CA - Enbridge Baby Bonds: An Easy Way To Play A Hawkish Fed

Summary

• Enbridge baby bonds have taken an abnormal drawdown.
• We look at how the underling coupon will move over the next 12-18 months.
• We examine whether this can form part of a diversified fixed income portfolio.

The long case for Enbridge Inc. ( ENB ) is quite compelling for an income investor. The midstream company made some hefty promises six years back, and a lot of analysts had doubts about their ability to deliver such huge growth alongside deleveraging their balance sheet. But that's precisely what they have done and done so while raising their dividend, every single year.

We recently made a case for their preferred shares trading on TSX, and that can be read here. Those preferred shares are fantastic and offer even a safer level of income than the common shares. But they do come with their drawbacks for US investors, including currency risk and very poor liquidity. The one popular one that actually trades OTC Enbridge Inc. Series 1 ( EBBGF ) had a volume of 17 shares yesterday. Average volume is close to 2,280 shares on this one.

Hence, while the preferred shares remain excellent choices for Canadian investors, US investors have to primarily sit them out. Today, we will look at another issue from them, Enbridge Inc. 6.375 SNT18 B 78 ( ENBA ) which actually trades in the US and comes with a different set of perks.

Features

ENBA started trading 4.5 years back as a fixed to float series. The fixed rate was set at 6.375% on the $25 par valued baby bond and the issue and the interest are paid in US dollars. Interest distributions of 6.375% per annum ($1.59375 per year or $0.39844 on a quarterly) will be paid quarterly on Jan. 15, April 15, July 15, and Oct. 15 to holders of record on the record date that will be first business day of the corresponding month. The final maturity of the bond is pretty far out and stated for April 15, 2078. So, while these are baby bonds, with a maturity that far out, it's easier to think of these as preferred shares. Enbridge can redeem them any time after April 15, 2023, and that's the key reason to like these as we shall see.

Ratings

Enbridge gets high marks from all credit rating agencies. Its focus on reducing debt to EBITDA to close to 4.0X based on 2023 numbers might get it another upgrade within 24 months.

Fitch actually mentions this as the sole criterion in its positive rating sensitivity.

Rating Sensitivities

Factors that could, individually or collectively, lead to positive rating action/upgrade:

--Leverage, defined as total debt with equity credit to operating EBITDA, that is below 4.5x on a sustained basis .

Source: Fitch (emphasis ours)

In our view, not only is this possible but actually highly probable. ENB is running out of mega projects and the attack of fossil fuels means that it's looking at smaller bolt-on projects. It's even more unlikely ENB will take on risky projects with the cost of capital rising so rapidly. So deleveraging is going to be on point. Further, in our view, these ratings vastly understate ENB's credit quality. We say that as ENB has significantly lower counterparty risk today than it did a few years back. The bulk of its customers, the E&P companies, have used excess cash flow to deleverage their balance sheets. Hence, a 4.0X debt to EBITDA in 2023 would be more like a 3.0X debt to EBITDA in 2018.

The Case For ENBA

ENBA is the junior subordinated debt, so in theory, it would fit between the senior unsecured debt and the preferred shares. The rating agencies tend to lump it in with the preferred shares. This methodology by the rating agencies actually makes sense in light of the provisions in the prospectus.

The issuer may defer the interest payable on the Notes on one or more occasions for up to five consecutive years (see prospectus for further information). Upon the occurrence of an Automatic Conversion Event, the Notes, under certain circumstances, will be converted automatically into shares of a newly issued series of the Company's preference shares, designated as Preference Shares

Source: ENBA Prospectus

Nonetheless, the actual BBB- rating and the far higher quality credit quality for ENB (in our opinion) help us get behind this issue.

ENBA's fixed rate regime ends in April, and at that point, its float rate will be determined by the hawks and doves at the Federal Reserve.

The Fed Funds implied rate shows a peak number of 4.85% and a drop to about 4.5% by year-end.

Of course, these are market expectations and investors need to be cautious in interpreting these. For example, one year back, the Peak Fed Funds Rate was projected to be under 2%. If you do accept this 4.85% number and accept that the Federal Reserve is too scared to try and blow the epic bubbles of the past, then ENBA makes sense. ENBA's reset (if not redeemed) on 4/15/2023 until 4/15/2028 will be the three-month LIBOR plus 3.593%. So ENBA will yield about 8.25% to 8.50% in the middle of 2023 on par. At the current price, that works out to about 8.50% to 8.75%. Of course, Enbridge will only evaluate the payments on par, and the amount is rather high for the company. Short-term debt currently yields about 5%.

Enbridge can borrow even cheaper than this in the Canadian market, as 5-Year Government of Canada yields are lower than the US counterpart.

So the question becomes whether the company will accept the idea of paying 3%-4% over shorter-term alternatives to take the chance that it may save money way down the line. This is a massively-sized issue as well, with $533 million in float. Paying $16-$23 million extra annually is not exactly going to be easy for CFOs to digest. Pembina Pipeline Corporation ( PBA ) balked at the idea of even locking in a five-year fixed rate at 7.25% on its preferred shares, and its credit rating is one notch below that of Enbridge. So, redemption appears to be very probable and would result in a very strong return over the next six months (about 14.6% annualized).

Verdict

ENBA cannot be considered a risk-free endeavor, and a lot can change in six months. But it can be an excellent diversifier for a fixed income portfolio. You can think of the probabilities of redemption as directly proportional to the Federal Reserve hawkish tone. The more they talk about "higher for longer" or a higher terminal rate, the more likely ENBA is to be redeemed. So, while the rest of your fixed income securities may get hurt by such a stance, ENBA would move up to par and get redeemed. Conversely, if the tone switches at the Federal Reserve, and they start giving hints of a rate cut cycle, it's possible (though highly improbable) that ENBA gets left to float. Of course, in that case, all your other fixed income securities should really do well. There's also some solace in the fact that the "LIBOR Plus" portion of ENBA will continue to move higher every five years.

On 4/15/2023 until 4/15/2028 the interest rate on the Notes will be reset at per annum equal to the three-month LIBOR plus 3.593%. On 4/15/2028 until 4/15/2043 the three-month LIBOR will be, plus 3.843%. On 4/15/2043 until 4/15/2078 the three-month LIBOR will be, plus 4.593%.

Source: ENBA Prospectus.

We like ENBA here and think it has 90% plus odds of being redeemed in the next six months.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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