Tuesday 31 May 2016 by FIIG Securities adani3 Trade opportunities

A rare opportunity – Adani bonds offer equity like returns

Originally published in The Australian on 31 May 2016

Standard and Poor’s has affirmed Adani Abbot Point Terminal’s investment grade credit rating, a significant event that has the market buzzing

Before Easter, Moody’s announced a two notch credit rating downgrade on Adani, taking its rating to non investment grade. The implication being that risk had increased and investors needed to be paid higher returns in order to invest. The move raised questions in the market about the validity of the higher S&P investment grade rating with investors cognisant of the possibility it could follow Moody’s lead and downgrade Adani’s credit rating.

It is now apparent that the two credit rating agencies have divergent views on the coal market.

Moody’s view is that the coal market is in structural decline whereas S&P have consider the market is at a cyclical low and should recover, thus in part affirming its stable investment grade credit rating.

In bond markets, credit ratings matter. Big institutional investors often have mandates where they can only invest in companies if they have an investment grade credit rating – sometimes the mandate requires two investment grade credit ratings. Once Moody’s downgraded its rating, institutional investors would have been repositioning their holdings – some selling whole stakes, while others watching in case they needed to do so.

This week’s affirmation by S&P was welcomed by the market. Just a few months ago Adani’s longer dated bond maturing in 2020 had a yield to maturity of over 10 per cent per annum, which is equity like and very high in this low rate environment.

To put it into perspective other corporates with an equivalent S&P credit rating had yields to maturity of around 4.2 percent per annum, while those equivalent to the Moody’s credit rating were around 6.0 percent per annum. The plus 10 percent was a standout opportunity for investors no matter how they viewed the risk.

Since the announcement, prices have rallied and yields have dropped but remain around 8 per cent per annum, still very attractive.

When the bond was first issued there was a covenant that provided for a step up in the interest paid to investors should credit ratings fall. As an added bonus, the clause is invoked due to the Moody’s downgrade and at the end of this month interest payable on the 2020 bond rises by one per cent per annum. Thus will push the yield higher to around 9 per cent per annum, assuming current prices hold.

It will take a while for prices and the yield to settle as investors digest the news and come to their own conclusions about the relative risk and reward, but the opportunity for high returns remains.

Now that S&P have affirmed its investment grade rating and the two ratings between the two agencies differ across the investment grade and non investment grade spectrum we have what is known as a ‘crossover’ bond. There is only one other Australian dollar denominated bond in a similar position, the Dalrymple Bay Coal Terminal bonds – same sector and same variation.

It is hard to say what influences the bond price and thus yield more – the higher or the lower credit rating.

I tend to think there is a bit of emotion tied up in this credit with the Galilee Basin project progressing and the concern about the environment. However, the Adani bonds when first issued were used to help purchase the Abbot Point coal port from the Queensland government and the port facility has been in operation for over 30 years. The finance has nothing to do with the new project or port extension.

Adani has two fixed rate bonds due to mature in 2018 and 2020, current yields to maturity are 8.3 per cent and 9 per cent per annum. This includes a 1 percent per annum step up penalty due to the Moody’s credit rating downgrade.  The 2018 bond is available to wholesale investors only in minimum $200,000 parcels, while the 2020 is available to retail and wholesale investors from $10,000.

Dalrymple Bay Coal Terminal has a floating rate bond maturing in June 2021 with a projected yield to maturity of 5.2 per cent, also available to retail and wholesale investors from $10,000.

Note: Prices are accurate as at 25 May 2016 but subject to change.