Tuesday 27 January 2015 by Lincoln Tragardh Week in review

From the Trading Desk

This week: Europe takes centre stage; inflation expected to be lower; USD volumes continue to increase as AUD falls; gold and Newcrest Mining rally; new DirectBond Fortescue Metals Group 2017s; and Emeco downgraded by Moody’s.

Economic wrap

Last week Europe took centre stage in financial markets with a number of key news items. The European Central Bank announced a Quantitative Easing program to inject stimulus into the European economy. This €1.1trn asset purchase program commits to the purchase of €60bn per month of government bonds, through to at least the end of September 2016.

In Greece, government elections were held, with anti-austerity party Syriza claiming victory. Market commentators suggested the result would unsettle the Eurozone due to a greater likelihood of Greece exiting the European Union. Markets outside of Greece were however unaffected, suggesting that contagion implications of a Greek financial crisis have been reduced.

In other European news, ratings agency Standard & Poor’s downgraded Russia’s credit rating to BB+ with a negative outlook, citing weaker growth prospects, rising external pressures and increased government support to the economy. Standard & Poor’s downgrade puts Russia into ‘non-investment grade’ territory.

Our currency experienced sharp falls last week after the European Central Bank vowed to keep rates low. The Aussie dollar fell to 78.63 US cents after the announcement, reaching levels we haven’t seen since July 2009. The AUD has since recovered marginally and is currently trading at just over 79 US cents.

Government bond yields finished the week relatively unchanged. The five year fell 2bps in yield to 2.18% while the ten year started and finished the week at 2.63%. Benchmark swap rates had more significant moves, with the five year falling 9bps to 2.57% and the ten year falling 11bps to 2.88%

Later today many of our investors will be anticipating Australian inflation data (CPI). Last quarter year-on-year inflation printed at 2.3%, which marked a decline from the previously strong figure of 3.0%. Markets now expect CPI to come in at 1.8% year on year, which is below the RBA’s target range of 2-3%. Any figure below that target range will give the RBA further motivation to cut the cash rate.

Flows

USD bonds continue to dominate weekly trading activity as investors take advantage of the strengthening USD/falling AUD.

Amongst the top traded bonds were FMG Resources (Fortescue or FMG), Newcrest Mining (NCM) and Virgin (with indicative offer yield to maturity shown for each):

  • FMG 17 – 6.62% (indicative offer yield to maturity)
  • FMG 19 – 10.21%
  • FMG 22 – 10.45%
  • NCM 22 – 4.72%
  • Virgin 19 – 7.47%

With the climb in the gold price over recent weeks, investors have increasingly been buying NCM 22s. The yield to maturity on this bond has rallied from 4.90% to 4.72% in the space of just a week.

In the AUD space, decent volume was seen in the Qantas 2022s which ended the week 6bps tighter at 6.09%.

New USD DirectBond – FMG Resources (August 2006) Pty Ltd 6.00% 1 April 2017 senior unsecured bond

Last week we added the FMG 6.00% 2017 USD bond to the DirectBonds list. The bond is available to wholesale investors only in minimum face value parcel sizes of US$10,000. As highlighted above, it is currently indicatively offered at a yield to maturity of 6.62%. This bond suits investors looking for a shorter dated exposure to Fortescue.

For further details on this bond please click here to see the factsheet (requires login).

Emeco downgraded

Last week Moody’s downgraded Emeco’s credit rating on the bond and the ‘corporate family’ from B2 to B3, and both ratings were placed on negative outlook citing the potential for further rating action. The following reasons were provided by Moody’s for the downgrade:

  • The rating downgrade reflects the continued significant weakness in key commodity prices which is pressuring Emeco's credit profile to a level that is no longer consistent with the previous rating. The steep drop in oil prices is also constraining the outlook on Emeco's Canadian oil sands operations
  • Moody’s expectation is that operating conditions for mining services companies will remain weak through 2016, increasing uncertainty around Emeco's ability to improve earnings and de-lever
  • Prices of coal, copper and iron ore, which are key products for Emeco, are trading at very weak levels due to poor fundamentals, and Moody’s does not expect any material improvement in the near term. Furthermore, Emeco generates about 30% of revenue from oil sands operations in Canada. With the collapse of crude oil prices, there is increased uncertainty around Emeco's ability to extend contracts following the current winter works program and improve earnings in FY16, which was a major underpin for the previous rating
  • The negative outlook reflects these concerns and Moody’s view that there could be risk to the downside with potential contract deferrals and/or cancellations.

