regardless of the type of security you choose, carefully examine the security’s characteristics. Unlike common stocks, they all have special features – some of them almost unique – and you could have an unpleasant surprise down the road. For example, one of our subscribers recently purchased First Capital Realty 4.95% convertible debentures due March 31, 2017 (TSX: FCR.DB.H). The idea was to hold the debentures to maturity and earn regular, reliable income. He was then shocked to discover that First Realty pays principal and interest on its convertible debentures by issuing common shares. Fortunately, our reader was able to sell his position without loss.

Let me say right away that First Capital is not engaged in anything untoward although I can easily see how our reader was misled. FCR.DB.H is posted on the TSX along with a yield to maturity like other convertible debentures. There is nothing to show investors that the issue is different and presumably the advisor in this case failed to point out the unusual feature.

We do not cover First Capital except for comparison purposes but it is an excellent corporation with a market cap of almost $3.5 billion. It is also Canada’s leading owner of retail properties in high-quality urban locations. However, the company has been holding cash and using it to reduce debt and secure a BBB (high) rating in line with RioCan. As part of that retention program, First Capital pays principal and interest on all of its convertible debentures in common stock. This was clearly stated in the prospectus and public announcements when First Capital successfully issued $50 million 4.95% convertible debentures in February 2012. These were obviously designed for institutional investors who were seeking to gradually establish equity in the company.

This arrangement is not commonplace but I have come across provisions in prospectuses that allow a company to replace cash payments with share distributions. So make sure you look for hidden pitfalls, especially when dealing with convertible debentures or convertible preferred shares. These often have unusual wrinkles. Here at Income Investor we always carefully review the prospectus before making a recommendation.

Even some of the fixed income terminology can be confusing. Another reader recently enquired about the “Government of Canada Yield,” which companies sometimes use in connection with reset and redemption features, as well as floating rate adjustments. In this case, he was concerned with the “five-year Government of Canada Yield” and had found three slightly different five-year yields published on the Bank of Canada website. I can understand his frustration.

Presumably a five-year Canada yield pertains to the yield that an entirely new five-year Government of Canada would have to pay if issued on the date in question. However, the prospectus governs and sometimes terms established by the company and its underwriters can be confusing. Take, for example, TD Bank’s 10.05% Subordinated Notes maturing on Aug.4, 2014. The bank can redeem these notes at any time at the higher of par and the Canada Yield Price. TD defines this as “a price calculated to provide an annual yield to maturity, compounded semi-annually, which a non-callable Government of Canada Bond would carry if issued with a maturity date of Aug. 4, 2014.” In other words, the Government of Canada yield in this case is equal to what a new government issue would pay with the same term. Of course, you would expect this to be close to comparable yields shown on the Bank of Canada website.

Fixed income investing is not complicated but it does require some superficial research. If you are concerned about a feature then pass on the issue, choose another investment. Our biggest safeguard is that the issuing companies are keen to keep things as simple as possible. They and their underwriters want to tap the market for more capital in the future, not confuse investors. Just decide exactly what you require or need – income, safety, growth or all three – and then ask your advisor for some suggestions. Choose from our Buy List or at least use it as a guide.

 

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

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OCTOBER’S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on Oct. 21 unless otherwise indicated.

Ensco plc (NYSE: ESV)
Type: American Depositary Receipt
Trading symbol: ESV
Exchange: New York Stock Exchange
Current price: US$55.11
Entry level: Current price
Annual payout: US$2
Yield: 3.6%
Risk Rating: Moderate risk
Recommended by: Gavin Graham
Website: www.enscoplc.com

The business: With a market cap of $2.8 billion (all number in U.S. dollars), Ensco is the second largest offshore oil and gas contract drilling company. The company had earnings of $1.47 billion and overall revenues of $4.3 billion in the year ending on Dec. 31, 2012.
It has a fleet of 75 rigs – 29 floaters (drill ships and semisubmersibles which can operate in deep waters) and 46 jack-up rigs, which operate in 22 countries for 47 different oil companies.

The security: Ensco trades as an American Depository Receipt on the New York Stock Exchange under the ticker symbol ESV.

Why we like it: Ensco has grown substantially over the last five years. Ensco’s transforming deal was the acquisition of Houston-based Pride International in 2011 for $7.3 billion. This gave the company exposure to the two fastest-growing oil exploration areas of Brazil and Africa, and increased the number of its floaters from two in 2008 to 29 today. Its overall fleet also increased by 60%. Since the Pride acquisition, deep-water average day rates have increased by over 50%, so the deal was well timed.

Ensco’s fleet is among the youngest in the industry, with an average age of three years for its floaters. Drill ships and semisubmersibles that are less than 10 years old have higher margins (more than 60%). Floaters more than 10 years old have margins in the 40% range, while 20-year-old floaters achieve margins only in the 30% range.

Financial highlights: Sales in the second quarter were up 17% to a record $1.25 billion, while operating income grew 12% to $452 million and net earnings by 6% to $341 million. This was driven by the addition of a new drillship and jack-up rig to the fleet, as well as a full quarter’s results for a jack-up added last year.

Ensco is rated Baa1/BBB by Moodys and S&P, has a long-term debt-to- capital ratio of 28% and $458 million of cash and equivalents. It also had $11 billion of contracted revenue.
Dividends have been gradually raised from $1.40 in 2008 to $2 this year. Ensco has a 31% payout ratio.

