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Fixed Income

Fixed-Income Update

By Roger S. Conrad, on Feb. 17, 2018

Attractive yields and favorable risk-reward propositions remain in short supply in the fixed-income market, a condition that has prevailed over the past few years.

Nevertheless, we continue to leverage our expertise in the utility sector and other essential-service industries to uncover opportunities for fixed-income securities.

What do we look for when selecting fixed-income securities?

We never base our decisions solely on yield or the issuer’s merits, even if we’re bullish on the company’s common stock. Our ideal bond holding sports an attractive yield to maturity, doesn’t entail too much interest rate risk and offers upside potential.

These criteria mean that our basket of fixed-income favorites remains relatively small. And because bonds don’t trade with as much liquidity as common stocks, investors need to be patient and disciplined to avoid paying more than our buy target.

Our most recent foray into the wilds of the bond market yielded a few new ideas to restock our basket of fixed-income securities.

A Bond Basket

AES El Salvador Trust’s 6.75% Notes of 03/28/23 (CUSIP: 00105NAA1) represent a bet on AES Corp’s (NYSE: AES) ongoing progress toward an investment-grade credit rating. The company took a big step in that direction in late December, announcing the sale of the remaining 51 percent interest in its Philippines assets for $1.05 billion.

The deal divests 965 megawatts of coal-fired generation capacity and eliminates exposure to a high-growth market where the regulatory environment has become increasingly unpredictable and populist.

CEO Andres Gluski asserted that the proceeds from the transaction will accelerate AES’ debt repayment plan, putting the company on course to achieve an investment-grade credit rating in 2019.

Investors who are able to buy AES El Salvador Trust 6.75% Notes of 03/28/23 below 98 percent of par ($980) will enjoy a yield to maturity of 7.5 percent over the next five years. We also wouldn’t be surprised if AES were to call these higher-cost bonds as part of its refinancing efforts.

CenturyLink’s 5.8% Notes of 03/05/22 (CUSIP: 156700AS5) yield 6.1 percent to maturity with minimal credit and interest rate risk. The common stock, on the other hand, has tumbled over the past year and looks set for a dividend cut later this year.

However, the regional telecom’s acquisition of Level 3 Communications transformed the company into a leading provider of fiber-optic broadband that’s expected to generate about $2.3 billion in free cash flow this year—more than enough to pay off all its debt maturities through the end of 2020. We wouldn’t be surprised if CenturyLink were to buy in these notes as part of a push to shore up its balance sheet.

CenturyLink’s 5.8% Notes of 03/05/22 rate a buy up to 102 percent of par ($1,020).

Infraestructura Energetica Nova (Mexico City: IENOVA, OTC IENVF) offers pure-play exposure to Mexico’s growing demand for midstream and renewable-energy capacity and enjoys the backing of California-based Sempra Energy (NYSE: SRE), which owns a 66 percent equity interest in the company.

The Mexico-based energy company should benefit from the deregulation of the energy sector and the country’s plan to increase the proportion of its electricity that comes from renewable power and gas-fired plants.

Thanks to the backing of Sempra Energy, Infraestructura Energetica Nova boasts an investment-grade credit rating. The 8.6 percent yield to maturity on Infraestructura Energetica Nova’s 6.3% Notes of 02/02/23 (CUSIP: EJ5584903) stems primarily from misplaced concerns that the Trump administration’s policies will flatten the peso.

These bonds are denominated in and pay interest in pesos. However, despite the Trump administration’s rhetoric, Mexico’s national currency is roughly flat relative to the US dollar since the 2016 presidential election.

To be sure, the ongoing renegotiation of the North American Free Trade Agreement (NAFTA) creates headline risk, as do the approaching elections in Mexico. But Mexico’s economic growth has accelerated, and the government continues to work on a trade deal with the EU.

In our view, the 8 percent yield to maturity on Infraestructura Energetica Nova’s 6.3% Notes of 02/02/23 prices in too much currency risk for an investment-grade bond issued by a company that generates highly visible cash flow from assets that operate under long-term contracts.

Buying these bonds likely will require patience, and prospective buyers should note that some brokers don’t transact foreign-currency bonds. Inflows and outflows to exchange-traded funds focused on emerging-market bonds can also cause volatility. But if you have the ways and means, Infraestructura Energetica Nova’s 6.3% Notes of 02/02/23 rate a buy up to 94 percent of par ($940).

NuStar Logistics’ 5.625% Notes of 04/28/27 (CUSIP: 67059TAE5) also look appealing and yield about 5 percent to maturity.

The risk that the master limited partnership (MLP) will need to cut its distribution remains elevated, with the midstream operator covering only 66 percent of its payout in the third quarter. Management also no longer expects the partnership to achieve full distribution coverage in the back half of 2018.

With minimum volume commitments starting to roll off on its system in the Eagle Ford Shale and a $350 million debt maturity in April 2018, a distribution cut appears likely.

NuStar Energy Partners LP (NYSE: NS) trades at an enterprise value to operating cash flow that’s on par with drop-down deals completed by the likes of Philips 66 Partners LP (NYSE: PSXP) and other MLPs that rely on these close transactions for growth.

A high-quality acquirer would be able to unlock value by refinancing NuStar Energy’s debt; the partnership doesn’t have an investment-grade credit rating. At the same time, NuStar Energy’s gathering system in the Midland Basin, as well as its dock and storage space in Corpus Christi, would be valuable assets for any of the MLPs competing to develop a pipeline from the Permian Basin to the area.

A distribution cut or a takeover offer would be positive developments for the MLP’s bonds. NuStar Logistics’ 5.625% Notes of 04/28/27 rates a buy up to 103 percent of par ($1,030).

Consolidated Communications’ 6.5% Notes of 10/01/22 (CUSIP: 20903XAE3) have tumbled 9 percent since early November and trade at 89 percent of par. Despite this recent weakness, we continue to regard these bonds as a compelling value.

The selloff in these bonds closely coincides with the rout in Frontier Communications Corp’s (NSDQ: FTR) common stock and bonds, after the regional telecom’s disappointing third-quarter results raised even more questions about its solvency.

In contrast, Consolidated Communications’ third-quarter earnings indicate that the integration of FairPoint Communications has proceeded as planned. More important, Consolidated Communications still generates almost twice as much free cash flow as it disburses in dividends. The company continues to cut costs, and the $21 million sale of noncore assets in in Virginia strengthens the balance sheet.

For those without a position, Consolidated Communications’ 6.5% Notes of 10/01/22 look like a bargain.

Roger S. Conrad is the founder and editor of Conrad’s Utility InvestorHe also co-edits Energy & Income Advisor and Deep Dive Investing with Elliott Gue.

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