Given the sharp falls in oil and copper prices, combined with the observed falls in the market price on Emeco bonds, it is not surprising to see Emeco’s credit rating being further downgraded. The Canadian oil sands and Chilean copper businesses have been Emeco’s shining lights in recent years. We reiterate that credits in the ‘single B’ category carry a very high credit risk, with Emeco now being rated at the bottom end of the single B rating scale by Moody’s with the possibility of further downgrade(s). As an approximate guide, according to historical S&P default tables, the probability of default for B- credits within a 4 year horizon is 24%. For ‘CCC and below’ rated credits, the probability of default in a 4 year window steps up to 44%.

We remain cautious about Emeco’s medium term credit risk profile, and it now seems less likely that a recovery can occur within the next 12-18 months given the falls in oil and copper prices. There have been very limited announcements from the company in recent months, and Emeco is expected to report its 1H15 results on 20 February. The company has already guided that while it expects to achieve a full year EBITDA for FY15 at around a ‘normalised FY14’ figure of ~$80m, the half yearly split of EBITDA will be 30/70. Therefore, we are expecting a 1H15 EBITDA of around $24m. More importantly, we will be looking for commentary from the company around outlook for the oil sands and copper businesses, new contracts / extensions and whether the company has made any inroad into new countries/ventures.

With $30m of cash, $75m available under the asset backed loan and around $40m of assets slated for sale over FY15, it is likely that Emeco has sufficient liquidity to ride out another 12 months. The litmus test will be over FY16 - if oil prices do not recover to the $60-$70 levels needed to keep the oil sands businesses viable, it’s difficult to see Emeco’s Canadian oil sands contracts being renewed into the 2015/16 winter. Generally, mining services contracts can be terminated at the convenience of the miner with little/no recourse to the mining services company. Suncor is Emeco’s single largest Canadian client and has announced major cuts to capital expenditure, but has also mentioned that they will proceed with all their major Canadian oil sands construction projects. While we don’t yet know specifically how and whether the proposed Suncor cuts will flow through to Emeco’s contracts, the risks are skewed towards the downside and provide some guidance on the cost cutting measures going on in the oil sands sector.

We also note that Emeco’s debt is now very covenant light. The asset backed loan has no maintenance covenants until 50% of the facility is drawn, and after that Emeco would need to meet an interest cover ratio of 1.25x and gearing of 65%, which are relatively weak tests. As a guide, Emeco’s FY14 interest cover ratio was 3.0x. Therefore, despite Emeco’s weak earnings outlook, the default triggers in the debt documentation are now much lighter following the refinancing of the revolving credit facility. This means a longer period of time before a default can be called (and hence more coupon income in the meantime).

The market for second-hand mining equipment has faced continued oversupply which has driven the prices of second hand yellow goods even lower. According to a recent publication by E&Y in relation to second hand mining equipment, ‘yellow goods’ values as a percentage of replacement cost are between 20%-45% depending on the hours the kit has been worked – we note however that these percentages would be higher when expressed against written down value. We expect that in a default/liquidation scenario, recovery on the bonds would more likely be closer to 50c in the dollar but we will update this view following the 1H15 results release.

In terms of options, bondholders could consider selling some Emeco now and de-risk if they think the credit risk is too great, or see how the 1H15 results look (and get some more visibility on the impact of the oil price on their business) before making a decision. The next coupon payment is due in March, which we expect the company can pay based on its available liquidity. It's also worth considering that secondary market liquidity is more limited in the Emeco bonds at the moment than say six months ago, so to the extent possible it would be easier to de-risk in smaller parcels than trying to sell a larger parcel at once if an investor decides to reduce their exposure. Alternatively, investors may continue to be comfortable holding onto the bonds given the 40 year history of the company, the very high coupon and US dollar exposure, and the company’s ability to generate additional cash to repay debt through selling assets and reducing capital expenditure. In addition, while the credit outlook for Emeco is negative, we note that Emeco was recently able to renegotiate a $75m asset backed loan with lighter covenants. The ability to raise new debt with lighter covenants/more flexibility would have been unlikely had the incoming financiers thought Emeco was risk of imminent default.

The Emeco Pty Ltd 9.875% USD senior secured bonds with a maturity date of 15 March 2019 are available to wholesale investors only in minimum face value parcels of USD 200,000. The bonds continue to exhibit very patchy trading around the “low $70s” however investors should consult their FIIG representative for updated pricing if they wish to trade.

All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities. For more information, please call your FIIG representative.