CA - Series 1 Preferred Is Now The Best Enbridge Security For US Income Investors

2023-11-04 03:28:11 ET

Summary

• Enbridge's common stock has performed like a bond, losing over 15% as interest rates have increased.
• Enbridge offers preferred shares denominated in US dollars with rates that reset every 5 years based on the 5-year US Treasury yield.
• Having just reset, Series 1 offers a current yield 1 percentage point above the common, which investors can lock in until June 2028.

Common Stock Still Unimpressive

It's been 9 months since I last covered the US Dollar denominated preferred shares of Enbridge ( ENB ) ( ENB:CA ). Since then, the common stock has continued its bond-like behavior, losing over 15% in the US on a total return basis as interest rates have increased. The common has been beaten up worse than the preferreds.

The main development with the company since then was the September announcement that it would be buying 3 US-based natural gas utilities from Dominion Energy ( D ). I was unimpressed with the deal, because even though the gas utilities looked like good assets, the added debt and stock issued by Enbridge to finance the transaction appear to make it barely accretive.

Outside of that deal, earnings have been steady but with slow growth only in the low single digits. Looking out further, Enbridge seems to be de-emphasizing its liquids pipelines in favor of gas transmission projects like the T-system in British Columbia, and gas distribution, including rate base growth in the US acquisitions. They are also pursuing renewables projects including offshore wind in Europe. Fortunately, they have so far avoided such projects in North America, where economics have been more challenging, as shown by the $540 million write-down ( BP ) recently took. The company plans to grow distributable cash flow only 3% per year through 2025.

Enbridge stock has become popular with income investors as it doubled the dividend over the 2013-2020 period. Since early 2021, dividend growth has slowed. In US dollar terms, the dividend has actually declined over that period thanks to the weaker Canadian dollar.

With its lack of growth and exchange rate risk, there is little to recommend Enbridge to US investors. The company's USD preferred shares look like a better buy, especially the ones that have recently reset to higher rates.

New Developments In The Preferreds

Enbridge now has 19 different series of preferred shares outstanding, one more than when I wrote my last article. Dividend history and prospectuses for all these can be found on Enbridge's website . Collectively, they are still a small part of the company's capitalization, with $6.8 billion on the balance sheet compared to $65.1 billion in common equity. Preferred dividends year to date were $260 million, compared to income attributable to common and preferred shareholders of $4.37 billion. (all values CAD). While I am not excited about the growth prospects of the company, the preferreds look very well covered. They are rated BBB-/Baa3 or equivalent by the major rating agencies.

Most of these preferreds have a coupon rate which resets every 5 years and is indexed to either a Canadian or US Treasury yield. At the reset date, the company may redeem them or keep them outstanding and let them reset to the new rate. Of special interest to US shareholders are three series of preferreds which are denominated in US dollars and indexed to the 5-year US Treasury yield. 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 )

The details of each security are in the table below:

The biggest development since my last article is that Series 1 hit its reset date and Enbridge elected to let it reset higher rather than redeem it. Once again, Enbridge got lucky and saw the 5-year Treasury yield near a local bottom on the reference date (which is 30 days before the reset date).

Having reset in June 2023, Series 1 has the longest time of the three US preferreds before the next reset. It also has the highest coupon and current yield of the three. The current yield of 8.65% is one percentage point above the common stock yield, and well above the BBB- rated preferreds of US-based issuers. At the current share price, Enbridge would need a quarterly common dividend of $1.00 (Canadian) to yield the same as the Series 1 preferred. If the common dividend grows at its recent rate of 3.2% per year, it would take 4 years before the common has a similar yield to the preferred, assuming no change in common share price.

Series L has 9 months fewer to go until the next reset compared to Series 1, and the current yield is a little lower at 8.32%. That makes Series 1 the clear winner at this time. The low liquidity of these preferred shares can cause the prices to bounce around, however, so it's worth double-checking the prices of both in the future before deciding which one to buy.

The biggest risk with both Series L and Series 1 is that the 5-year Treasury could be trading considerably lower in 2027 or 2028 when these preferreds next reset. This carries the risk of lower income and capital losses as the reset dates approach.

Series 5 has traded much higher than the other two US preferreds since the last Seeking Alpha article on the stock was published on October 3. Series 5 now has a current yield of 6.36%, well below Enbridge common stock and more in line with several US BBB- rated preferreds listed in that article. It's not uncommon for preferreds to become "pinned to par" if a redemption date is approaching. We now have 4 months to go until the reset date of 3/1/24, and less than 3 months until the reference date for the 5-year Treasury yield of 1/31/24.

The 5-year is now yielding 4.65%. If it is still there on 1/31/24, the Series 5 preferred will reset to a coupon of 7.47%. A redemption is by no means guaranteed considering the capital raising Enbridge has been doing to finance the Dominion gas utility deal. If it is redeemed at $25, it would mean a quick capital gain of 18.3%. If not redeemed, the new coupon would produce a current yield of 8.84% based on the current price, just slightly above the current yield of Series 1.

Of course, the 5-year could continue on its downtrend that it recently started. My best guess is that the market expects Series 5 to reset and not be redeemed, and the 5-year Treasury will be yielding slightly less than today. Given those assumptions, the current price of Series 5 makes sense, as it will have a current yield in the same ballpark as Series L and Series 1 after the reset.

Series 1 therefore looks like the best bet for conservative income investors. Series 5 at current prices is only a trade for those who want to bet on redemption in March 2024 or higher 5-year rates on the 1/31/24 reset date. For those who bought at lower prices before the early October price spike, Series 5 is a Hold.

I have said this in earlier articles, but it bears repeating. These preferreds are illiquid and trade at low volume in the US. Please use limit orders and consider limiting buys to a few hundred shares at a time. Enbridge is a corporation, not an MLP. There is no K-1 to deal with. There is 15% Canadian tax on the dividends withheld from US taxable accounts. Generally, you can obtain a credit for this by filing Form 1116 with your annual return. If held in a tax-advantaged account like an IRA, there should be no Canadian tax withheld. The dividends are supposed to be qualified for the lower tax rate. In the past, my broker has marked them qualified when paid, then 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 midstream company with steady operating performance but slowing dividend growth. Acquisitions like the Dominion gas utilities help grow operating income but do not move the needle much on earnings and dividends per share due to the debt and stock issued to fund the deal. The common stock of Enbridge has provided little capital appreciation and only small dividend increases in recent years. The Series L, Series 1 and Series 5 preferred shares are denominated in US dollars, eliminating foreign exchange risk for US investors. These preferreds are indexed to the 5-year US Treasury yield and reset every 5 years.

The Series 1 preferreds are now yielding 1 percentage point over the common shares. With almost 5 years until the next reset, investors can lock in the current yield for that length of time. Series 5 now has only 4 months until the next reset. While the current yield on the 5-year Treasury suggests Series 5 could have the highest yield after reset, there is too much risk of it dropping in the next 3 months. Those who want to bet on an increase in the 5-year or the possibility of Enbridge redeeming Series 5 at $25 may consider Series 5 as a trade. Series 1 looks like the best choice for conservative income investors.

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