Double Blind

After doing quite a bit of due diligence, I have placed my TFSA proceeds into Harvest Energy Trust, specifically the 6.4% debentures due October 2012, making this a 3.6 year debt investment. The price I paid was 40 cents on the dollar. This gives me a (tax-free!) current yield of 16%, or a yield to maturity of 33.25% assuming I don’t reinvest the interest payments in anything (a 3% return on coupon payments gives a yield to maturity of 33.59%). Harvest Energy is vertically integrated, doing production and also refining of petroleum products. It also has equity that trades as trust units, but I do not consider the equity to be a good investment because of the future de-leveraging the company will have to perform to be viable.

This achieves an investment objective of increasing my fixed income, and also exposing myself to the energy market. It is also relatively “conservative” being a debt investment, opposed to equity. Finally, it beats ING Direct’s risk-free 3.5% for a 4 year GIC by 12.5%, plus there is a good chance of capital appreciation if the debenture matures.

Harvest has three debt issues in the way before payout of their 2012 debt – a CAD$1.2 billion secured revolving bank loan which extends to April 2010, and a US$250M secured debt bond due October 2011. After that is the October 2012 issue (CAD$175M face outstanding).

The bank loan is of concern, obviously due to the size relative to the rest of the capital structure of the company. This is the primary reason why the debentures (which are junior to the secured debt facilities) are trading so low – there is refinancing risk with the bank loan and the secured bond. It is likely that the company will have to reduce distributions to unitholders.

It is more likely than not that management can see the need to de-leverage their balance sheet, and in the process they will be hurting their unitholders. But the people holding the debt will be the ones to take advantage of this situation since they are required to be paid and not the unitholders. The unitholders should survive (i.e. the entity won’t restructure) but it will be messy for them – I’d expect distributions to go down to about $75M/year or about 50 cents per unit, until oil prices rise.

The operation produced $640M in cash from operating activities in 2007, and $508M in 2006. Although this number will likely be lower in 2009, the company should have sufficient cash flow to reduce leverage.

Finally, the debentures contain a conversion feature. The debt holder can convert their debt at a rate of $46/unit (given that the current units are trading at $9.50, the implied value in this feature is not great). At maturity, the company has a conversion option of choosing to pay the debt back in cash, or to give units of the underlying trust at 95% of market value of the last five business days worth of trading – by that point, the debentures will likely be trading close to maturity if the company chooses to go through the dilutive option.

The major risk of this investment is primarily centered around the price of oil. Inevitably if things get that bad, the company is likely to sell itself out, which in that case the debt would mature at par. Of course if they can’t find buyers (mainly because the buyer would have to take on the additional debt), then ultimately this would go into liquidation and there would need to be more than $1.5 billion raised in such a liquidation before the debenture holders would get their take. Right now at $9.50/unit, investors are pricing the equity value of the trust at about $1.4 billion, so you can easily see where the embedded risk in the debentures are.

Finally, there were other candidate investments in this same firm, mainly the 2013 debenture issue (which was materially the same, except with a 7.25% coupon instead of a 6.4% coupon), but I preferred the 2012 investment due to an 11 month quicker payback (Yield to maturity of 28.7% for the 2013 vs. 33.6% for the 2012). There are also 2014 (7.25% coupon, YTM 26.9%) and 2015 (7.5% coupon, YTM 22.5%) debt issues, but they trade at materially the same prices and while the current yield on the 2013, 2014 and 2015 issue is better, the yields to maturity are significantly lower and the risks are higher.

The usual word of warning – I could lose my first year’s TFSA investment on this one – the oil market could crash further. If this does work, however, I’ll have tripled my TFSA in three years (assuming I make no 2010, 2011 or 2012 contributions). The limited sized of the first year’s TFSA deposit pretty much allows for a maximum of two investment choices to be made when you consider the frictional costs of commissions. The other candidates for investment I had were considerably less attractive, so I decided to concentrate the full amount on this one. If you are following this, you’ll might be able to get a better price than 40 cents – or you might not. The 52-week low was 35 cents, but this was done during the great purge in December when everybody was jettisoning everything for tax reasons.

This entry was posted on Tuesday, February 10th, 2009 and is filed under Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.