Risks: The obvious risks for an offshore oil-drilling contractor are the price of oil and the possibility of a BP Deepwater Horizon-type disaster. The margins for oil companies are reasonable with oil costing around $100 a barrel. But the cost of drilling deep-water wells continues to rise and Ensco’s labour costs have risen meaningfully over the last year.

Some analysts have worried about oversupply developing in the rig market, with 40 new floaters and 60 new jackups due to be delivered by the end of 2014. Ensco feels that its focus on premium rigs and use of standardized rigs from one yard makes it an attractive option for the oil companies. Current utilization rates for Ensco’s floaters and jack-up rigs are 97% and 94%, respectively.

On the safety front, Ensco has been rated first for customer satisfaction in 10 categories including job quality, performance and reliability. The International Association of Drilling Contractors has accredited Ensco training programmes for their focus on safety and efficiency of operations.

Distribution policy: Dividends are paid quarterly in March, June, September and December.

Tax implications: As with other ADRs, Ensco’s dividends are regarded as foreign income. However, as they are derived from a U.S.-traded security, the shares are subject to a 15% withholding tax, unless they are held in a retirement plan. In a non-registered account, the tax can be reclaimed as a foreign taxcredit.

Who it’s for: Ensco is for income investors who are willing to accept some volatility in return for a reasonable and growing yield.

Summing up: Ensco’s success is based on a growing fleet of premium rigs resulting in expanding profits and margins. – G.G.

 

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OCTOBER UPDATES

Here are the updates for this issue. All prices are as of the close of trading on Monday, Oct. 21 unless otherwise indicated.

Dundee International REIT (TSX: DI.UN, OTC: DUNDF)

Type: Real Estate Investment Trust (REIT)
Trading symbol: DI.UN, DUNDF
Exchange: TSX, Grey Market
Current price: C$9.30, US$9.17
Originally recommended: Nov. 28/12 at C$10.32, US$10.44
Annual payout: $0.77
Yield: 8.2%
Risk Rating: Medium risk
Recommended by: Gavin Graham
Website: www.dundeeinternational.com

Comments: Dundee International is the only Canadian REIT specializing in European property, specifically Germany. The REIT got its start in 2011 by buying the Deutsche Post property portfolio of approximately 60 buildings, including Deutsche Post’s headquarters. Since going public two years ago, Dundee International has used its access to public markets to raise funds to diversify its property portfolio. It raised $190 million in new equity in 2012 and $394 million so far this year. This has led to its market capitalization exceeding $1 billion and Dundee being included in the S&P/TSX Composite Index in June.
 
With the funds raised, Dundee International has acquired over $860 million of office properties this year. Its most recent acquisitions were two office properties in Munich and Berlin in June for $141.5 million, while locking in $88.6 million of mortgage financing at 2.56% for six years. It had 88,000 sq. ft. of space rented in the second quarter, giving it an occupancy rate of 86%, compared to 88% last year. Its average rent was up almost 50% to $11.13 per sq. ft. compared to $7.56 last year and its interest cost was 3.35% against 4.21%.
 
The major issue facing Dundee International has been the expiry of the Deutsche Post leases at the end of June 2014. Leases from five buildings were terminated and Dundee negotiated a five-year lease extension on the remaining 55 properties. But this came at a cost – a reduction of $2.2 million a year in the base rental and a one-off payment of $1.9 million to refurbish Deutsche Post’s offices.

The $2.2 million reduction in Deutsche Post’s rentals represents 3.2% of Dundee’s annual Adjusted Funds From Operations (AFFO) of $68.5 million for the twelve months through June 30, 2013. However, the much higher rents that Dundee is getting on its new acquisitions should more than compensate.

While distributions of $0.40 for the first half of 2013 exceeded AFFO of $0.39, excluding the $81 million in undeployed cash, AFFO per unit was $0.45, giving Dundee International a payout ratio of 88.9%. Interest coverage was 3.37 times on debt to capital of 54%.
 
Dundee’s share price decreased from $10.70 in June to $9.30 now. That’s mainly due to May’s REIT sell-off, the doubling of the number of units issued over the last 18 months and uncertainty about the Deutsche Post leases. But we feel the distribution remains safe. Dundee has a forecast p/e ratio of 9.4 times 2013’s AFFO and a yield of 8.2%.

Action Now: Buy. – G.G.

Canadian Pacific Railway 6.25% Notes
Type: Guaranteed notes
Current price: $114
Originally recommended: Nov. 28/12 at $114
Yield to maturity: 3%
Credit rating: S&P: BBB, DBRS: BBB
Risk Rating: Conservative risk
Recommended by: Tom Slee

Comments: The Canadian Pacific Railway 6.25% Notes due June 1, 2018, are now priced at $114 and yield 3% to maturity. The substantial coupon has shielded these BBB investment grade notes from recent market fluctuations but as the term shortens, the yield is becoming less attractive. Canadian Pacific itself has been reporting better earnings and should make about $6.30 a share this year.

My feeling is while interest rates are likely to move sideways, the underlying trend remains upward. Therefore, it’s a good idea to shorten term. Top quality, two-year corporate debentures now yield about 2% and the 3% from CPR’s Notes is an insufficient spread for four-year term.

