TRP - Pembina Preferreds: 10% Plus Yields From Quality Midstream Player

2023-09-21 14:04:52 ET

Summary

• Canadian preferred shares offer high yields with low duration risk, making them an attractive investment opportunity.
• Pembina Pipeline continues its measured capital allocation process and the debt to EBITDA will be under 3.5X very soon.
• Investors can lock in attractive returns with upcoming resets of Pembina Pipeline preferred shares.

Note: All amounts discussed are in Canadian Dollars and prices of securities discussed are for those trading on TSX.

There are a few asset classes that have been battered. REITs, for example, have been feeling the heat from higher interest rates as risk-free choices throw TINA under the bus. Value as a whole has been hit as investors chase AI mania to new highs. In all such cases, we can usually see a strong force which reduces the appeal of investing in that sector.

One unusual opportunity that has developed is the one in Canadian preferred shares. The asset class is primarily made up of 5 Year Reset preferred shares, i.e., ones that reset every 5 years based on the prevailing Government Of Canada 5 Year Bond yields (GOC-5). As such, they should have only modest duration sensitivity. Many of them are also convertible into a floating rate preferred share linked to short-term rates. This choice also appears once every 5 years, and you can swap shares linked to shorter-term rates and GOC-5, once every 5 years. In other words, you get high yield with almost no duration risk with the resetting preferred shares. Shockingly, this asset class is being given away, just when interest rates are increasing dividend payouts by leaps and bounds. We look at one in the sector today where you can get some hefty yields.

Pembina Pipeline Corporation ( PBA ) ( PPL:CA )

The Canadian midstream sector has been on the receiving end of the bear vengeance. Once a beacon of stability relative to the US midstream sector, it has delivered a gut-churning performance in 2023. TC Energy ( TRP ) cannot seem to be able to deliver anything shareholders want and Enbridge's ( ENB ) acquisitions are getting the side eye from rating agencies.

While PBA has also dropped, it has fallen with the general disdain for the sector. Its own performance has been exemplary. The company which refused to increase its bid for Inter Pipeline and instead pocketed the large break-up fee, continues to set an example for capital allocation.

Q2-2023 results were also good with adjusted funds from operations (AFFO) of a $1.10, which was in line with consensus. Management changed its adjusted EBITDA guidance range to $3.55 billion-$3.75 billion, which was a slight narrowing of the range. At current run rates, we expect year-end 2023 net debt to EBITDA to be close to 3.5X. The AFFO would likely be somewhere in the $4.75 range, putting PBA at near 8.75X AFFO.

The Preferred Setup

At the current midpoint of management guidance, the total AFFO should be in the neighborhood of $2.6 billion. This is AFFO and calculated after interest expense, maintenance expenditures, and preferred share dividends. The preferred share dividends themselves will be about $136 million. So we have a coverage ratio of close to 20-fold (($2,600+136)/$136). At a broader interest coverage basis, we are looking at adjusted EBITDA of $3.65 billion and finance expenses of $475 million. So interest coverage should be above 7.5X. These are metrics we would align with A rated firms. The official rating from S&P is BBB, but the real quality here is way higher.

Resets Upcoming

PBA has multiple preferred share series outstanding currently. We will focus on a few examples where investors can get attractive risk-reward setups.

The most immediate opportunity to lock in a fantastic return for the next 5 years comes with Pembina Pipeline Corporation PFD 5 YR CL A 1 ( PPL.PR.A:CA ). Their current yield is almost irrelevant as they are supposed to reset by December 1, 2023. Generally, the reset itself is announced 30-60 days prior. So we are rapidly approaching the October 1-November 1 window for the same. The reset will be at GOC-5 plus 2.47%. With the current yields of 4.28%, you are looking at 6.75% on par. With PPL.PR.A trading at $17.47 you are locking in 9.66% for the next 5 years assuming interest rates stay the same. That is an extraordinary amount for the level of safety that PBA offers. The key point to focus on here is that the rest results in you getting a 9.66% versus the 4.28% on the GOC-5. So the effective spread here is 5.38%. PBA's 6-year corporate bonds trade at under 5.54%.

So their spread is less than 1.3% while the preferred equity which is just as safe in our opinion and offers a far better tax-advantaged yield, is trading at 5.38% effective spread.

Very few opportunities in the market compare to this.

Pembina Pipeline Corporation PFD CL A SER 3 ( PPL.PR.C:CA )

While several of the PBA preferred clan offer different advantages, we also like the near-term resetting Series 3. This one has a reset date of March 1, 2024, so you are not going out on a limb with the wait. The reset will be at GOC-5 plus 2.6%, and it is trading at $16.50. That means at current interest rates you would lock in about 10.4% for the next 5 years. Again, extraordinary in light of the quality of the firm.

Pembina Pipeline Corporation CONV PFD A SR 22 ( PPL.PF.B:CA )

PPL.PF.B:CA is another one to consider for those bullish on the higher-for-longer concept. It is tied to short-term interest rates. The calculation is done as the 3-month Treasury Bill rates for Government of Canada plus 3.26%. But the shares are convertible into Pembina Pipeline Corporation CONV PFD A SR 21 ( PPL.PF.A:CA ) which are tied to GOC-5, on March 1, 2028. We have described PPL.PF.A:CA in more detail over here .

Verdict

We generally look for diversification and never go "hand over fist" on any single name. We will hold true to that principle here as well. But as an asset class, Canadian preferred shares are incredibly compelling. We are increasing allocation here as the spreads relative to their risk make them fantastic for almost any outcome for interest rates. One point to note here is that the longer you wait and risk until reset, the higher is your implied yield. While some risk here is acceptable, one should at least lock-in some portion of these near-term resets.

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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