by
Alen Golubovic | Dec 09, 2014
The high yield bond market, which represents bonds with sub-investment grade credit ratings, is an increasingly prominent sector for FIIG investors who are seeking high-yielding fixed income investments. The volatility in the high yield bond market has been pronounced in recent months, particularly for bonds in the mining sector.
Some of the US dollar high yield bonds available to FIIG investors are in the commodities/resources sector. Spreads on US dollar high yield bonds in this sector are very sensitive to movements in the price of the commodities underpinning the operations of the companies that issued the bonds. A very recent and notable example of this has been the impact on credit spreads on US dollar bonds in the energy sector as a result of the fall in oil price. Since the fall in the oil price began in June 2014, the US high yield energy bond index, which represents the average credit spread of high yield bonds in the energy sector, has doubled (from about 400 basis points to 800 basis points), which is an almost ‘equity like’ movement in value in response to the commodity price falls.
One way to combat volatility is to think about investing in companies that benefit from falling commodity prices. For example, investing in a combination of airline bonds, such as Qantas and Virgin, and resources bonds. The airlines’ earnings and credit profile improve with the weaker oil price, offsetting the impact on the resources bonds from a falling iron ore and gold price.
Overall when considering an allocation to high yield bonds we recommend that high yield bond exposure is diversified across different sectors, which will go some way to ‘smoothing out’ the unwanted capital price fluctuations, while still providing the high running yield which investors are seeking.
Recent performance in Emeco and Ausdrill
High risk Ausdrill and Emeco bonds have recently suffered price falls. The observed price falls have been large in the context of what might be considered typical for a bond, and have been driven by a variety of factors:
- Falling commodity prices impacting the creditworthiness and investor sentiment in the mining services sector
- Poor earnings results, earnings downgrades and loss of contracts for both of these companies
- More active trading in the US dollar bond market as well as block sale trades from large institutional bondholders
The chart below shows that the declines in the price of these companies’ bonds have been driven to some extent by the falls in the price of the key commodities underpinning these companies’ operations – iron ore and gold.
However, despite the capital price falls in Ausdrill and Emeco, bondholders’ total returns have been buffered by the high coupons and the currency devaluation over this period.
Since the beginning of September, the Australian dollar has weakened by over 10% which has gone a long way to offsetting the impacts of the falls in bond prices. In addition, when allowing for the high running yield on the bonds, many investors would have an overall positive return on the bond investment when expressed in Australian dollars. The table below looks at indicative total bond versus equity performance based on a 1 July investment date. The total bond performance on both of these names has actually been positive after adjusting for currency, and in both cases the bonds have significantly outperformed the equity return over the same period. Notably in the case of Ausdrill, the bonds have returned 2.9% overall in Australian dollars over this period versus a 49.1% drop in the equity price over the same period.
Emeco and Ausdrill are both considered to be at the ‘very high risk’ end of the credit spectrum, suiting investors who are comfortable with high risk in return for the high yield on offer, which has been a consistent message in relation to these credits. The falls in their bond prices have been related to the falls in the value of the underlying commodities in which they operate – iron ore and gold.
We continue to believe that Ausdrill is a stronger credit than Emeco. However, both companies are experiencing the impacts of a downturn in the mining cycle, which have had a negative impact on the earnings and creditworthiness of these names. Conditions in the mining services sector are expected to remain tough for at least the next 12-18 months. In addition to its weak domestic business, Emeco’s Canadian business, in particular, is exposed to the weakening in the oil price.
In relation to these bonds, you need to decide whether you are in for the long haul, or prepare to exit if you believe the probability of default has become too high given the conditions facing the sector. Emeco is currently rated B+/B2 with a stable outlook and Ausdrill is rated BB-/Ba3 with a negative outlook. Based on historical default rates, a B+ rating implies a 16% probability of default over the next five years, while a BB- rating implies a 10.3% probability of default. Note that these default probabilities are based on historical data across a range of sectors, and future outcomes may differ from historical data.
Note that in continuing to hold either Emeco or Ausdrill, you are being paid a high running yield as compensation for the weak credit rating, as well as having exposure to currency fluctuations. If the Australian dollar continues to weaken, this will also improve the future income returns on these bonds. In the event of a default and wind up scenario, it is expected that Emeco would have a higher recovery percentage than Ausdrill. This is because the Emeco bond is senior secured while the Ausdrill bond is senior unsecured. Recovery rates, however, are likely to be impacted by the low point in the mining cycle.
In continuing to maintain exposure to the mining services sector, one additional mitigating factor to note is the possibility of external capital support should either company face severe financial distress. We have seen this in the case of Boart Longyear, another Australian mining services company. Boart Longyear was recently recapitalised through a combination of debt and equity from a private equity firm. While shareholder returns were heavily impacted by the private equity deal, existing bondholders benefited from the additional liquidity injected into the company. This shows that there is the possibility of external support for companies that are facing financial distress in a downturn in the cycle, and Emeco and Ausdrill are both businesses with a relatively long operating history.
If you choose to sell the bonds at this point in time, note that increased illiquidity may mean it takes some time to liquidate your position. During that period of time the actual sale price may fall further and there may be a resultant loss on the bonds.
The risks in the mining services sector are currently skewed to the downside given the recent spate of earnings downgrades and falling commodity prices, and we remain cautious on the outlook for this sector. We will continue to monitor these credits closely, particularly if continued ‘bad news’ such as earnings downgrades, weaker than expected earnings results, further commodity price falls or loss of contracts emerges. In the absence of any earlier updates, the next announcements from both companies will be their half yearly results for 1H15, which are due to be released in February.
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