Action now: Canadian Pacific 6.25% Notes due June 1, 2018, are a Hold. – T.S.

iShares Diversified Monthly Income Fund (TSX: XTR)

Type: Exchange-traded fund
Trading symbol: XTR
Exchange: TSX
Current price: $11.98
Originally recommended: June 22/11 at $12.26
Annual payout: $0.72
Yield: 6%
Risk Rating: Conservative
Recommended by: Gordon Pape
Website: www.ishares.ca

Comments: This fund is actually a portfolio of eight iShares ETFs. The goal is to provide consistent monthly income, which it does through regular payments of $0.06 per unit ($0.72 annually). That works out to a yield of 6% based on the current price.

The main problem is that most of the ETFs in the portfolio are vulnerable to interest rate increases. There are three bond funds, a preferred share fund, a REIT fund, and a utilities fund. As a result, the fund dropped sharply when interest rates rose earlier this year, trading as low as $11.63 in June. It has recovered somewhat but the potential for another drop remains if rates move higher.

We have received $1.56 in distributions since the original recommendation so we have a profit of 10.7% on this trade. However, going forward I feel that monthly income funds with more exposure to equities are better positioned so I am advising selling this position and moving on.

Action now: Sell. – G.P.

City of Hamilton 4.95% Debentures

Type: Municipal debenture
Current price: $104.50
Originally recommended: Nov. 23/11 at $105.67
Yield to Maturity: 3.85%
Credit Rating: AA Stable (Standard & Poor’s)
Risk Rating: Conservative risk
Recommended by: Tom Slee

Comments: Our City of Hamilton 4.95% Debentures due March 31, 2018 recommendation is a similar situation. At $104.50 and currently yielding 3.85% to maturity, these are no longer attractive vis-a-vis comparable four-year government issues. The excellent AA rating remains unimpaired and investors who purchased these debentures when we recommended them in November 2011 with a 3.94% yield, may wish to maintain their positions. The debentures provide worry-free, above-average income during a period of record low interest rates. However, I would not be a buyer at current levels.

Action now: City of Hamilton 4.95% Debentures become a Hold. – T.S.

 

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YOUR QUESTIONS

Confused about rates

Q – This morning on the radio, I heard an expert from Scotiabank proclaim that interest rates won’t begin to increase until 2016. We have money invested in the TD Canadian Bond Fund, which is decreasing in value. If interest rates haven’t increased, why are bond funds losing value? Are they not supposed to go in opposite directions? It almost feels like we’re being scammed by the big banks. I would like to hear your thoughts about this. – John M.
 
A – A lot of people are struggling with this. The problem stems from the fact there are two types of interest rates. One is the policy rate, which is set by central banks, such as the Bank of Canada and the U.S. Federal Reserve Board. Those rates have been artificially low since the crash of 2008-09 in an effort to stimulate growth. The Fed is on record as saying its target rate will remain at 0.25% until at least 2015 and some experts believe it will be 2016 before the economy is healthy enough to begin raising rates again.

The second type is commercial rates, which are driven by traders in the bond market and the major banks. Back in May, fears arose that the Fed might taper off its program of quantitative easing (QE), which currently involves spending $85 billion a month on bonds and mortgage-backed securities. QE has the effect of keeping interest rates low because of all the new money being pumped into the market each month. Concerns over what would happen when the program ended drove bond prices lower, thereby increasing yields and effectively raising rates. This explains why your bond fund (and all others) has slipped in value. – G.P.

 

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That’s all for this issue. Look for your next Update Edition on Nov. 7. The next regular issue will be published on Nov. 28.

Best regards,
Gordon Pape, editor-in-chief

In this issue:

Next Update Edition: November 7

Next regular issue: November 28

HIGH YIELD PORTFOLIO DOES WELL

By Gordon Pape, Editor and Publisher

As we have seen on previous portfolio reviews, many income stocks took a hit in recent months after interest rates took a sudden jump in May. Our Income Investor High Yield Portfolio did not escape unscathed with three of our securities suffering losses. Fortunately, we had some big winners, which more than offset the losers.

We launched this portfolio in March 2012, stressing at the time that it was designed for investors who could tolerate risk in exchange for above-average cash flow. With one exception (Sun Life) the components of the portfolio are small to mid-size companies. Two are income trusts, six are former trusts and we own one REIT.

The goal of the portfolio is to provide above-average cash flow. It is best suited to non-registered accounts for three reasons. First, registered plans like RRIFs and RRSPs should not be exposed to as much risk as you’ll find here. Second, any capital losses in a non-registered account can be deducted from taxable capital gains. Third, a high percentage of the payments from this portfolio will receive favourable tax treatment in a non-registered account.

Here is a rundown of the securities we own and how they have performed in the six months since our last review on April 19.

The Keg Royalties Income Fund (TSX: KEG.UN, OTC: KRIUF). This fund, originally recommended by contributing editor Gavin Graham, is the leading operator and franchisor of steakhouse restaurants in Canada and has a substantial presence in select regional markets in the United States. We added it to the portfolio in April when it was trading at $15.25. We have a small capital loss to date but that was more than offset by the distributions we received, resulting in a modest profit of 2.1%.

Davis + Henderson (TSX: DH, OTC: DHIFF). This company, which used to derive most of its revenue from cheque printing, has successfully diversified its business into other areas. The stock pays a quarterly dividend of $0.32 per share ($1.28 a year). It was a powerhouse performer over the past six months with the stock price advancing almost 26% in addition to the dividends we received. That was good enough to make it the portfolio’s number one performer to date by a narrow margin.

