Tuesday 11 October 2016 by FIIG Securities fencing Opinion

Qantas quandary – stay on tarmac with bonds or risk sharemarket turbulence

As published in The Australian on 8 October 2016

Qantas has managed a remarkable stock price recovery in recent years under CEO Alan Joyce. Now the airline has launched a new Australian dollar fixed rate bond, maturing in 2023. The question for potential investors is, which is better — the share or the bond?

The deal closed tighter than original price guidance at 2.65 percent margin over the benchmark rate delivering a fixed rate of around 4.4 percent per annum.

Before we start the comparison, you need get some comfort regarding the business – the sector, management, business operations, strategy and the regulatory environment amongst other factors.  If there are aspects you can’t reconcile, then it’s a no brainer – don’t invest in either!

And of course, both investments have risks.

The deal for bondholders

The first point to make is that bonds are always lower risk than shares in the same company, and thus investors should expect to earn a lower return. The 4.4 per cent bond yield is less than what you would expect to earn with the shares and there is no franking with bonds.

Having said that the airline has only just started to pay dividends again after a long period of turbulence. There is a good reason for lower returns — bonds are loans and companies have legal obligations to pay interest and capital on specific dates, just as you would if you borrowed from a bank to buy a house. This means even in lean years, bondholders expect to be paid.

Source: FIIG Securities, Bloomberg

If we look at historic bond versus share prices, the Qantas 2020 fixed rate bond began its life in 2013 at $100 face value. It initially declined to reach a low of about $95 in December 2013 before rising to trade above $100 from late 2014, and its most recent price is around $108. The share has been much more volatile over the same time, starting at approximately $2 before declining to $1, then up over $4 late 2015, early 2016 with the most recent price about $3.30.

The greater capital stability of bonds means they will trade in a tighter range. For investors, it becomes a trade off between the certainty of bonds and the higher potential returns and possible losses of shares.

A key question for bondholders will be the ‘‘survivability’’ of the company and what sources of debt it can access or assets it can sell to make sure they get paid. A few lean years will be a concern but palatable if you think the company will continue to operate.

The new bond is a fixed rate bond. If interest rates go up in the next few years the price of the bond would be expected to fall. So another thing potential bond investors need to assess is their expectations for interest rates.

The deal for shareholders

Qantas shares can be bought for as little as $500, making them much more accessible to everyday investors.

However, in tough times shareholders may not receive any dividends, and unlike a bond that has a maturity date, there is no repayment date for shares. Overall returns for shares are uncertain, which translates to higher volatility and the need for a higher return compared to the bond to compensate. It is worth noting that Qantas did not pay a dividend for seven years and only just announced a dividend in its latest set of results. So the shares would have been a poor investment for an income seeking investor.

A fundamental metric for shareholders is the potential for growth. Can the company continue to increase passenger numbers, limit oil price rises and fend off competition from state backed airlines? In the short term the share buyback program will help support the share price, which will provide comfort, but this probably has already been factored in to the share price.

Choosing between the two will depend on the expectations you have of the company. Initially the bond will only be available to wholesale investors in $500,000 parcels. Final minimum denominations are yet to be determined but will be at much lower figures.