Tuesday 19 November 2013 by Week in review

From the Trading Desk – Break even analysis on Sydney Airport capital indexed bonds shows great value

Market commentary

By far the best value bond at the moment is the Sydney Airport 2020 and 2030 capital indexed bonds. The 2020 bond is currently offered at CPI+4.15% and the 2030 is offered at CPI+4.65%, translating into estimated yields around 6.65% and 7.15% respectively (assuming an average 2.50% inflation rate until maturity of the bonds).

A couple of weeks ago I wrote suggesting that certain bonds issued by Morgan Stanley, ING Bank, and AMP Bank appeared overvalued (see Sell FinancialsExternal link - opens in a new window). Since then the AMP bond has backed off around 10-15 basis points after the issuer announced a new subordinated debt offering at a much higher margin of 265 basis points over BBSW, but the ING Bank and Morgan Stanley bonds are still well bid, even after a negative ratings move on Morgan Stanley by ratings agency Moody’s Investor Services. We still view these bonds as overvalued and recommend investors switch into alternative fixed income assets.

Sydney Airport break even analysis

Key points:

Sydney Airport capital indexed bonds offer outstanding value as a result of market uncertainty regarding inflation.

Best and worst cases for inflation still result in attractive returns on these bonds.

Breakeven yields are far beyond levels ever seen.

I’m not normally one to repeat myself unnecessarily; however, as I pondered ideas for this week it became clear that my chosen topic is the confluence of two recent articles. In September I discussed the recent underperformance of Sydney Airport capital indexed bonds as a result of anticipated changes to economic policy in the US (see Sydney Airport recent price performanceExternal link - opens in a new window). Then in October I wrote about how high-yielding bonds bear up under adverse market conditions due to the income on the investments (see High yield bonds fare well in stress testsExternal link - opens in a new window).

Inflation linked bond prices continue to be dragged down by global inflation uncertainty in the market, and the Sydney Airport bonds are no exception (see Figure 1). I will use the bond maturing in 2030 in my analysis in this article, but both the 2020 and the 2030 bonds represent very good value.

sydney airport cap indexed bond

Source: Bloomberg/ FIIG Securities

Figure 1

The nervousness in the market concerning global inflation notwithstanding, the Reserve Bank of Australia has done a reasonably good job keeping the local inflation rate contained within a band of 2% to 3% historically, with the risk weighted toward the high side rather than the low side of the band (see Figure 2).

australian cpi all goods component

Source: Bloomberg/ FIIG Securities

Figure 2

In Table 1 below, we examine theoretical internal rates of return (IRR) on the Sydney Airport 2030, using high and low assumptions for Australian inflation over the next year of 50 basis points outside the RBA band (i.e. 1.50% and 3.50%). In each case, the bond is valued out of the forward date at the same level for which it is available today (CPP+4.65%). The best and worst case IRR on the investment under these scenarios is 6.74% and 8.34% respectively.

sydney airport 1 year cash flow and irr

Table 1

If we use the same assumptions over two and three years, the worst/best case IRRs are 6.53% / 8.39% (two years) and 6.45% / 8.40% (three years).

However, this is only the first part of our analysis. The purpose of this article is to highlight how far from here yield must drift to reach a breakeven level (the level where your IRR turns negative) after one, two, and three years. As shown in Table 2 below, these levels in the high and low inflation scenarios are 5.21% (56 basis points higher) and 5.33% (68 basis points higher).

sydney airport breakeven yield

Table 2

Again, using the same assumptions over two and three years, we find the worst/best case breakeven yields are CPI+5.81% / CPI+6.13% (two years) and CPI+6.51% / CPI+7.07% (three years). Given that the highest real yield I have ever seen since I began watching this security was CPI+5.85% back in August 2011, it seems unlikely that a three-year breakeven point will be reached under normal circumstances.

My conclusion and message to clients is two-fold. If you are a holder of these bonds, be patient and you will be rewarded. If you are not a holder, then you should give serious consideration to adding them to your portfolio.

Key terms

Capital indexed bonds (CIB)

A bond whose base payment rises and falls with the CPI.

Real Yield

The margin over CPI yielded by a security, normally quoted in quarterly terms.

Internal rate of return (IRR)

The discount rate that makes the net present value of all cash flows from a particular project equal to zero. The formula for calculating IRR is an iterative one, where a rate is sought that satisfies the following formula:

internal rate of return formula

where:

Pi = the ith payment

Di = the ith payment date

D1 = the first payment date

Disclaimer

The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or  distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not provide tax advice and is not a registered tax agent or tax (financial) advisor, nor are any of FIIG’s staff or authorised representatives. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.