Freehold Royalties (TSX: FRU, OTC: FRHLF). This oil and gas royalty company pays a monthly dividend of $0.14 per share ($1.68 a year). The stock price moved up a modest 4% in the six months since April 19 but when that was combined with the dividend the overall result was a good return.

Firm Capital (TSX: FC). This mortgage investment company was added in October 2012 to replace Just Energy (TSX, NYSE: JE). The move worked out fine in the first six months but Firm was among the companies hit hard when interest rates spiked. The shares are down 11.4% since April and the monthly distribution of $0.078 ($0.936 annually) wasn’t enough to offset that. As a result, we are now in a loss position on this one.

Liquor Stores (TSX: LIQ, OTC: LQSIF). This company operates retail liquor stores in Alberta, British Columbia, Alaska and Kentucky. It pays monthly dividends of $0.09 a share ($1.08 annually). Despite that attractive payout, the stock has been sliding in value, losing 11% since our last review. It too is in an overall loss position.

Morneau Shepell Inc. (TSX: MSI, OTC: MSIXF). Morneau Shepell Inc. is the largest Canadian-based firm offering benefits and pension consulting, outsourcing, as well as health management services. It has performed well and the stock is up $1.15 (8.7%) since April. The monthly dividend is $0.065 ($0.78 a year).

Pembina Pipeline Corp. (TSX: PPL, OTC: PBNPF). This pipeline company continues to be an outstanding performer for us. The share price is up 6% since our last review and in August the company increased its monthly dividend by half a cent to $0.14 a share ($1.68 a year).

Sun Life Financial (TSX, NYSE: SLF). This insurance company is the only blue-chip stock in the portfolio and it has turned out to be one of our best performers. The shares took a big jump over the past six months, rising $7.12 (26.3%). Combine that with the quarterly dividend of $0.36 ($1.44 a year) and the result is the second-best gain in the portfolio.

Chemtrade Logistics Income Fund (TSX: CHE.UN, OTC: CGIFF). Chemtrade is one of the world’s largest suppliers of sulphuric acid, liquid sulphur dioxide, and sodium chlorate. The share price is up a modest 1.6% since April. Distributions are $0.10 per unit monthly ($1.20 a year).

Pure Industrial REIT (TSX: AAR.UN). This REIT invests in a portfolio of income-producing industrial properties across Canada. All REITs were hurt by the interest rate jump and in this case we saw a drop of 12.6% in the unit price. Thanks to the monthly distribution of $0.026 per unit ($0.312 a year) we still have a modest gain but the recent results were unsatisfactory.

Here’s what the portfolio looks like now, with prices as of the close of trading on Oct. 18. The weighting is the percentage of the market value of the security in relation to the total market value of the portfolio. Sales commissions are not taken into account. Note that the original book value was $24,947.30. The return since inception is based on that amount. We received interest on our cash position of $10.50 during the latest six months.

Income Investor High Yield Portfolio – a/o Oct. 18/13

Security Weight
%		 Total
Shares		 Average
Price		 Book
Value		 Current
Price		 Market
Value		 Dividends Gain/Loss
%
KEG.UN
8.3
150
$15.25
$2,287.50
$15.09
$2,263.50
$ 72.00
+ 2.1
DH
13.2
135
$18.45
$2,490.75
$26.99
$3,643.65
$256.50
+56.6
FRU
11.1
125
$20.24
$2,530.00
$24.48
$3,060.00
$332.50
+34.1
FC
6.6
150
$13.54
$2,031.00
$12.08
$1,812.00
$148.50
– 3.5
LIQ
7.9
140
$17.77
$2,487.80
$15.58
$2,181.20
$259.40
– 1.9
MSI
10.8
210
$11.80
$2,478.00
$14.17
$2,975.70
$239.35
+30.6
PPL
11.0
90
$28.23
$2,540.70
$33.68
$3,031.20
$231.75
+28.4
SLF
13.0
105
$23.44
$2,461.20
$34.23
$3,594.15
$226.80
+55.2
CHE.UN
9.3
150
$16.66
$2,499.00
$17.05
$2,557.50
$285.00
+13.7
AAR.UN
8.7
540
$4.64
$2,505.60
$4.43
$2,392.20
$262.44
+ 5.9
Cash
0.1
$40.34
$50.84
Total
100.0
$24,351.89
$27,561.94
$2,314.24
+22.7
Inception
$24,947.30
+16.5

Comments: The total value of the portfolio, including distributions, now stands at $29,876.18. That’s a gain of almost $2,000 or 7.2% since April, which is a very good result. Since inception, the portfolio has gained 16.5% which works out to an annualized rate of return of 12.1%. I’m sure that most income investors would be quite content with that result. However, I believe we can do better.

Changes: We are going to sell three of our positions, not because they are bad companies but because they have the greatest vulnerability to future increases in interest rates. They are:

Firm Capital. We will sell our position at $12.08 for a capital loss of 10.8%. With accumulated dividends we will realize a total of $1,960.50.

Liquor Stores. We are down 12.3% on this one, although the overall loss is only 1.9% when the dividends are factored in. The total value of this position is $2,440.60.

Pure Industrial REIT. Our capital loss here is very small, only 4.5%, and with distributions included we have a modest profit overall. But there doesn’t appear to be much upside potential at present. We will receive $2,654.64 for this one.

This gives us a total amount to reinvest of $7,055.74. Here are the new positions.

