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Income from Residential Real Estate Development Opportunities

The desire to locate a corporate bond denominated in Canadian dollars that both steps away from so many of concerns currently plaguing the financial industry and steps up yields to outpace inflation has again motivated us to look outside the normal "investment grade" rating boundaries set by official rating agencies. Although this week's best bond stands as "unrated" by these popular agencies, we will present how it does meet and exceed the strict criteria that we previously developed and found highly successful for evaluating lower rated bond issues. Denominated in Canadian Dollars, which is currently trading at par with the US dollar, this Canadian company's Convertible Unsecured Subordinated Bond has a coupon of 6.375% and matures 8/31/17. Because it currently trades at a slight premium of about 107 and it can be redeemed at par in 2016, the yield to worst call indication is about 4.3%. However, because the holder has the option to convert this debenture to common equity stock at anytime for C$6.00 (Canadian dollar trading at par to the US dollar), this issue includes the potential for significantly higher returns. Tricon Capital Group (TCN.TO) currently trades for about C$5.80, and has been paying a quarterly dividend that amounts to about 4.14% annually.

Given the possibility of significantly increasing this already very respectable 4.3% yield through the added capital gains its conversion to stock option allows for, as explained further in this review, we find it timely and appropriate to include these 57 month Canadian dollar Tricon Capital convertible notes in our Foreign and World Fixed Income holdings.

Tricon Capital Group

Founded in 1988, Tricon Capital Group Inc is one of North America's asset managers focused on the residential real estate development industry. It has participated in the development of residential properties in Canada and the United States by acting as the manager of a growing series of limited partnerships that provide financing for residential land development, single-family homebuilding, multi-family construction and retail developed in conjunction with residential projects. Tricon is focused on four major geographic markets in Canada (Toronto, Vancouver, Calgary and Edmonton) and five major geographic markets or regions in the United States (Southern California, Northern California, Phoenix, Atlanta and South Florida). It currently manages 7 active funds with about C$1.2 billion in assets under management and a growing portfolio of U.S. single-family rental homes. Over its 23 year history, Tricon has financed about 150 transactions valued at roughly C$10 billion and has an outstanding track record of investment performance and fund raising.

Tricon is an asset manager and principal investor focused primarily on the for-sale housing sector. As an asset manager, it manages private funds and separate investment accounts for investors participating in the development of real estate in North America by providing financing (generally in the form of participating loans which consist of a base rate of interest and/or a share of net future cash flow) to developers. As a principal investor, it co-invests in its private fund and separate account business, and most recently has established a U.S. single-family rental platform whereby it can acquire, renovate, lease and manage distressed single-family homes through a network of "best in class" local operating partners. The company believes that U.S. single-family homes can be purchased at meaningful discounts to peak pricing and replacement cost and even to current retail pricing through foreclosure, short and bank REO ("real estate owned") sales and that the Tricon will generate attractive risk-adjusted yields from the rental, sale and future appreciation of these properties.

Tricon completed its Initial Public Offering in May of 2010 (at C$6.00/share), and in April of 2012 completed a C$51.75 million equity offering priced at $C 4.00/share. Tricon announced it record quarter earnings for Q2 2012, with key earnings metrics increasing more than 100% year over year. Highlights for the quarter included net and comprehensive income of C$2.16 million on revenues of C$4.95 million compared to the loss of $509,000 incurred with revenues of C$2.84 in Q2 of 2011. Similarly, adjusted EBITDA for Q2 2012 increased by C$1.6 million or 119% year over year to C$2.95 million. Tricon continues to successfully deploy capital into its new U.S distressed single-family for rent platform. However, no meaningful income is expected until Q4 2012 as it generally takes 60 to 90 days to renovate, lease and stabilize recently acquired rental properties and to renovate and harvest the flip properties. At August 10, 2012 over 420 homes were owned across four partnerships including Tricon's most recent partnership in Southeast Florida which was finalized subsequent to quarter end. Tricon continues to pay equity holders a quarterly dividend of six cents, or C$.24 annualized, to its shareholders.

At the end of Q2 2012, Tricon reported cash equivalents at C$37.88 million. In July of 2012, Tricon completed an offering of C$51.75 million aggregate principal amount of convertible unsecured subordinated debentures, and it is currently the only debt issuance of the company. Considering that the coupon for this debt is 6.375% and the average internal rate of return for Tricon's various funds utilization of capital appears to have been over 24%, a deployment of this new funding with anything remotely similar to its previous results (they are targeting 18-20% after market recovery) would result in very sound income coverage ratios for both its quarterly interest payments of about C$ .83 million and a continuation of dividend distributions of about C$1.73 million. With a debt to equity ratio of less than 40%, Tricon maintains strong balance sheet flexibility. Along with strong insider ownership and buying support, Tricon has the approval to the Toronto Stock Exchange to buy back up to 5% of its common shares should it believe it to be an appropriate use of available cash and to be in the best interest of Tricon and its shareholders.

