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Harry Koza

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Buy bonds, wear diamonds

Harry Koza

 

 TORONTO (GlobeinvestorGOLD)—When I was a kid, there was a gas station and restaurant out on Highway 11 south of Cobalt that had a sign which read, "Eat here and Get Gas," which is the catchphrase of the markets these days. Everyone seems to be getting gas; some people from watching their speculation, errr, investment in Stupididea.com vaporize, but mainly from the markets suddenly waking up to the realization that while gasoline prices may have dropped post-Iraq, natural gas prices are holdings their highs.

Natural gas is still hovering around a sporty $6 (U.S.) per million British thermal units, and it shows no sign of relenting anytime soon. Turns out, we don't have nearly as much gas as we thought we did, storage levels are at historic lows, and despite a rise in the rig count, new supplies aren't being found nearly fast enough to replace our growing usage.

To make matters worse, all the nifty computers and server farms and other technological wonders of the age are energy pigs. And, let's face it, as long as the Ontario government keeps encouraging us to conserve energy by keeping electricity prices artificially low, we'll continue to spend our summers with our air conditioners set to Pangnirtung. So gas is in huge demand.

It must be the next big trend, since Trade by Numbers is doing an entire issue on the sector.

Being a contrarian by nature, that semiotic event itself almost makes me want to run out and liquidate all my gas holdings. Just kidding—the natural gas phenomenon (I hesitate to call it a "bubble") still has legs.

So, how best to capitalize on the stream of lovely cashflow pouring through the coffers of natural gas companies? Personally, I'm long a slew of gas-heavy income trusts, and have been for several years now, and also own some EnCana Corp., North America's biggest gas producer. Then there are plenty of other gas-related stocks and income funds—producers, drillers, pipelines, gas-fired electrical generators, and various permutations of those things. I leave it to others to make suggestions in those areas.

Gentlemen prefer bonds

But what about bonds, you insist? Everyone likes bonds these days. Bonds have been on a tear. "Buy bonds, wear diamonds," as they say in the trade. Investors are jumping into bonds, having embraced the novel notion of actually earning a return on their capital and getting their money back, quicker than a politician jumps on a dumb idea. What about natural gas bonds?

There are all kinds of possible candidates. TransCanada Corp., Enbridge Inc., EnCana, Transalta Corp., Alliance Pipeline LP, Westcoast Energy Inc., Nexen Inc., Canadian Natural Resources Ltd.—all have investment-grade public debt issues that you may be able to buy retail amounts of from your friendly investment dealer.

Some things to bear in mind:

  1. 30-year Government of Canada Bonds traded below 5.00 per cent in recent days, so it's hard to get a lot of yield.
  2. Really short corporate maturities (under 5 years) will trade at relatively narrow spreads, and buying small amounts (anything under $100,000 is an odd lot) will eat up a lot of your yield at even nominal rates of commission. You're better off buying Ontario Savings Bonds than paying a commission on, say, EnCana 7.5 per cent bonds due 2005 at 50 basis points over the comparable Government of Canada 5.75 per cent bonds maturing in 2006. That's about a 3.88 per cent yield at the time of this writing and 50 basis points is the spread for institutional market amounts.
  3. To get a decent yield, you'll have to go further out the yield curve. You can buy something like TransCanada PipeLines 6.28 per cent bonds due 2028 at 165 basis points over comparable government bonds. Again, that's the institutional rate, and you'll still lose several basis points in transaction costs. The TCPL 6.28/28 would thus yield about 6.65 per cent today.

There are variations in spread for credit rating and maturity, for industry (producers are usually higher yielding than utilities, for instance), for coupon—the bond world is a nuanced one, for all its apparent boring qualities—but, let's face it, yields like this aren't going to set the world on fire for you.

Up around the bend

Much as I like corporate bonds, and bullish as I've been on the natural gas story, I haven't bought any bonds. I did buy Canadian Crude Separators income trust at $15, when it was yielding 15 per cent, and still own it—still yielding 15 per cent, though if you bought it today at $20 and change, it yields far less. (OK, I admit, I bought it partly because its TSE symbol was “CCR” and it reminded me of a favourite band from my younger days).

So, earning 6 per cent and change in a long TCPL bond doesn't turn my crank at all. Heck, you can get 4 per cent or so from the stock, and if they ever build a pipeline to all that Arctic gas up the MacKenzie Valley (which someone will, and sooner rather than later) you'll have a lot more upside, too.

If you must buy corporate bonds issued by companies in the gas sector, I'd look for maturities in the 15- to 20-year term: you get almost all the juice in the yield curve, but without all the convexity and duration (Don't ask! You really don't want to know).

Pembina Pipeline Income Fund one-year chartI'm also intrigued by a couple of recent retail-oriented issues I've seen. There's a $220-million 7.35 per cent unsecured subordinated convertible debenture from Pembina Pipeline Income Fund currently being marketed. OK, so it primarily owns an oil sands pipeline and an ethylene storage facility, but it also owns an interest in 15 natural gas liquids gathering systems and pipelines, and it's the only one for which I still had a prospectus kicking around. (Usually the dog chews most of them up when I'm not looking: this is what we professionals call "screening" investment ideas).

Driving in CARS

There are several deals with this sort of structure around, including some gas ones—ask your broker. The Pembina Pipeline debentures are convertible into Pembina income trust units, at the holder's option. The issuer, on the other hand, has the option of delivering income trust units to a trustee to sell to pay the 7.35 per cent coupon. That's a much higher yield than straight bonds and with an equity kicker to boot. They mature in 2010, and the company can redeem them starting in 2006. On the other hand, don't forget that they are unsecured, and subordinated to other debt.

Another way to play the sector is through instruments like PARS and CARS (Par Adjusted-Rate Securities and Coupon And ResidualS), which are retail-oriented bonds reconstituted from secondary market paper issued by various companies, usually high-coupon bonds issued back when interest rates were in double digits. Ask your investment dealer: his firm may have some in inventory stripped and reconstituted from TCPL or Consumers Gas bonds. These instruments will give you corporate debt exposure at near-institutional spreads.

And if you think that the crisis in the gas market is going to keep prices high for a long time, take a hard look at investing in energy efficiency in your home or business. That can, even at lower gas and electricity prices, yield a very attractive return on your investment.

Harry Koza is Senior Analyst in Canadian markets for Thomson Financial/IFR. At various times in his career, Mr. Koza has been a prospector, metallurgist, project manager, engineer, as well as an institutional bond salesman for 15 years. His current area of expertise is in high-yield distressed securities and corporate bonds in general.

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