TAL International Group (NYSE: TAL). This shipping container company has done very well for us since I recommended it last January at US$37.11. The stock is now trading at US$49.99, for a gain of almost 35% since the recommendation. However, it is still yielding 5.2% based on the trailing 12-month dividend. It’s important to understand that TAL’s dividends are tied directly to profits so they will vary from one quarter to the next. The good news is that since November 2011, every dividend has been higher than the previous one. We will buy 50 shares at the current price for an investment of $2,499.50. (Note that for purposes of this portfolio the U.S. and Canadian dollars will be treated as being at par.)

FLY Leasing (NYSE: FLY). This Irish-based airplane leasing firm was added to our Recommended List in this month’s Update Edition and it is off to a good start. I recommended it at US$13.40 and it is now trading at US$14.39 for an advance of 7.4% in two weeks. Despite the price rise, the yield is still attractive at 6.1% based on a quarterly dividend of $0.22 a share. We will buy 150 shares for a total of $2,158.50.

Premium Brands Holding Corp. (TSX: PBH, OTC: PRBZF). This stock hasn’t done much since I recommended it in July at $19.49. It closed on Oct. 18 at $19.30, down a modest 1%. However, the yield is a very appealing 6.5% based on a quarterly dividend of $0.3125 per share. We will buy 125 shares for an investment of $2,412.50.

The total value of the new positions is $7,070.50. That’s $14.76 more than we received from our sales so we will take the balance from our cash position. The remaining cash plus dividends will be invested in a high-interest savings account paying 1.35%.

Here is the revised portfolio.

Income Investor High Yield Portfolio – revised Oct. 18/13

Security
Weight
%
Total
Shares
Average
Price
Book
Value
Current
Price
Market
Value
Dividends
KEG.UN
8.1
150
$15.25
$2,287.50
$15.09
$2,263.50
$ 72.00
DH
12.9
135
$18.45
$2,490.75
$26.99
$3,643.65
$256.50
FRU
10.8
125
$20.24
$2,530.00
$24.48
$3,060.00
$332.50
TAL
8.9
50
$49.99
$2,499.50
$49.99
$2,499.50
0
FLY
7.6
150
$14.39
$2,158.50
$14.39
$2,158.50
0
MSI
10.6
210
$11.80
$2,478.00
$14.17
$2,975.70
$239.35
PPL
10.7
90
$28.23
$2,540.70
$33.68
$3,031.20
$231.75
SLF
12.7
105
$23.44
$2,461.20
$34.23
$3,594.15
$226.80
CHE.UN
9.1
150
$16.66
$2,499.00
$17.05
$2,557.50
$285.00
PBH
8.5
125
$19.30
$2,412.50
$19.30
$2,412.50
0
Cash
0.1
$36.08
$36.08
Total
100.0
$24,393.73
$28,232.28
$1,643.90

Gordon Pape’s on Twitter: http://twitter.com/GPUpdates

 

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THE FED’S CREDIBILITY IS IN TATTERS

By Tom Slee, Contributing Editor

The U.S. Federal Reserve has often been described as the most powerful single actor in the economy. It certainly has awesome power and responsibilities. The Fed’s Governors control inflation, protect consumers, monitor banks and stabilize markets. It’s a full plate by any standard and yet, until recently, the arrangement worked well. We all confidently relied on the Fed’s guidance and directives. But the Fed Chairman’s devastating about face last month undermined his credibility. Fixed income markets had been a roller coaster all summer. Now they are a mess.

To recap briefly, on April 3 Federal Reserve Governor John Williams announced that the government’s bond buying stimulus was coming to an end. This was the message investors were waiting for and interest rates surged. A few weeks later, Fed Chairman Ben Bernanke poured cold water on the rally. He denied plans to taper quantitative easing. Investors were puzzled and interest rates churned, then moved sideways. Economists began to question whether Mr. Bernanke had a grip on the situation. It became apparent that the Fed’s governors were divided over whether to ease the stimulus. They kept issued conflicting signals.

As we mentioned at the time it would have been much better if the Fed had remained silent until there was a decision about the stimulus. Instead, Mr. Bernanke continued to hedge his bets throughout the summer. Gradually, it became apparent the stimulus was coming to an end. The Fed seemed to confirm this and long-term interest rates moved higher. Analysts started revising corporate earnings forecasts to allow for increased debt costs. Then, in recent weeks, the Fed Chairman prepared markets for a tapering in quantitative easing. As you know, here at Income Investor we were expecting a 33% reduction in October, another 50% in January and a halt to the program in March. This was the consensus forecast. Richmond’s Fed Governor Jeffrey Lacker said, “We must make our exit from the bond buying program quick.”

We were all wrong. On September 18, Mr. Bernanke announced that quantitative easing would continue full bore. Short-term interest rates are to remain near zero. There is no relief for investors who depend on fixed interest income. Markets were stunned. Bond prices jumped, gold soared. Yield on the benchmark 10-year Treasury notes, which reached a two-year high of 3%, slumped to 2.65%. On the plus side, income stock prices recovered some of their recent losses. There was the biggest single day move in fixed income securities for two years. By comparison, when the U.S. government shut down two weeks later these markets hardly moved.

There was an immediate response. Economists and market analysts blasted Chairman Bernanke for the chaos. University of Michigan economist Justin Wolfers called the entire exercise “the result of a needless miscommunication, the whole taper debate should never have happened. Bernanke can’t just rewrite the past three months.” Chris Low, chief economist at FTR Financial, a division of First Tennessee Bank, said: “It’s almost as though Bernanke got up this week and said, ‘do not believe everything you have heard’ – his communications credibility is shredded.”