In addition to the 6.375% coupon (paid semi-annually) that they offer, a very important feature of this bond to consider is the holder's option to convert it at anytime prior to maturity to common stock at the conversion price of C$6.00. This strike price represents a mere 3.5% rise from the C$5.80 price TCN is currently priced at on the Toronto exchange, and it is our belief here that there is very strong upside growth potential remaining within this company that may significantly exceed the 4.25% yield to worst call (at par) in 2016 that is indicated in the bond's current premium. This reminds us of the opportunity we identified earlier this year in Neo Materials, which soon after became MolyCorp (NYSE:MCP) convertible debentures and brought a very quick return of over 10% shortly after they were acquired for our clients and subsequently sold with the news of a buyout offer. After missing the tremendous capital gains that could have been realized in MolyCorp's takeover deal by owning the stock versus its correlated convertible debenture, we acknowledge that this bond bypasses the potential dividend increases should they be the result of Tricon's high internal rate of returns. However, we would also like to point out that it will capture most of the stock equity gains that might be seen here should Tricon's stock increase above C$6.00, which we think quite likely. Furthermore, the convertible note offers a higher 6.375% accrued interest payment and significantly more protection from a possible adverse decline in stock value. For those that don't mind slightly more risk and prefer dividend income to interest income, Tricon's stock and the greater than 4% dividends that are expected may prove to be a better choice.

Being a smaller issue, Tricon's debt is not covered by the major credit rating agencies and is therefore classified as "unrated." However, this appears to be a very astutely managed, well financed company with reasonably low debt, ready options for additional funding if necessary, and a prudent use of existing cash flows.

Risks

The default risk is Tricon Capital's ability to perform. Considering their historical and recent performance, their flexible balance sheet, their sound cash position, and the excellent cash flow that is projected to service their interest bearing debt, as outlined above, it is our opinion that the default risk for this short to medium term bond is minimal relative to its more favorable return potential. An option that further reduces the default risk of this convertible bond, should at its maturity the company decide not to pay off or roll over the debt, is a conversion of the principal (at par) to TCN common stock at a 5% discount to stock's valuation at maturity on 8/31/2017.

As a result of being denominated in Canadian dollars, the currency exchange risk will affect the returns of these bonds and possible in a negative way as it exposes investors to the Canadian economy.

The company also has execution and market risks as very fast growth company in developing markets, as companies often encounter unforeseen issues. This is a common risk associated with younger, fast growing companies.

We believe that these Tricon Capital convertible debentures are very similar to the previously reviewed MolyCorp convertible debentures, and can also be compared to other unrated issues such as Fred Olsen (OTCPK:FOEAY) Energy bonds denominated in Norwegian kroner and the unrated Jaguar Land Rover (NYSE:TTM) bonds in British pound sterling, both of which have performed very well since our initial reviews.

Conclusion

We applaud Tricon Capital's successful and intelligently leveraged approach to the currently distressed North American real estate market, and this relatively small and less well known issue appears to be a savvy investment risk offering solid returns from a company that has good management, a good cash position, good interest coverage, and a strong and flexible balance sheet. Its bond appears to be an exceptional opportunity for obtaining a very respectable 4.3% yield with significantly lower default risk than is typically associated with an unrated (or low rated) medium term bond, not to mention the additional capital gains return potential that its conversion at any time feature allows for. However, we see both its stock and its convertible debenture as excellent vehicles to gain exposure to the Canadian dollar in our continued efforts to diversify away from overweighted U.S. dollar based assets, and it is why we have chosen them for addition to our offshore bank income investment opportunities.

Tricon Capital Group Inc.
Ticker: TCN.TO
TSX: $5.80 11/1/2012

Debenture (BOND):
Coupon: 6.375%
CUSIP: 89612WAA0
Maturity: 8/31/2017
Conversion Price: C$ 6.00
Rating: none
Pays: Semi-annually
Price: 107
Yield to Maturity: ~4.7%
Yield to Worst: ~4.3% call at par, 8/31/2016

Disclosure: Some Durig Capital clients may currently own Tricon Capital stock and/or its bonds.

Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.

Source: 4.3% Canadian Dollar Income Yields From Tricon Capital, Real Estate Development Group