That’s One Ugly Convertible

The energy sector has been a market laggard for years, but it never seems to run out of investment propositions that are too good to last, nor of investors who buy them regardless.

Last week, I discussed a midstream infrastructure fund with a crazy high yield and tax issues that will bite its owners sometime in the future.

This week, it’s the turn of another double-digit energy midstream yield. Only this one has a clear sell-by date.

In October 2015 energy pipeline giant Kinder Morgan (KMI) marketed a mandatory convertible preferred issue to raise badly needed capital. One of its subsidiaries was facing  a credit downgrade, it already had too much debt on its books and it didn’t want to issue more common equity. In retrospect, given what its shares fetched then and what they’re worth now, it would have been wise to do so.

Instead, Kinder raised $1.6 billion from preferred shares yielding 9.75% annually at face value. On Oct. 26, 2018 these Series A securities (KMI.PRA) will convert into KMI common stock. The kicker is that the conversion price will be at least $27.56 per KMI common share, equivalent to where the common traded when the convertibles were issued but 34% above the recent price of $20.48 for the KMI common.

Which means that, barring appreciation in excess of 34% over the next 15 months, that $50 face value of the convertible preferred will turn into 1.8 common shares. At KMI’s recent share price that would be worth $37. Add in the $6.09 in preferred dividends still to be paid, and you only get to $43 or so, still less than the preferred issue’s current price of $43.73. People buying at this price are getting full exposure to the downside of KMI’s common stock but only partial exposure to the upside, given the currently unfavorable conversion ratio.

The bottom line here is that income investors can’t afford to be dazzled by a shiny yield with strings attached. If you’re a bull on Kinder Morgan’s prospects relative to those of other pipeline operators, you’re much better off buying its common stock.

Me, I’ll stick with a much smaller midstream MLP currently yielding 12.5% and with a realistic shot at lowering that number dramatically through capital appreciation. It’s a risky investment, of course. But the upside isn’t capped the way it is with the KMI preferred.

For more on this and other promising income investments, join us at Income Millionaire.