This is not just an academic debate. The Fed Chairman’s latest bombshell affects us all. Normally professional money managers would make their own investment decisions based on economic fundamentals. Since the crash in 2008, however, the Fed has become an overriding factor in the bond market. Arguably it has distorted rates and created a bond bubble. As a result, the Fed’s traders dictate rates and now the feeling is they could change direction at any time.

It’s an unhappy scene. Nevertheless, as investors we have to have a strategy. My own feeling is this new turn of events underscores the need to stop market timing. Instead of trying to guess where interest rates are going, we should deal with the here and now. The Fed is likely to remain a major player. Therefore, rates are likely going to remain close to their present levels for the foreseeable future. Despite all the excitement about rising yields, there has been relatively little movement, certainly not enough for most income investors to buy long bonds.

Here are some typical Canadian quotes as I write. Best Canadian one-year GIC rate, annual pay, is 2.03% at Bridgewater Bank. One-year Government of Canada bonds yield about 1.05% and the Canada five-year issues pay about 1.8%. On the corporate side, Bank of Montreal’s 6.17% debentures due March 28, 2018, are trading at $113.32 to yield 2.98%. Further out in the 10-year range, Province of Ontario’s 8.1% debentures maturing September 8, 2023, are priced at $138.40 to yield 3.5%. As you can see, these are relatively unattractive returns. Keep in mind that a lot of the initial rate surge in this cycle is probably behind us. Moreover, the market remains directionless now that institutions have lost confidence in Mr. Bernanke.

Incidentally, I am not recommending any of the bonds quoted, merely showing the top quality returns available.

My suggestion: investors needing reliable income should take a look at preferred shares or REITs even though they are out of favour at the moment. Any of the names on our Buy list are a better bet than bonds at this time. I would make market timing a secondary consideration. Funds that you park in cash awaiting significantly higher bond interest rates could be there for a long time.

Regardless of the type of security you choose, carefully examine the security’s characteristics. Unlike common stocks, they all have special features – some of them almost unique – and you could have an unpleasant surprise down the road. For example, one of our subscribers recently purchased First Capital Realty 4.95% convertible debentures due March 31, 2017 (TSX: FCR.DB.H). The idea was to hold the debentures to maturity and earn regular, reliable income. He was then shocked to discover that First Realty pays principal and interest on its convertible debentures by issuing common shares. Fortunately, our reader was able to sell his position without loss.

Let me say right away that First Capital is not engaged in anything untoward although I can easily see how our reader was misled. FCR.DB.H is posted on the TSX along with a yield to maturity like other convertible debentures. There is nothing to show investors that the issue is different and presumably the advisor in this case failed to point out the unusual feature.

We do not cover First Capital except for comparison purposes but it is an excellent corporation with a market cap of almost $3.5 billion. It is also Canada’s leading owner of retail properties in high-quality urban locations. However, the company has been holding cash and using it to reduce debt and secure a BBB (high) rating in line with RioCan. As part of that retention program, First Capital pays principal and interest on all of its convertible debentures in common stock. This was clearly stated in the prospectus and public announcements when First Capital successfully issued $50 million 4.95% convertible debentures in February 2012. These were obviously designed for institutional investors who were seeking to gradually establish equity in the company.

This arrangement is not commonplace but I have come across provisions in prospectuses that allow a company to replace cash payments with share distributions. So make sure you look for hidden pitfalls, especially when dealing with convertible debentures or convertible preferred shares. These often have unusual wrinkles. Here at Income Investor we always carefully review the prospectus before making a recommendation.

Even some of the fixed income terminology can be confusing. Another reader recently enquired about the “Government of Canada Yield,” which companies sometimes use in connection with reset and redemption features, as well as floating rate adjustments. In this case, he was concerned with the “five-year Government of Canada Yield” and had found three slightly different five-year yields published on the Bank of Canada website. I can understand his frustration.

Presumably a five-year Canada yield pertains to the yield that an entirely new five-year Government of Canada would have to pay if issued on the date in question. However, the prospectus governs and sometimes terms established by the company and its underwriters can be confusing. Take, for example, TD Bank’s 10.05% Subordinated Notes maturing on Aug.4, 2014. The bank can redeem these notes at any time at the higher of par and the Canada Yield Price. TD defines this as “a price calculated to provide an annual yield to maturity, compounded semi-annually, which a non-callable Government of Canada Bond would carry if issued with a maturity date of Aug. 4, 2014.” In other words, the Government of Canada yield in this case is equal to what a new government issue would pay with the same term. Of course, you would expect this to be close to comparable yields shown on the Bank of Canada website.

Fixed income investing is not complicated but it does require some superficial research. If you are concerned about a feature then pass on the issue, choose another investment. Our biggest safeguard is that the issuing companies are keen to keep things as simple as possible. They and their underwriters want to tap the market for more capital in the future, not confuse investors. Just decide exactly what you require or need – income, safety, growth or all three – and then ask your advisor for some suggestions. Choose from our Buy List or at least use it as a guide.

 

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

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OCTOBER’S TOP PICK

Here is our Top Pick for this month. Prices are as of close of trading on Oct. 21 unless otherwise indicated.

