Contango Microcap Convertible Notes (CTN, CTNG)

It's been a while since I've had a good look through the ASX listed interest rate securities. These are found at the back of the tables in the AFR. See below for this weekend's (6-7 June): 

I tend to call all of these securities 'hybrids' including the corporate bonds, floating rate notes and convertible notes, although this is not strictly correct in some cases. As noted in previous posts, hybrids have been good hunting although the by and large the market is now more comfortable with this sector than five years ago and therefore there are less opportunities. Again, as previously noted I think there is room for more of these types of securities as there are a lot of investors who really just want income to help fund their retirement. 

One security that I like (but don't own) are the AFIG convertible notes: AFIG. I've written a few posts up on AFIG before here, here and here. On a similar note are the Contango Microcap Convertible Notes CTNG. Let's look at these in a bit more detail - starting with fundamentals and then structure.  

Fundamentals  

Contango Asset Management is a fund manager of both unlisted trusts and the listed Contango Microcap (CTN). The underlying performance of CTN has been solid (note these are pre-fee figures):

Source: Contango Quarterly March Update 2015

As you can see, CTN has been around over 10 years, and the market cap is $176m with 160m shares at a share price of $1.08. Pre-Tax NTA is $1.17 and post-tax NTA is $1.132. 

The company holds no debt except the CTN notes which we will come back to shortly. 

Like other good LIC's, CTN pays a healthy dividend stream of a minimum of 6% of NTA each year. Forecast full year dividends are 7.7c partly franked. So at $1.08 that gives a yield of 7.1%.

Anyway, all of this is pretty straight forward as a background to CTN. Let's move on to CTNG itself. 

Structure

CTNG is very similarly structured to AFIG. To be honest, if I were running a LIC I would seriously thinking about raising some debt in a similar fashion. 

In summary, here are the key features of CTNG: 

• Face value $100
• Current Price $102.85
• Unsecured
• Fixed interest of 5.5% p.a. (on face value, unfranked)
• Interest Payment dates are March and September each year
• Convertible into CTN shares at each Interest Payment date at a rate of $100/$1.30 = 76.92 CTN shares (i.e. each CTNG allows you to buy 76.92 shares)
• Final maturity date 31 March 2020 of $100

Like AFIG, CTNG has allowed CTN to take on some leverage without the annoying standard margin loan features such as the lenders ability to just remove a stock from a margin lending list. There are some gearing covenants which should be noted - see page 17 of the prospectus. However CTNG is hardly an Alan Bond style debt-ears-pinned-back move: there are $26.5m CTNG on issue versus CTN gross assets of $206.6m (31 December). 

So, what's to like from an investors point of view? Firstly, the yield is okay which is currently 5.3% p.a. (remember this in context of an RBA rate of 2%). Secondly, the twist in the tail is the embedded optionality. You get exposure to upside in the CTN share price above $1.30. Remember, CTN is $1.08 and is trading at a discount to NTA. And you have four and a half years to achieve this - even a mediocre investment performance by CTN would get you there. The biggest point to like is a floor in the price of $100. It's unlikely CTN will blowup, so the more probably worst case scenario is a mediocre investment performance and you just get your $100 back in 2020. 

Imagine some basic scenarios of CTN being $1.50 in March 2020. Your CTNG shares are worth 76.92 *$1.50 = $115.38 each. Throw in the interest payments of $5.50 p.a. and assuming you paid the current price of $102.85, your pre-tax IRR is 7.6% p.a. If the CTN moves to $2 then your pre-tax IRR is 13.4% p.a.  

What's not to like? Well if you think interest rates will move up then fixed rate securities aren't so fun. And Cantango could hold the share price down by increasing dividends and/or issuing dilutive options. And obviously we don't know if the CTN share price will move above $1.30 in the future. 

Also, CTN is not a pure-play Listed Investment Company (LIC). Contango internalised management and the proceeds of the fund are invested in another Contango vehicle Contango Income Generator fund which itself has not yet listed. This is potentially confusing to investors and distracting for management. 

However I think the main point is that CTNG is ultimately a bearish trade. If you just buy CTN you immediately get a higher dividend yield 7.1% p.a. (plus some franking). And if the CTN share price moves up to $1.50 your pre-tax IRR is 13.4% and for $2 it is 19.5% p.a. So unless CTN moves south in a decent way, you are better off with CTN rather than CTNG. However, I've been through the GFC and the appeal of a floor in the price has decent appeal and obviously everyone has their own preferences.    

It's tough to get excited by CTNG. For me to buy CTNG I would need to see a bigger divergence between CTN and CTNG so there is more value in the security.  

Kristian 

Disclosure: no position in any of the above securities.