Tuesday 09 February 2021 by Jonathan Sheridan tips-for-assessing-bonds-1000 Trade opportunities

Top 10 tips for assessing bonds

There are a number of factors to consider when assessing a new bond investment – not just the return

In 2006, Sydney Airport Finance, the financing vehicle for ASX-listed Sydney Airport, issued AUD300m of inflation-linked debt, scheduled to be repaid in November 2030. Since the issuance of the bond, Sydney Airport’s market capitalisation has increased by 2.5x having reached a COVID low of 10.6bn in March and a current value of 15.7bn.

Air travel continues to be severely affected by the COVID-19 pandemic. The uncertainty around domestic borders opening and closing and the likelihood of international borders remaining closed until at least 2022 has severely restricted the operations of airlines, and by extension the airports they rely on. Sydney Airport, like many other airports around the country, has experienced a material impact on its earnings. In January 2021, Sydney Airport’s share price had recovered to about 75% of its pre COVID level, after having fallen by almost half from January to March 2020.

The Sydney Airport bond, on the other hand, has experienced significantly lower price movements. This is because, fundamentally, bonds have the benefit of a number of structural features which we explore through the Sydney Airport bond as an example.

Our top 10 tips for assessing bonds:

1. Assess the “survivability” of the company

Do you think the company will be able to survive for the term of the bond and thus pay you interest and return the face value of the bond at maturity? Although highly correlated to passenger numbers, Sydney Airport also generates other forms of revenue that is independent (e.g. lease rentals from its property portfolio) and also benefits from minimum revenue guarantees from its retail operators. Combined with very low costs (as evidenced by its historical EBITDA margin of about 80%), Sydney Airport is in a much stronger position than airlines which have much higher fixed costs.

2. Understand where the bond sits in the capital structure

This bond is senior secured, which means it not only sits at the senior debt level but has the benefit of security over Sydney Airport’s assets (the key asset being the concession over Sydney Kingsford Smith airport). This level, in the event of a wind up, means that subordinated debt, hybrids (if there are any) and shares that rank below senior secured in the capital structure, must be wiped out completely before you would incur a loss. It also means that holders of Sydney Airport’s debt rank in priority to unsecured creditors and would have a significant say in the (highly unlikely) scenario of Sydney Airport appointing a voluntary administrator. Well before reaching such a (remote) case, we believe that Sydney Airport would raise fresh equity in addition to the $2bn raised in August 2020 to support its liquidity.

3. Check if the bond is fixed, floating or inflation linked

The Sydney Airport bond is inflation-linked. This means that the amount outstanding will gradually increase over time in line with inflation. To illustrate this, while Sydney Airport received only AUD300m of proceeds when the bond was issued, the company would have to repay AUD406m if the bond was to mature today. This increase reflects the inflation impact over the last 15 years. Inflation-linked bonds will see their periodic interest payments reflect any movement in inflation as well.

Other companies will also issue fixed rate or floating rate bonds. Fixed rate bonds will have a fixed schedule of payments over their life and will not change. This provides complete certainty for investors. On the other hand, floating rate bonds will have their interest payment determined on each payment date (typically quarterly) by reference to a particular benchmark (BBSW in Australia).

The key difference between fixed and floating rate (other than the fluctuation in interest payments) is that fixed rate bonds are a lot more sensitive to interest rate movement. When rates go down, the price of a fixed rate bond will go up. Floating rate notes have virtually no sensitivity to interest rates, since interest payments are reset on a periodic basis (usually monthly or quarterly).


4. Check the term to maturity

There is a large secondary market where bonds are traded, but if you hold a bond to maturity, you’ll need to make sure the maturity date suits your portfolio.

5. Determine if you can buy the bond

The vast majority of bonds are traded in the over the counter (OTC) market and you need to find a bond broker to trade on your behalf. Over the counter bonds are available to retail and wholesale investors, however wholesale investors have a greater range of bonds to choose from.

The Sydney Airport bond was issued in the wholesale OTC market and is available to both wholesale and retail investors through a bond broker.

6. Assess the return given the risks

Every bond and company has risks. Do you know what they are and do the returns on offer adequately compensate you for the risks involved?

7. Check the size of the issue

The larger the issue, the likely greater the liquidity, as there will be a larger number of investors that hold the bond and it will be included in bond indices. The Sydney Airport bond raised AUD300 million on issue and typically is available to trade either buying or selling.

8. Confirm the bond has a credit rating

This will give you an indication of the risk involved. The higher the credit rating, the lower the risk. The highest investment grade credit rating is “AAA”. Others include “AA”, “A” and “BBB”. The last three categories can also have a “+” or a “-" attached to them. The lower the risk, the lower the expected return. Sub-investment grade is anything rated “BB+” or lower.

Sydney Airport has an investment grade credit rating, and it is considered low risk. It’s important to note that in Australia, only wholesale investors can be informed of the credit rating.

9. Assess the relative value to other company investments

What returns are available on other investments in Sydney Airport’s capital structure? Does the company issue senior unsecured or subordinated debt? Is the return on the senior bond what you would expect, given returns on these other investments?

10. Assess the relative value compared to other bonds from similar companies

What rates of return are available from companies in the same sector and/or similarly rated companies?

At the time the bond was issued, it was attractive to wholesale investors as it met the above criteria.

This list will help you determine if a bond is suitable for your portfolio and can be used to ask your broker questions.