Ensco plc (NYSE: ESV)
Type: American Depositary Receipt
Trading symbol: ESV
Exchange: New York Stock Exchange
Current price: US$55.11
Entry level: Current price
Annual payout: US$2
Yield: 3.6%
Risk Rating: Moderate risk
Recommended by: Gavin Graham
Website: www.enscoplc.com

The business: With a market cap of $2.8 billion (all number in U.S. dollars), Ensco is the second largest offshore oil and gas contract drilling company. The company had earnings of $1.47 billion and overall revenues of $4.3 billion in the year ending on Dec. 31, 2012.
It has a fleet of 75 rigs – 29 floaters (drill ships and semisubmersibles which can operate in deep waters) and 46 jack-up rigs, which operate in 22 countries for 47 different oil companies.

The security: Ensco trades as an American Depository Receipt on the New York Stock Exchange under the ticker symbol ESV.

Why we like it: Ensco has grown substantially over the last five years. Ensco’s transforming deal was the acquisition of Houston-based Pride International in 2011 for $7.3 billion. This gave the company exposure to the two fastest-growing oil exploration areas of Brazil and Africa, and increased the number of its floaters from two in 2008 to 29 today. Its overall fleet also increased by 60%. Since the Pride acquisition, deep-water average day rates have increased by over 50%, so the deal was well timed.

Ensco’s fleet is among the youngest in the industry, with an average age of three years for its floaters. Drill ships and semisubmersibles that are less than 10 years old have higher margins (more than 60%). Floaters more than 10 years old have margins in the 40% range, while 20-year-old floaters achieve margins only in the 30% range.

Financial highlights: Sales in the second quarter were up 17% to a record $1.25 billion, while operating income grew 12% to $452 million and net earnings by 6% to $341 million. This was driven by the addition of a new drillship and jack-up rig to the fleet, as well as a full quarter’s results for a jack-up added last year.

Ensco is rated Baa1/BBB by Moodys and S&P, has a long-term debt-to- capital ratio of 28% and $458 million of cash and equivalents. It also had $11 billion of contracted revenue.
Dividends have been gradually raised from $1.40 in 2008 to $2 this year. Ensco has a 31% payout ratio.

Risks: The obvious risks for an offshore oil-drilling contractor are the price of oil and the possibility of a BP Deepwater Horizon-type disaster. The margins for oil companies are reasonable with oil costing around $100 a barrel. But the cost of drilling deep-water wells continues to rise and Ensco’s labour costs have risen meaningfully over the last year.

Some analysts have worried about oversupply developing in the rig market, with 40 new floaters and 60 new jackups due to be delivered by the end of 2014. Ensco feels that its focus on premium rigs and use of standardized rigs from one yard makes it an attractive option for the oil companies. Current utilization rates for Ensco’s floaters and jack-up rigs are 97% and 94%, respectively.

On the safety front, Ensco has been rated first for customer satisfaction in 10 categories including job quality, performance and reliability. The International Association of Drilling Contractors has accredited Ensco training programmes for their focus on safety and efficiency of operations.

Distribution policy: Dividends are paid quarterly in March, June, September and December.

Tax implications: As with other ADRs, Ensco’s dividends are regarded as foreign income. However, as they are derived from a U.S.-traded security, the shares are subject to a 15% withholding tax, unless they are held in a retirement plan. In a non-registered account, the tax can be reclaimed as a foreign taxcredit.

Who it’s for: Ensco is for income investors who are willing to accept some volatility in return for a reasonable and growing yield.

Summing up: Ensco’s success is based on a growing fleet of premium rigs resulting in expanding profits and margins. – G.G.

 

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OCTOBER UPDATES

Here are the updates for this issue. All prices are as of the close of trading on Monday, Oct. 21 unless otherwise indicated.

Dundee International REIT (TSX: DI.UN, OTC: DUNDF)

Type: Real Estate Investment Trust (REIT)
Trading symbol: DI.UN, DUNDF
Exchange: TSX, Grey Market
Current price: C$9.30, US$9.17
Originally recommended: Nov. 28/12 at C$10.32, US$10.44
Annual payout: $0.77
Yield: 8.2%
Risk Rating: Medium risk
Recommended by: Gavin Graham
Website: www.dundeeinternational.com

Comments: Dundee International is the only Canadian REIT specializing in European property, specifically Germany. The REIT got its start in 2011 by buying the Deutsche Post property portfolio of approximately 60 buildings, including Deutsche Post’s headquarters. Since going public two years ago, Dundee International has used its access to public markets to raise funds to diversify its property portfolio. It raised $190 million in new equity in 2012 and $394 million so far this year. This has led to its market capitalization exceeding $1 billion and Dundee being included in the S&P/TSX Composite Index in June.
 
With the funds raised, Dundee International has acquired over $860 million of office properties this year. Its most recent acquisitions were two office properties in Munich and Berlin in June for $141.5 million, while locking in $88.6 million of mortgage financing at 2.56% for six years. It had 88,000 sq. ft. of space rented in the second quarter, giving it an occupancy rate of 86%, compared to 88% last year. Its average rent was up almost 50% to $11.13 per sq. ft. compared to $7.56 last year and its interest cost was 3.35% against 4.21%.
 
The major issue facing Dundee International has been the expiry of the Deutsche Post leases at the end of June 2014. Leases from five buildings were terminated and Dundee negotiated a five-year lease extension on the remaining 55 properties. But this came at a cost – a reduction of $2.2 million a year in the base rental and a one-off payment of $1.9 million to refurbish Deutsche Post’s offices.

