Description

TC Energy Corporation cumulative redeemable first preferred shares series 7 (TSX: TRP.PR.D, last price C$18.5) will likely provide attractive total return over the next 5 years with limited risk. Due to low trading volume (approx. C$300k per day) and tax attributes, this idea is best suited for PAs and small funds in Canada. One could buy a basket of Canadian fixed-reset preferred shares that just reset or will shortly reset their dividends to get a bigger dollar exposure. 

TRP.PR.D is a fixed-reset preferred stock. Its next reset date is April 30, 2024. On this date, three things could happen:

1. It could be redeemed by the issuer.

2. It could be converted to a new series (Series 8) of quarterly floating rate preferred (dividend rate=90 day Gov of Canada treasury bill rate+2.38%). The rate determination date is 30 days ahead of the reset date, or April 1. On March 8, the 90 day GoC rate was 5.17% so the new floating dividend rate would initially be 7.55% assuming the same GoC yield on April 1. 

Note: The company would only create the new Series 8 if more than 1 million shares elect to convert, and the company would only force all Series 7 shares to convert to Series 8 if there would be fewer than 1 million Series 7 shares outstanding. There are currently 24 million TRP.PR.D shares.

3. It could have its dividend reset for the next 5 years (dividend rate=5 year Gov of Canada bond yield+2.38%). With the 5-year Canada yield @ 3.40%, the new dividend rate for the next 5 years would be 5.78% assuming the same GoC yield on April 1. 

With the expectation that interest rates have peaked, it is unlikely that enough shareholders will elect conversion to Series 8 despite the higher initial yield. In fact, none of the fixed-reset preferreds by other issuers (they all have the same features) were converted in recent months. It is even more unlikely that more than 23 million Series 7 shares elect to convert so that a forced conversion happens. 

It’s unclear whether TRP would redeem this series of preferreds. The new rate isn’t atrocious, and the company only counts half of preferred stock face value in its leverage calculation. But in 2022, TRP redeemed the Series 15 preferred stock that would have reset to a new dividend rate of 6.6% and funded the redemption by issuing 60-year junior subordinated notes at 5.85%. If TRP decides to redeem Series 7, this idea would return 35% in the next month which would be terrific, but this is not my base case.

My base case is that the Outcome 3 would happen, and the TRP.PR.D would reset to a dividend rate close to 5.78%, 50% higher than the current dividend. On the current stock price of $18.5, this translates to dividend yield of 7.8% over the next 5 years. Due to tax attributes of the “eligible dividends” paid by Canadian preferred stock, the 7.8% yield is equivalent to ~10% yield from interest or other income on a pre-tax basis for Canadians.

On top of the high dividend yield, I think there’s a good chance that there could be capital appreciation as well. Prices of fixed-reset preferreds tend to move with 5-year GoC yields. This is because investors are forward looking - higher GoC yields result in a higher dividend rate in the future warranting a higher stock price, and vice versa. Curiously, this relationship broke down in this last hiking cycle. TRP.PR.D (and other fixed reset preferreds) price declined despite the significant uptick in Canada bond yields, only recovering a bit since the end of last year. I’m not quite sure as to the reasons for this performance. It might be that the Canadian preferred market is out of favour as banks which are the dominant issuers of preferred stock are increasingly using AT1 bonds in place of preferreds (see this article: https://www.theglobeandmail.com/business/article-insurers-preferred-shares-tax-change/). Nonetheless, the last times TRP.PR.D traded at $18.5, the 5-year GoC yields were significantly lower. So I think the current stock price already prices in/protects investors from a much lower interest rate. 

Looking from a spread perspective, TRP.PR.D’s dividend yield generally has a spread of 2~4% over the 5-year GoC yield outside the oil bear market in 2014~2015 and covid. Assuming 3.4% 5-year GoC yield, after the reset the new dividend yield on the current stock price would have a spread of 4.4% over 5-year GoC which seems too high.

The same conclusion can also be drawn by looking at dividend yield alone. 

The sensitivity tables below show where the stock price would land once it prices in the dividend rate in another 5 years. Total return is calculated with 5 years of dividends (assuming upcoming reset based on 5-year GoC yield of 3.4%). The return profile appears quite asymmetric.

Sensitivity with CA5Y and spread:

Sensitivity with CA5Y and dividend yield:

Spin off: TC Energy will spin off its slower growth liquids pipeline business (~15% of EBITDA) into a new company called South Bow in the second half of this year. The preferreds will stay with the RemainCo. The RemainCo targets 4.75x leverage ratio, and 97% of RemainCo EBITDA is from rate-regulated business or long-term contracts. TC Energy is a Canadian dividend aristocrat with 23 years of increases. The company is investment grade. 

Catalyst

Dividend reset