National Rural Utilities Cooperative Finance Corp. - A New Baby Bond IPOs, But Is It Good Enough?

Summary

Overview of National Rural Utilities Cooperative Finance Corp.'s new baby bond - NRUC.

Brief look at the company.

Comparison to the other baby bonds issued by an electric utility company.

Comparison with all other baby bonds that pay a fixed rate and have a maturity of between 40 and 50 years and all investment-grade ones.

How does the yield curve look?

Introduction

Our goal is to present to you our IPO analysis for every new fixed income security that enters the market and to find out if there is any trading potential. In this article, we want to shed light on the newest Baby Bond issued by National Rural Utilities Cooperative Finance Corp. (NYSE:NRUC) (a private company). Even though the product may not be of interest to us and our financial objectives, it definitely is worth taking a look at.

The New Issue

Before we submerge into our brief analysis, here is a link to the 424B5 Filing by National Rural Utilities Coop Finance Corp. - the prospectus.

Source: SEC.gov

For a total of 10M notes issued, the total gross proceeds to the company are $250M. You can find some relevant information about the new baby bond in the table below:

Source: Author's spreadsheet

National Rural Utilities Cooperative Finance Corp. 5.50% Subordinated Notes 5/15/2064 pays a fixed interest at a rate of 5.50%. The new issue bears a 'BBB+' Standard & Poor's rating, is callable as of 05/15/2024, and is maturing on 05/15/2064. NRUC is currently trading well above its par value at a price of $26.15 and has a 4.46% Yield-to-Call and a 5.23% Yield-to-Maturity. The interest paid by this baby bond is not eligible for the preferential 15% to 20% tax rate. This results in the "qualified equivalent" YTC and YTM sitting around 3.71% and 4.36%, respectively.

Here is the product's Yield-to-Call curve:

Source: Author's spreadsheet

The Company

National Rural Utilities Cooperative Finance Corporation (shortly CFC) is a member-owned cooperative association incorporated under the laws of the District of Columbia in April 1969. CFC's principal purpose is to provide its members with financing to supplement the loan programs of the Rural Utilities Service of the United States Department of Agriculture. CFC makes loans to its rural electric members so they can acquire, construct and operate electric distribution, generation and transmission ("power supply") systems and related facilities. CFC also provides its members with credit enhancements in the form of letters of credit and guarantees of debt obligations. As a cooperative, CFC is owned by and exclusively serves its membership, which consists of not-for-profit entities or subsidiaries or affiliates of not-for-profit entities. CFC is exempt from federal income taxes under Section 501(NYSE:C)(4) of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"). As a member-owned cooperative, CFC's objective is not to maximize profit, but rather to offer its members cost-based financial products and services consistent with sound financial management. CFC annually allocates its net earnings, which consists of net income excluding the effect of certain non-cash accounting entries, to (NYSE:I) a cooperative education fund; (II) a general reserve, if necessary; (NASDAQ:III) members based on each member's patronage of CFC's loan programs during the year; and (iv) a members' capital reserve. As a Section 501(C)(4) tax-exempt, member-owned cooperative, CFC cannot issue equity securities. CFC funds its activities primarily through a combination of publicly and privately held debt securities and member investments. The Company's headquarters are located at 20701 Cooperative Way, Dulles, VA 20166 and its telephone number is (703) 467-1800.

Source: 424B5 Filing by National Rural Utilities Coop Finance Corp

CFC's two affiliate organizations, the National Cooperative Services Corporation (NCSC) and the Rural Telephone Finance Cooperative (RTFC), are privately funded, member-owned cooperatives that provide specialized financing services to supplement those of CFC.

Despite the company is private, take a look at their capital structure credit ratings:

Source: 10-Q Filing | Quarterly Report (Q3)

And the Balance sheet:

Source: 10-Q Filing | Quarterly Report (Q3)

What we can almost immediately see is the high Debt-to-Equity ratio and the 16 times more debt than the equity. It must be said that this debt is backed up by the loan programs of the Rural Utilities Service of the United States Department of Agriculture.

The "CFC" Corporate Bonds

There are plenty of corporate bonds, issued by the company. Take a look at only a small part of them:

Source: FINRA

The bond with the closest maturity to the maturity date of the newly issued 2064 Subordinated Notes, is the 2049 Corporate bond, NRX4792611 (as it is the symbol in FINRA). Some information about the bond could be found in the table below.