The $2.2 million reduction in Deutsche Post’s rentals represents 3.2% of Dundee’s annual Adjusted Funds From Operations (AFFO) of $68.5 million for the twelve months through June 30, 2013. However, the much higher rents that Dundee is getting on its new acquisitions should more than compensate.

While distributions of $0.40 for the first half of 2013 exceeded AFFO of $0.39, excluding the $81 million in undeployed cash, AFFO per unit was $0.45, giving Dundee International a payout ratio of 88.9%. Interest coverage was 3.37 times on debt to capital of 54%.
 
Dundee’s share price decreased from $10.70 in June to $9.30 now. That’s mainly due to May’s REIT sell-off, the doubling of the number of units issued over the last 18 months and uncertainty about the Deutsche Post leases. But we feel the distribution remains safe. Dundee has a forecast p/e ratio of 9.4 times 2013’s AFFO and a yield of 8.2%.

Action Now: Buy. – G.G.

Canadian Pacific Railway 6.25% Notes
Type: Guaranteed notes
Current price: $114
Originally recommended: Nov. 28/12 at $114
Yield to maturity: 3%
Credit rating: S&P: BBB, DBRS: BBB
Risk Rating: Conservative risk
Recommended by: Tom Slee

Comments: The Canadian Pacific Railway 6.25% Notes due June 1, 2018, are now priced at $114 and yield 3% to maturity. The substantial coupon has shielded these BBB investment grade notes from recent market fluctuations but as the term shortens, the yield is becoming less attractive. Canadian Pacific itself has been reporting better earnings and should make about $6.30 a share this year.

My feeling is while interest rates are likely to move sideways, the underlying trend remains upward. Therefore, it’s a good idea to shorten term. Top quality, two-year corporate debentures now yield about 2% and the 3% from CPR’s Notes is an insufficient spread for four-year term.

Action now: Canadian Pacific 6.25% Notes due June 1, 2018, are a Hold. – T.S.

iShares Diversified Monthly Income Fund (TSX: XTR)

Type: Exchange-traded fund
Trading symbol: XTR
Exchange: TSX
Current price: $11.98
Originally recommended: June 22/11 at $12.26
Annual payout: $0.72
Yield: 6%
Risk Rating: Conservative
Recommended by: Gordon Pape
Website: www.ishares.ca

Comments: This fund is actually a portfolio of eight iShares ETFs. The goal is to provide consistent monthly income, which it does through regular payments of $0.06 per unit ($0.72 annually). That works out to a yield of 6% based on the current price.

The main problem is that most of the ETFs in the portfolio are vulnerable to interest rate increases. There are three bond funds, a preferred share fund, a REIT fund, and a utilities fund. As a result, the fund dropped sharply when interest rates rose earlier this year, trading as low as $11.63 in June. It has recovered somewhat but the potential for another drop remains if rates move higher.

We have received $1.56 in distributions since the original recommendation so we have a profit of 10.7% on this trade. However, going forward I feel that monthly income funds with more exposure to equities are better positioned so I am advising selling this position and moving on.

Action now: Sell. – G.P.

City of Hamilton 4.95% Debentures

Type: Municipal debenture
Current price: $104.50
Originally recommended: Nov. 23/11 at $105.67
Yield to Maturity: 3.85%
Credit Rating: AA Stable (Standard & Poor’s)
Risk Rating: Conservative risk
Recommended by: Tom Slee

Comments: Our City of Hamilton 4.95% Debentures due March 31, 2018 recommendation is a similar situation. At $104.50 and currently yielding 3.85% to maturity, these are no longer attractive vis-a-vis comparable four-year government issues. The excellent AA rating remains unimpaired and investors who purchased these debentures when we recommended them in November 2011 with a 3.94% yield, may wish to maintain their positions. The debentures provide worry-free, above-average income during a period of record low interest rates. However, I would not be a buyer at current levels.

Action now: City of Hamilton 4.95% Debentures become a Hold. – T.S.

 

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YOUR QUESTIONS

Confused about rates

Q – This morning on the radio, I heard an expert from Scotiabank proclaim that interest rates won’t begin to increase until 2016. We have money invested in the TD Canadian Bond Fund, which is decreasing in value. If interest rates haven’t increased, why are bond funds losing value? Are they not supposed to go in opposite directions? It almost feels like we’re being scammed by the big banks. I would like to hear your thoughts about this. – John M.
 
A – A lot of people are struggling with this. The problem stems from the fact there are two types of interest rates. One is the policy rate, which is set by central banks, such as the Bank of Canada and the U.S. Federal Reserve Board. Those rates have been artificially low since the crash of 2008-09 in an effort to stimulate growth. The Fed is on record as saying its target rate will remain at 0.25% until at least 2015 and some experts believe it will be 2016 before the economy is healthy enough to begin raising rates again.

The second type is commercial rates, which are driven by traders in the bond market and the major banks. Back in May, fears arose that the Fed might taper off its program of quantitative easing (QE), which currently involves spending $85 billion a month on bonds and mortgage-backed securities. QE has the effect of keeping interest rates low because of all the new money being pumped into the market each month. Concerns over what would happen when the program ended drove bond prices lower, thereby increasing yields and effectively raising rates. This explains why your bond fund (and all others) has slipped in value. – G.P.

 

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That’s all for this issue. Look for your next Update Edition on Nov. 7. The next regular issue will be published on Nov. 28.

Best regards,
Gordon Pape, editor-in-chief