ALE Notes 2: Another round at the bar
Relying on the creditworthiness of pub landlord ALE Property Group, ALE Notes 2 is a floating rate instrument that’s honest-to-goodness debt, with no arguments.
The proposition for buying rests on two attractive features. First, being a debt instrument, the quarterly income payments are in no way optional. A missed distribution would be an event of default. That offers an important protection for debt holders. The interest payments as promised are a near-certainty.
The second is the interest rate itself. Equal to the three-month bank bill rate plus a margin of 4.0% (as with all true debt, it is unfranked), that’s quite attractive.
Key Points
- Yield to maturity three-month bank bill rate plus 4.6%
- Decent return for a low risk investment
- Illiquid stock, be patient and keep bids below $100.50
For a deeper understanding of the structure and financing of the parent group, see ALE Property: Down in one of 2 May 12. The short story, though, is that the borrower is of a high quality and unlikely to default on its debts.
Learnt lesson
After a significant equity raising in 2009, ALE Property Group’s portfolio of 87 pubs is now financed with about half debt (including these notes) and half equity. Given the extremely reliable nature of its revenue stream—it grows in line with the consumer price index and is payable by the tenant, Woolworths-controlled Australian Leisure & Hospitality, for the next 16 years regardless of trading conditions—the financing is quite conservative.
The notes stand behind ALE Property’s other debts in terms of seniority (as is the case with most listed debt instruments). But the structure is notable for the lack of conditions stacked against the lender (that’s you). That fact that income payments are neither optional nor deferrable is but one example.
There also exists the protection of several covenants; one says the group must keep its loan-to-value ratio below 87.5%, the other keeping the interest coverage ratio above 1.2. Although these are Clayton’s covenants—we’d be uncomfortable well before these terms were breached—the sentiment is welcomed. Perhaps the board learned its lesson on maintaining prudent debt levels after the dilutive equity raising in 2009.
The stock pays interest quarterly at a rate equal to the three-month bank bill rate plus a margin of 4.0%, until its first (and likely) maturity in August 2014. With the bank bill rate currently around 3.5%, that adds up to annual interest payments close to 7.5% on the security’s $100 face value.
High yield to maturity
With more than $1 of 'accrued coupon' (that proportion of the next interest payment that has accrued but has not yet been paid) embedded in today's stock price, one is effectively able to buy the underlying stock at a small discount to its $100 face value. The all-in yield to maturity in 2014 works out about equal to the three-month bank bill rate plus 4.6%, or 8.1% in nominal terms.
ALE Property is, however, able to extend the duration of the notes. If it extends by up to one year, instead of paying $100 on redemption it must repay $101 (plus the interest that accrues over the extra year, of course). If it extends by up to two years to August 2016, it must repay $102. The notes’ duration cannot extend beyond 2016.
For today’s buyer, any such extension increases the yield to maturity and means a few more years of good returns. By our calculation, the margin would rise from 4.6% per annum on a 2014 maturity to 4.8% p.a. if it matures in 2015 and closer to 4.9% p.a. if in 2016. ALE will probably repay in 2014 but should it extend that date to 2015 or 2016, it would be a pleasant surprise.
Slowly, the case for purchasing becomes stronger. Having recently argued that ALE Property Group stapled securities are a low risk investment offering reasonable prospective returns, because of their higher ranking in the capital structure, these notes are an even lower risk (but also lower return) opportunity.
Conservative income investors and members looking for a low-risk home for their capital with a two-to-four year time horizon should find this pitch especially appealing. If you’re happy to accept greater risk in the hunt for higher returns, you might want to check out our buy list instead.
Not risk free
ALE Property: Down in one explains why the group isn’t risk free. Refinancing risk is always an issue for indebted entities.
As it pays out all of its earnings as distributions, ALE Property Group won’t have $125m in the bank when these notes fall due and require repayment. It’ll have to seek that funding elsewhere, perhaps including an ALE Notes 3 offering in 2014 (you won’t be obliged to participate). If credit markets happen to be frozen at the time, that might be a problem.
So, while we have a 5% suggested portfolio limit on both the notes and the stapled securities, we’d also suggest limiting your exposure to the total entity to perhaps 6-7% at a maximum. Let your risk profile guide your decision as to whether that goes towards the notes, the stapled securities, or both.
One particularly important drawback of the notes is the lack of liquidity. On many days, next to no stock is traded. On others, a few hundred thousand dollars worth is exchanged. Yesterday was one such day (we'd been waiting for it), and we hope it means there's a willing seller in the market. But, even on the bigger days, liquidity is low and so please, please be patient and limit your bid to no more than $100.50 at a maximum.
That’s a crucial point. If you ‘pay up’ to secure stock, you’ll up with a significantly lower overall return. For example, if you pay $101.00—just $0.50 more than in the calculations outlined above—the yield margin on a 2014 maturity falls from 4.6% to about 4.2% and the investment becomes less attractive. With short duration securities such as this, a few cents here or there actually is important to overall returns.
With that in mind, we’re recommending ALE Notes 2 as a BUY FOR YIELD at a strict limit of up to $100.50. If this stock suits your portfolio requirements, please bid patiently.
Note: We’re adding 60 ALE Notes 2 securities to the Income portfolio at a price of $100.50 (total cost $6,030), leaving capacity to add some stapled securities (ASX code LEP) to the portfolio down the track, as is the intention.