Tuesday 01 April 2014 by FIIG Securities FIIG Securities Opinion

Credit ratings impact cost of funding

A US bond insurer, Assured Guaranty recently had its credit rating upgraded leading to positive news for two Australian entities: Envestra and MPC which issue bonds insured or "wrapped" by Assured Guaranty.

Key points:

  1. Recently, a large US based insurer, Assured Guaranty Ltd Group had its credit rating upgraded by Standard and Poor’s.
  2. Assured Guaranty provides a “wrap” or insurance for bonds. Two Australian entities that issue bonds wrapped by Assured Guaranty are: Envestra, the monopoly gas distributor and MPC Funding limited, the funding arm for the project to develop the Melbourne Convention Centre.
  3. We believe the market currently provides limited value to the enhancement provided by the wrap, providing an opportunity to investors.

Investors worldwide, use credit ratings to help gauge risk. The main credit rating agencies, Standard and Poor’s, Moodys and Fitch influence financial markets. A change in credit rating; either up or down will impact the future cost of raising funds for the company (or government) and that’s why companies work hard at improving or retaining an existing credit rating.

The most common reference to ratings in Australia is to Standard and Poor’s. Their model uses AAA as the highest credit rating to BBB- as the lowest investment grade rating, then the scale goes to sub investment grade BB+, all the way down to D, the lowest rating which means “in default”. The scale includes pluses and minuses in the AA, A, BBB, BB, single B, CCC ranges. The CC, single C and D categories are stand alone. The theory being, the higher the credit rating, the lower the cost of funding. Credit ratings are useful indicators of perceived risk for investors but should not be relied upon and used as the sole source of an investment decision.

Recently, a large US based insurer, Assured Guaranty Ltd Group had its credit rating upgraded by Standard and Poor’s. I’m not allowed to disclose that rating to retail clients (an injustice in my opinion), suffice to say the rating is very high, implying low risk and a low chance of default.

The financial guaranty business is effectively a provider of insurance for bond holders, known as “credit wrapping”. So, if the company issuing the bond at any point was unable to repay interest or principal, the insurer would step in and make the repayments on the company’s behalf. As the insurer is ultimately responsible for repayment of the bond, the bond then is priced based on the insurer’s credit rating.

In return for this insurance, the bond issuers pay a fee to the guarantor, and for this fee, achieve a lower cost of funding (as they use the insurers rating which would be higher than the rating of the issuing company).

Theoretically, any bonds “wrapped” by Assured Guaranty Ltd Group, should increase in price to reflect the new, higher credit rating and the lower perceived risk.

Two Australian entities that issue bonds wrapped by Assured Guaranty are: Envestra, the monopoly gas distributor and MPC Funding limited, the funding arm for the project to develop the Melbourne Convention Centre. One of the strengths of the MPC bonds is that 98% of revenues come in the form of a quarterly payment from the State of Victoria.

Envestra has issued an August 2025 inflation linked bond which is wrapped by Assured Guaranty. Each quarter the value of the bond increases, assuming inflation remains positive. At maturity investors are repaid a lump sum. While I am confident in Envestra’s ability to repay interest and principal, the insurance provides additional comfort. The projected yield to maturity on this bond is 5.87 per cent (inflation is projected at the Reserve Bank target mid-point of 2.5 per cent).

MPC has two bonds wrapped by Assured Guaranty, one maturing in December 2025, the other December 2033. Like Envestra, both are inflation linked but these bonds work differently to the Envestra bonds. Investors pay a lump sum up front and MPC returns principal and interest quarterly, so there is no lump sum at maturity. The projected yield to maturity, assuming 2.5 per cent inflation, is 5.31 per cent and 6.02 per cent respectively.

We believe the market currently provides limited value to the enhancement provided by the wrap, providing an opportunity to investors.

The Envestra bond is available to retail and wholesale investors, while MPC is wholesale only. These bonds are available through bond brokers from $10,000 (minimum $50,000 in total) and are tradeable investments that can be sold prior to maturity.