Source: FINRA | NRX4792611

NRX4792611 is rated an 'A' from the S&P and has a Yield-to-Maturity of 3.747%. This should be compared to the 5.23% Yield-to-Maturity of the newly issued baby bond which is the maximum you could realize if you hold the baby bond until 2064. This results in a yield spread of around 1.5% between the two securities, that in my opinion is insufficient for the 15 years difference in the term. On the one hand, we have the corporate bond, that is higher in the capital structure, also has higher investment grade rating, and matures 15 years earlier. On the other hand, the company has the right to make an early call on its 2064 baby bond after 5 years and it exercises the redemption, the holders of NRUC will receive their Yield-to-Worst of 4.36%. My opinion is that at this point, the bond has increased significantly (trading at 5% premium) and the return one can get does not look very appetizing, despite the future expectation of lowering the Federal Funds Rate.

Sector Comparison

This section contains all baby bonds that pay a fixed interest rate in the 'Electric Utilities' sector (according to Finviz.com). The issues must also be with positive Yield-to-Call. It is important to take note that none of these and baby bonds are eligible for the preferential federal tax rate.

  • By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

The higher the YTM is, the better the bond is, and in this case, as they all are trading close to and above their par value, it is actually their Yield-to-Best. Yet, another clarification I want to do, all securities bear an investment grade rating by S&P.

  • Now, if we add their Yield-to-Call the chart, this is what we get:

Source: Author's database

The YTC is the Yield-to-Worst of the group. After that, let's see how the Yield curve looks like:

  • Years-to-Call and Yield-to-Call

Source: Author's database

  • Here is some more information about all issues:

Source: Author's database

Fixed-Rated Baby Bonds

Now, I want to make a comparison between the new IPO and all other baby bonds that pay a fixed interest, have a maturity date of between 40 to 50 years and also have a positive Yield-to-Call.

  • By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

  • By Yield-to-Call and Yield-to-Maturity. For a better idea, ELU and TDA are excluded from the second chart, because of their 25% and 88% YTC.

Source: Author's database

The picture above is repeated here as well. NRUC is located at the bottom of the charts which means it has comparatively low yields against the rest baby bonds. The differences here is that the highest yielding securities are rated below-investment grade.

Investment-Grade Rated Baby Bonds

The last charts contain all baby bonds that pay a fixed interest, have a positive Yield-to-Call and carry an investment grade S&P rating.

  • By Years-to-Maturity and Yield-to-Maturity

Source: Author's database

  • By Yield-to-Call and Yield-to-Maturity

Source: Author's database

  • The last one includes two more filters: excludes all callable issues and all that are currently below their par value. Again, what we see is the Yield curve of the investment grade baby bonds:

Source: Author's database

Special Considerations

In addition, we may redeem the Notes at our option, before May 15, 2024, in whole but not in part, at any time within 90 days, if certain changes in tax laws, regulations or interpretations occur, at a redemption price equal to 100% of the principal amount of the Notes, plus accrued and unpaid interest, if any, thereon to, but not including, the redemption date.

We may also redeem the Notes at our option, before May 15, 2024, in whole but not in part, at any time within 90 days, if a rating agency makes certain changes in the equity credit criteria for securities such as the Notes. In this event, the redemption price will be equal to 102% of the principal amount of the Notes, plus accrued and unpaid interest, if any, thereon to, but not including, the redemption date.

Source: 424B5 Filing by National Rural Utilities Coop Finance Corp

Use of Proceeds

We expect to receive proceeds, after deducting the underwriting discounts and other offering expenses payable by us, of approximately $243.5 million. The proceeds will be used by us for general corporate purposes.

Source: 424B5 Filing by National Rural Utilities Coop Finance Corp

iShares Preferred and Income Securities ETF

The main benchmark, PFF, which is the ETF that seeks to track the investment results of the S&P US Preferred Stock iShares Index, is in progress of changing its investment objective. The fund is expected to change the underlying index, passing through a Transition index ("ICE Exchange-Listed Preferred & Hybrid Securities Transition Index") during the period from February 1, 2019, to October 31, 2019, and after that will track the "ICE Exchange-Listed Preferred & Hybrid Securities Index". Since the requirements for an addition of the New Index are much likely the same as the old one (with the difference that the New Index will also include notes), which is why NRUC is now a part of the PFF holdings. This is important to us due to its influence on the behavior of all fixed-income securities. I'll just remind you about the last-year rally in the fixed-income borne from the redemption of the two "giants" HSEA and HSEB and the released cash of over $600M dollars used from PFF to buy more of the rest of its holdings.

Conclusion

As fixed-income traders, we follow every one preferred stock or baby bond, which is listed on the stock exchange. As such, NRUC is no exception, and the homework we always do we share it with the public. It is not necessary for the IPO to be an arbitrage and a bargain but in many cases, the new security happens to be better than the ones already trading on the market.

The high premium on which the new IPO is trading, which automatically translates into low Yield-to-Call (its YTW) and low YTM, does not make the bond competitive with the others "babies" in the sector, or the investment grade ones. The fact we do not intend to open position in NRUC does not mean we will stop monitoring it. At this point, I recommend waiting for better entry points.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.