The Kinder Morgan Mandatory Convertible Yield Trap

| About: Kinder Morgan, (KMI)

Summary

Kinder Morgan mandatory convertible stock is overvalued.

Mathematical comparison of KMI to KMI-PA.

High "yield" of KMI-PA is an illusion.

How I trade the idea.

I want to start this article with the simple fact that dividend yield means nothing. Kinder Morgan Inc. (NYSE:KMI) mandatory convertible stock KMI-A is one of the best examples of a sucker yield. The run to safety has made some interest rates around the world negative. It's a situation that has recently animated Bill Gross and inspired him to tweet, 'Global yields lowest in 500 years of recorded history. $10 trillion of negative rate bonds. This is a supernova that will explode one day.'

I could hardly describe KMI-A as a 'supernova that will explode one day', but the same factors are causing a mispricing and presents us with a trading opportunity.

KMI-A

  • 9.75% mandatory convertible preferred stock with par value of $50 and a yearly dividend of $4.875 paid quarterly
  • maturity date 26 October 2018
  • conversion rate at maturity is 1.544 shares of KMI for prices above 32.38, 1.8142 for prices lower than 27.56 and a ratio of 50 divided by the price of KMI for prices of the common stock in the range 27.56-32.38 (this is the standard pricing for most of the mandatory convertible issues)
  • a holder can convert his KMI-A for 1.544 shares of KMI at any time
  • the dividends are eligible for preferential tax treatment
  • all the information provided can be found in the prospectus

Valuing KMI-A

KMI-A is currently priced at $47.62. Holders expect to receive 10 quarterly dividends plus a certain amount of shares from the common stock on the mandatory conversion date in 2.5 years time. This seems to be a pretty simple calculation, but there are a few additional considerations.

The chart below shows the most simplified way of calculating the present value of the convertible stock by making the assumption that the price of the common stock is "frozen" until the conversion date:

Click to enlarge

source: author's database.

Comparison with common stock

Click to enlarge

source: author's charts

The only benefit KMI-A has over KMI is if it trades much lower by conversion date. So you may say it is marginally safer i.e. you will lose money, just slightly less of it. In these days of negative yields it isn't quite as crazy as it sounds. Nevertheless, KMI common is the better investment and the disparity offers a trading opportunity.

Anti dilution clauses

Anti-dilution clauses are not supposed to give extra value, but to adjust for any dilution of the common stock. I don't think they have significant effect on this particular idea, but we must do our due diligence. Pages 36-44 of the prospectus detail the adjustments. I can't spot anything that alters my analysis of KMI-A, but if any readers find something in the small print, please let us all know in the comments section.

How I trade it

I am short the convertible stock vs. long the common stock. This is the simplest way of trading this inefficiency.

My target for the trade will be reached when the stock reaches 0% static expectation IRR. This values the KMI-A at nearly $45 (if the common stock does not change the price). I will average this trade if it goes against me as long as there are cheap available shares to borrow. As of 6/9/2016 there were nearly 30 000 shares available to short at a rate of 12%. This is a tiny amount and should be taken into consideration when choosing your position size.

I am sure that the long position in the common stock can be replaced by a long call option plus a short put option with the appropriate ratios, and may initiate such a trade when further analyzing the behavior of my positions. I am adding this position in my arbitrage trading portfolio as per a follower request. I will continue to update this portfolio as I believe contributors should not only publish good ideas, but actionable ones that can be measured.

Risks

  • further widening of the arbitrage - I will try to average my arbitrage position, but this may not be possible
  • buy in on the short position at higher prices that leaves you naked long in the common stock - this is a disastrous scenario, but is not that common
  • a hidden clause in the prospectus that me and my team did not find. As a trader I sometimes have 200 positions in my portfolio and it is really hard to know every single detail for every single position. Readers should not blindly act on the ideas in any article. Please do your own due diligence and make your own conclusions.

Expected payout and timing

As pointed out earlier, I expect around $2.6 profit on every share I am short in KMI-A. To initiate this trade I need to hedge with the common stock or with a derivative instrument of the common stock. My first trade is 1 share short KMI-A for every 1.8 shares long KMI. This makes the expected return on the whole dollar value invested around 3-4%. One can say that this is not such a big deal, but this is a hedge with correlation >95% with no directional risk. You will be hard pressed to find larger deviations in mandatory convertible stocks.

Conclusions

KMI-A holders are over-paying for safety and the illusion of yield. This is symptomatic of the market at large as investors look for security above all else.

KMI-A is simply over-valued and a safe short when hedged with KMI common stock.

Note: The author is a member of the Panick Value Research Report. Members received an advance look at this article. Thanks the guys from the chat room for double checking the ratios.

Disclosure: I am/we are short KMI-A.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long KMI as a hedge