ENB - Enbridge: Stepping Up To Higher Yields For These 7%+ Preferreds

Summary

• Enbridge has a number of US-denominated preferreds with attractive qualities.
• They have modest duration, investment-grade profile, relatively high yields, and potential yield upside due to the Treasury Yield reset feature.
• We see value in EBBGF and are keeping an eye on EBGEF as a potential rotation option for later in the year.

This article was first released to Systematic Income subscribers and free trials on Jan. 9 .

In this article, we take a look at Enbridge (ENB) preferreds which remain attractive holdings in diversified income portfolios. The shares are trading at yields of 7-7.5% today, with further upside over the next couple of years in case of higher Treasury yields.

Enbridge Inc is a North American energy infrastructure company, headquartered in Canada with the common trading on both New York and Toronto exchanges. The company maintains a network of oil and natural gas pipelines, distribution utilities and renewable generation assets. To get a sense of its scale, it transports 30% of the crude produced in North America and 20% of natural gas. It has a market cap of around USD82bn and revenue of C$39.89B for the first 9 months of 2022 (full year guidance of $15-15.6bn). The company recently increased its dividend for the 28th consecutive year.

Reasons For Considering Enbridge Preferreds

Enbridge preferreds have a number of attractive features. First, they are relatively high-quality, boasting investment-grade ratings from major rating agencies. Building a high-quality preferreds portfolio that is also diversified is very difficult for preferred investors because the vast majority of high-quality preferreds are concentrated in financials such as Banks or Insurance Companies.

Two, the yields of the three USD-denominated Enbridge preferreds are very attractive for their rating. The chart below shows S&P-rated preferreds (with BBB-rated preferreds highlighted). Enbridge preferred yields are 7-7.5% at the moment (and will be higher in some cases this year if current Treasury yields remain stable).

Three, the company's essential infrastructure focus means it can remain relatively resilient in various economic scenarios. For instance, in a market when the S&P 500 was down around 20%, Enbridge was pretty flat. However, while the S&P 500 is up around a third over the last 5 years, Enbridge is also fairly flat over that period.

Four, all three preferreds have a 5Y CMT coupon (i.e. linked to a 5Y Treasury Yield, reset every 5 years) unless redeemed. This keeps the duration of these preferreds relatively modest (i.e. at a maximum of 5) unlike the duration of most preferreds which can be as high as 20 in the case of some low-coupon fixed-rate preferreds.

Finally, most Fix/Float preferreds are anchored off either 3-Month Libor or SOFR - short-term interest rates ultimately under the control of the Fed. Having exposure to 5Y CMT preferreds allows investors to maintain exposure to a part of the yield curve not fully controlled by the Fed. Furthermore, the yield curve is unusually inverted today. A reversion to a more natural position will favor 5Y CMT preferreds at the expense of Libor/SOFR-based preferreds.

A Closer Look At The Preferreds

The table below shows three USD-denominated Enbridge preferreds:

• Enbridge Series L (EBBNF)
• Enbridge Series 1 (EBBGF)
• Enbridge Series 5 (EBGEF)

EBBNF reset recently to a new 5-year coupon of 5.8579% (the sum of 5Y Treasury yield of 2.7079% plus 3.15%) which will accrue from Sep-22 to Sep-27. At the end of the period (i.e. around Sep-27), the stock can be redeemed by Enbridge and, failing that, will reset to a new coupon made up of the 5Y Treasury Yield + 3.15%. The Treasury yield will be reset at the start of August in this case as it was in 2022. In short, investors can view EBBNF as a fixed-rate preferred that will be redeemable in roughly 5 years' time. It currently trades at a 7.55% yield.

EBBGF currently trades at a 6.89% yield. Its coupon will be reset in mid-2023 to 5Y Treasury Yield + 3.14%. Current 5Y Treasury Yield forward rate as of that date is 3.62% - slightly lower than today's 5Y Treasury Yield of 3.69%. At today's stripped price, we get to an expected yield of 7.83%. Unless Treasury Yields continue to move lower, EBBGF should have a higher yield than EBBNF at the time of its reset. 5Y Treasury Yields are already 0.76% lower from their 2022 peak, so a further collapse seems unlikely. For this reason, we favor EBBGF over EBBNF, particularly for investors who worry about a further rise in interest rates. Clearly, the stock can be redeemed, however, this seems unlikely. Its low stripped price indicates the market expects it to carry on after its mid-2023 call date. Plus, the fact that EBBNF was not redeemed suggests that EBBGF will also fail to be redeemed. It should be said that another Enbridge-preferred ENBBF was redeemed in mid-2022.

EBGEF currently trades at a 7.26% yield. Its next call date is in Mar-2024. Based on today's expectation of Treasury Yields, its yield on that date, i.e., its reset yield, is expected to be around 8.4%.

There are a lot of moving parts in thinking about yields of preferred stocks., particularly for those with coupons set to change at certain dates. One way to compare them is to simply plot out today's stripped yields and what yields are expected to be at future dates based on today's interest rate forwards or what is implied by today's interest rate curve in the future. Interest rate forwards don't have to hold - in fact, they nearly never come true. However, their value is in putting everything on the same footing, allowing for easy comparison.

The chart below shows the forward yields of the three preferreds. We added a couple of green arrows to show a very common pattern in the preferreds market which is that preferreds with future reset dates often have higher expected reset yields even if their yields as of today are lower. Note that the yield of EBBGF (red line) is lower today than the yield of EBBNF (blue line) but then steps up to be above that of EBBNF. The same is true of EBGEF (yellow line), which steps up to the highest expected yield on its next call date. As already highlighted, this doesn't have to hold if Treasury Yields continue to move lower. If Treasury yields do move lower, the yield of EBBNF will remain the same for the next 5-odd years, but the yields of EBBGF and EBGEF will be lower when they reset to their 5-year fixed-rate periods in 2023 and 2024.

Overall, we see value in EBBGF today, and we would look to shift to EBGEF if the same yield premium remains towards the end of next year. This strategy of yield step-up is a very common one in the preferreds market where investors often take time to catch on to the fact that certain preferreds are expected to move to higher yields than their counterparts. We saw this kind of delayed reaction in the mortgage REIT sector with NLY.PF and AGNCN in 2022.

Something to keep in mind with Enbridge preferreds is that they have withholding tax - at the 15% qualified rate. This works as a kind of prepayment of taxes for US investors. There is no withholding for IRA/Roth accounts. Investors should also watch out for significant differences in fees when trading OTC securities.

For further details see: