When bonds have non standard features like step up coupons, a positive corporate performance can actually reduce returns to bondholders
Alumina Ltd (ASX:AWC) is a pure play aluminium company with global operations through a 40% ownership in Alcoa World Alumina & Chemicals (AWAC) – a joint venture with Alcoa Corporation (NYSE:AA). Alumina has no other business activities and is effectively a holding company for the stake in AWAC. However counterparty risk to Alcoa is also factored into Alumina’s credit rating.
AWAC is among the largest and lowest cost producer in both bauxite mining and alumina refining[1] with global operations. Put very simply, bauxite is the raw, mined material that is then refined to alumina (aluminium oxide). Alumina is smelted into aluminium ingots. AWAC’s activities involve the earlier steps in the aluminium value chain.
Unsurprisingly, AWAC’s performance is closely linked to the prices of alumina and aluminium. In both cases, these have been exceedingly strong at USD405/t and USD2,143/t at time of writing. Standard & Poor’s most recent credit analysis on Alcoa[2] assumes an aluminium price of USD1,800/t and an alumina price of 20-22% of that through to 2019. Goldman Sachs’ analysis predicts that alumina prices above USD400/t are not sustainable, and that the average price over the last seven years of USD320/t is “a reasonable level for the medium term forecasts”.[3]
The forecasts available to us from a wide range of equity and credit analysts are largely above S&P’s and a significant proportion (including the ratings agency’s) have been revised higher.
| Unit | 2016 | 2017 f | 2018 f | 2019 f |
| Aluminium spot | US$/t | 1,604 | 1,995 | 1,957 | 1,766 |
| Alumina spot | US$/t | 253.2 | 324.3 | 322.2 | 304.7 |
Source: Office of the Chief Economist, Australian Government[4]
AWAC’s cost position has improved over recent years as a result of the closure of more expensive assets[5] and an increase in competitors’ costs. In addition to the primary benefits, this rationalisation in combination with a reduction in growth capex has led to a significant decrease in contributions from JV partners Alumina and Alcoa to AWAC. Total contributions over the past decade have totalled almost USD6bn of which some USD2.5bn came from Alumina. During reporting season, it was reported that Alumina management saw contributions to AWAC going to zero for so long as alumina prices stay above USD300/t.
As an effective holding company, free cash flow for Alumina improves with the lower contributions to and the receipt of higher dividends from AWAC. This has been borne out in recent results. Alumina’s half year report to 30 June 2017 shows USD300m of committed bank facilities from which USD15m is drawn, in addition to AUD125m of fixed rate notes
[6] which is very manageable.
In April, S&P released their most recent update on Alumina. Although the agency highlighted the modest level of leverage and the low likelihood of significant debt at the AWAC level, they did note that the exposure to Alcoa was key in limiting the credit rating. Indeed, S&P stated that “Upward movement in the rating would most likely occur from an improvement in the creditworthiness of the joint-venture partner Alcoa Corp”.[7]
Setting aside the aforementioned improvements in Alumina’s business position since this update which will be credit positive, S&P has also updated their research on Alcoa. As part of this June update, the outlook for Alcoa was revised to ‘Positive’ from ‘Stable’ – an indication that the rating may be raised. S&P commented that improved credit metrics could result in an upgrade “in the next year” and that aluminium prices above their current assumption of USD1,800/t “could accelerate the improvement in credit measures if sustained”. [8]
Alumina’s fixed rate bonds maturing in 2019 feature coupons that are linked to the credit rating of the issue (Factsheet here). The original 5.5% coupon was contingent on maintenance of an investment grade rating, and increased to 7.25% when the rating fell from BBB- to BB in September 2016. The rating was then upgraded to BB+ in April 2017 and as a result, the coupon fell to 6.75%.
A fixed rate bond without coupon step up features will generally increase in yield and fall in price as a result of a ratings downgrade. In this case however, the higher coupon offsets the higher yield and the relationship with price does not necessarily hold. Reactions highlighted in the graph below were based on small volumes and more indicative of a kneejerk reaction.
Yield and price in response to credit rating changes
Source: FIIG Securities, Bloomberg
Figure 1 Alumina’s 2019 bonds now have two years until the final legal maturity and 18 months until the first possible redemption at $100. As such, as time moves on, they must track towards $100 face value. In our view, this is unlikely to occur on a straight line basis, but would accelerate with an increase in credit rating as a result of the significant change in yield to worst. Figure 2 details the difference in return based on a call at the first opportunity, current bid pricing, and a ratings upgrade within each coupon period.
Source: FIIG Securities
Figure 2
Clearly, holders of Alumina need to consider their outlook for key commodities and for the credit, as well as consider how the price will react to unusual terms and conditions. Counterintuitively, the better they think the credit is (and therefore the sooner it returns to investment grade), the worse the bonds look on a relative value basis. Indeed, it could be argued that the expectation of any upgrade at all makes the bonds very expensive.
Holders should not expect to be able to sell the bonds whenever they wish, or to be able to take advantage of kneejerk pricing. Liquidity is typically a function of credit rating and issue size, and as a $125m sub investment grade issue, the Alumina 2019 is not widely traded. Holders should speak to their relationship manager regarding their position and at the very least have a discussion about whether or not better options are available.
Bibliography
Alumina Ltd, 2017. 2017 Half-Year Result. [Online].
Alumina Ltd, 2017. Alumina Ltd Presentation, BAML Global Metals, Mining & Steel Conference. [Online]
Available at: https://www.aluminalimited.com/database-files/view-file/?id=9043
Goldman Sachs Australia Pty Ltd, 2017. Alumina: 3 D O L L A R. [Online].
Office of the Chief Economist, 2017. Resources and Energy Quarterly, September 2017. [Online]
Available at: https://www.industry.gov.au/Office-of-the-Chief-Economist/Publications/ResourcesandEnergyQuarterlySeptember2017/index.html
S&P Global Ratings, 2017. Alcoa Corp. Outlook Revised To Positive From Stable; 'BB-' Corporate Credit Rating Affirmed. [Online].
S&P Global Ratings, 2017. Alumina Ltd. [Online].
[2] (S&P Global Ratings, 2017)
[3] (Goldman Sachs Australia Pty Ltd, 2017)
[4] (Office of the Chief Economist, 2017)
[5] (Goldman Sachs Australia Pty Ltd, 2017)
[7] (S&P Global Ratings, 2017)
[8] (S&P Global Ratings, 2017)
[1] (Goldman Sachs Australia Pty Ltd, 2017)
[1] (Goldman Sachs Australia Pty Ltd, 2017)