CA - A Fresh Look At Enbridge USD Preferreds

Summary

• Enbridge common stock continues to perform in a bond-like fashion, with minimal capital appreciation and a tiny dividend increase.
• The company has 3 series of preferred shares denominated in US dollars indexed to the 5-year Treasury note.
• As they approach reset dates, the preferreds have the potential for a significant dividend increase or a capital gain if redeemed.

Steady Operating Results, Little Gains For Common Shares

Enbridge ( ENB ) ( ENB:CA ) is by far the largest midstream company in North America. The company is best known for its liquids pipelines, which bring Canadian crude to the US Midwest and Gulf Coast. Enbridge also has gas pipelines, liquids and LNG export terminals, a gas utility, and even a few offshore wind assets in Europe. For newer investors who want more on the basics, refer to my last article or the many frequent articles published on this site that focus on the common stock.

Enbridge recently reported 4Q and full year 2022 results . The company had steady, reliable operations and very modest growth, mostly from the Line 3 oil pipeline replacement and expansion of the Ingleside terminal in Texas. The company also faced headwinds from higher maintenance capital spending, as well as higher interest expense from higher debt levels and higher floating rates. While the Liquids Pipelines and Gas Transmission segments look like they had strong EBITDA growth, some of this was due to their US results being translated into weaker Canadian dollars. This is offset by hedging losses in the Eliminations and Other segment.

Looking forward, Enbridge does not appear to have big growth plans for the liquids pipelines. Gas Transmission and Distribution appears to be the growth focus, with increasing capex also being spent on Renewables. This is a yellow flag for me, as even European companies like ( BP ) have recognized that renewables investments have a significantly lower rate of return and are slowing their pivot from oil and gas investments.

In line with their slow growth, Enbridge recently raised their common dividend by only 3.2% to $0.8875 Canadian. This marks the third year of small raises after much faster dividend growth pre-2020. The last increase was less than the depreciation of the Canadian dollar over the past year, resulting in an effective cut for US investors.

The slow dividend growth has produced bond-like performance for the common stock. Over the past year, ENB has produced a total return around zero in US dollar terms, similar to its US dollar denominated preferred shares. Over the past 3 years, ENB has actually underperformed the preferreds.

I Still Prefer The Preferreds

Enbridge has a whopping 18 different series of preferred shares outstanding. To keep track of these, the company has a website with a link to each prospectus. Collectively, they still do not make up a huge part of the company's capitalization, with $6.8 billion on the balance sheet compared to $59.9 billion in common equity. Preferred dividends last year were just $414 million, compared to income of $3 billion. (all values CAD)

Three of these 18 preferreds are denominated in US dollars and also declare their dividends in USD. This eliminates any foreign exchange risk for US investors. These three are:

• Series L ( EBBNF ) ( ENB.PFU:CA )
• Series 1 ( EBBGF ) ( ENB.PRV:CA )
• Series 5 ( EBGEF ) ( ENB.PFV:CA )

In addition to these, the company has an exchange-traded baby bond ( ENBA ) issued in 2018 with a 60-year term and par value of $25 USD.

The preferreds have no maturity date, however, their rates reset every 5 years and are indexed to the 5-year US Treasury rate 30 days before the reset date. The company has the option to redeem the preferreds at $25 on their reset date. The details of each security are in the table below:

Notice that Series L just reset on 9/1/2022. This was fortunate timing for Enbridge as the 5-year note traded down to a local minimum yield of 2.71% that day before beginning a steady climb to over 4%. As a result, the coupon for the next 5 years will be 5.86% based on $25 par value.

Series L preferreds now trade for only $20.26, a 19% discount to par, producing a current yield of 7.23%, the highest of the set. The big risk is the 5-year note could have an even lower yield in 2027, as it did from 2010-2017 and again in 2020-21. This could result in a dividend cut and no capital gain in 5 years. This unknown is not worth the extra yield, so I would concentrate on the two preferreds that are closer to their reset dates.

With the 5-year Treasury now yielding 3.87%, we see that the Series 1 preferreds would have a coupon of 7.01% if the 5-year is still trading there on 5/2/2023, less than 3 months off. With the "higher for longer" rate thesis taking hold in the market with the recent strong employment report , the market expects the Fed Funds rate to be 0.5% higher by May 3 Fed meeting. If the 5-year stays where it is, investors can expect either a handsome dividend increase or a quick capital gain of 9.4% if the shares are redeemed for $25.

The Series 5 preferreds are a little trickier, with the reset date on 3/1/2024. That means the reference date for the 5-year note is a little less than a year away. The market is currently factoring in one or two rate cuts from the 5-5.25% terminal Fed Funds rate by then, which would put it right at the 4.50-4.75% rate where it is now. With a year to go, there is, however, more opportunity for the 5-year and the Fed Funds rates to move differently. If we do get a recession in the second half of 2022, the 5-year rate could be much lower on the reset date, whereas if there is no recession, it could be higher than today.

If the 5-year yields the same on 1/31/2024 as it does currently, Series 5 would have a coupon of 6.69% for the subsequent 5 years. This is about even with the common stock yield. Enbridge recently obtained buyback authorization for $1.5 billion worth of common stock over the next year. I think there is a good chance that the company would forgo the common stock buyback to redeem preferreds if they are higher yielding. In the case of Series 5, that makes redemption a toss-up if 5-year treasury rates are similar to current levels.

To touch quickly on ENBA, the reset date is fast approaching. The bonds have been yielding the initial fixed rate of 6.375% since issuance in 2018, however the reset formula is 3-month LIBOR + 3.593%. With LIBOR now at 4.87%, the rate would reset to 8.463% if not redeemed. The market seems to think redemption is a very likely outcome, with the bonds now trading very close to par.

For conservative investors, Series 1 appears to be the best bet with either a quick capital gain or a higher rate reset. Those with a higher risk tolerance might like Series 5 which could deliver a 20% capital gain in one year if called. The risk is a dividend cut if the 5-year Treasury yield falls more than 1.3% from current levels.

The caveats I issued in my last article still apply to these securities:

These shares are rather illiquid and trade at low volume in the US. Make sure to use limit orders and consider bidding for no more than a few hundred shares at a time when starting a new position.

Like all Enbridge securities, there is no K-1 to deal with. While the dividends are marked as qualified when paid, my broker in the past has reclassified them as non-qualified when issuing my 1099 at the end of the year. I recommend consulting your own broker and tax advisor if this happens to you.

Conclusion

Enbridge is a solid midstream company with steady operating performance but slow growth. The common stock of Enbridge has provided little capital appreciation and only small dividend increases in recent years. The Series 1 and Series 5 preferred shares have current yields close to the common and are denominated in US dollars, also eliminating foreign exchange risk for US investors.

These two preferreds are indexed to the 5-year US Treasury note and reset every 5 years. With the 5-year yield now at 3.87%, the Series 1 preferred offers a good chance of either a dividend increase or capital gain if redeemed on June 1. Series 5 has a higher capital gain potential, but also more risk of a dividend cut if Treasury yields fall considerably over the next year. These preferreds remain a better choice for income investors than the common.

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