Australians’ reliance on the mining boom has come back to haunt most investors over the past few years. Even BHP has seen a 50% fall in its share price since 2011. But not all investors have lost money. Smart income investors, in this case those that have invested in the USD denominated corporate bonds of our mining sector, have profited from the slide in world commodity prices, and earned a healthy income along the way
Two examples are Newcrest 2041 and Fortescue 2019 bonds.
Newcrest Mining Limited - Equity returns of -65% versus USD bond returns of +51% since 2011
Newcrest’s share price has fallen 65% since 2011, mostly because of the fall in the price of gold (down 33% in the same time). The company has shed costs, changed management and now stabilised, but for shareholders it has been a volatile and expensive lesson.
FIIG’s clients have had the opportunity to invest directly in US Dollar denominated corporate bonds across that period, and many have recently invested in Newcrest’s bonds.
The result: Australian investors in these bonds have seen a 28% rise in value over a four year period, and have earned 6.8% per annum in income. The AUD fall against the USD has delivered a 26% gain in the value of the USD bond plus there has been a small 2% increase in the USD priced bond itself. The 6.8% pa income has come from Newcrest’s legal obligations to pay all bondholders a semi-annual interest payment.
So for the same underlying company, an investment of $100,000 into the shares would have produced $35,341 four years later, while an investment into the USD bonds would have produced $150,983. This extraordinary difference shows the value of choosing between equities and corporate debt at different stages of the cycle; when markets are more bullish on a particular sector, choose the equities, but when the bears come out, choose the bonds.
This example however really highlights the unique hedge strategy available to Australian investors when they choose USD denominated bonds in the mining sector. Instead of falling in value along with much of the Australian economy, the USD exposure and lower risk of the bonds creates a profitable investment rather than the highly volatile shares in a downturn.
Fortescue Metals Group Limited - Equity returns of -40% in 2015 versus USD bond returns of +9%
Gold has been one of the least impacted commodities in this downturn. Iron ore on the other hand has had a dramatic fall in price, particularly in 2015. Fortescue’s main product is iron ore. FMG’s shares are down more than 40% so far this year, but investors in their 2019 US Dollar bonds are up around 9%. Much with the same as Newcrest, this counter-intuitive outcome is explained simply:
- Commodity prices have fallen steeply in response to weak global economic growth and in particular the slowdown in China.
- This includes iron ore, FMG’s main product. The result has been a 41% fall in the share price, and a fall in FMG’s bond prices - the 2019 Bonds are down 15%.
- Lower commodity prices means a lower AUD, and so the value of the USD in Australian Dollars has risen 17% since the start of 2015.
- This means that an Australian investing in the FMG USD bonds has had the fall in the bond price offset by currency gains.
- So once income is included, the bond investor is up 9% in nine months.
Why does this strategy work?
Because of the tendency of the AUD to fall when commodity prices fall, investing in USD denominated bonds from the resources sector has a natural hedge built in for the following reasons:
1. Profit from lower commodity prices
As much of our export revenue is from the sale of commodities, lower commodity prices push the AUD down against the USD. So investing in resource company bonds, denominated in USD creates a natural hedge. If commodity prices fall, the price of the bond in USD will fall, but the value to an Australian investor, is that the rising USD will offset losses. This is illustrated in the chart using the more volatile FMG 2019s as an example.
2. Profit from weakening global economy
The weaker global economy that is typically the cause of lower commodity prices also lowers global interest rates. The lower interest rates fall, the higher fixed rate bonds rise in price. As opposed to investing in shares where a weaker economic outlook is typically only bad news, fixed rate bond investors profit from a weaker outlook.
3. Lower risk
Because bonds are an legal obligation and “rank” higher than shares, the bonds of a company are by definition lower risk than the shares, so switching from equities to bonds will lower overall risk.
4. Increase income
Many resource companies pay no dividends and those that do are either low or likely to be reduced as commodity prices fall. Corporate bonds of some of Australia’s largest resource companies pay between 3% pa and 10% pa.
5. Lower volatility
Bond prices have less than half the volatility of share prices of the same company. For example, FMG 2019 bonds have had 50% of the volatility of FMG shares; Newcrest bonds have had 43% of the volatility of their shares and CBA bonds have had just 13% of the volatility of CBA’s shares this year.
In the chart below we show the results of analysis comparing Fortescue’s equities and bonds. The shape of the chart looks much the same if we were to use Newcrest, or any other mining company for that matter.
Australian SMSF investors still have around $8 billion directly invested into Fortescue shares and as much as $30 billion in mining stocks in general. The horse may have bolted, but if the global economy still has some downside risk to come (which we believe it does), shifting some of this allocation to USD denominated bonds in either of the miners or other corporates, providers a strong hedge.