Monday 10 November 2014 by FIIG Securities Legacy

Lower iron ore prices open up opportunities in Fortescue USD bonds

Fortescue has ridden the wave of Chinese growth and high iron ore prices in recent years but the sudden decline in iron ore prices from USD120 earlier this year to around USD80 as at 31 October has impacted the price of its USD bonds.

Bond prices have declined as the outlook for the miner has lost some of its shine. While Fortescue has moved from relative obscurity to being the world's fourth largest iron ore producer in only six years, questions have been raised about its ability to handle sustained lower iron ore prices given high leverage and lack of diversification.

In its favour, it has reduced its gearing level from a whopping 71 per cent last year, which was far too high for a cyclical commodity producer to a more comfortable 56 per cent this financial year. The flow-on impact of the debt reductions and refinancing is expected to reduce borrowing costs by USD330 million per annum.

Since November 2013, Fortescue has repaid USD3.6 billion of debt and has the ability to repay another AUD5.3bn early but has no scheduled debt repayments due until April 2017. In other words, it has significant flexibility to repay debt early if it can generate enough operating cash flows, but if the iron price stays at current levels or continues to fall it can ride out the downturn and wait for the debt to mature before it repays.

While debt is still relatively high, the company plans to reduce gearing to circa 40 per cent levels and transform its balance sheet to reflect credit metrics of an investment grade credit, higher than its current non-investment grade status. 

About 40 per cent of Fortescue’s debt has been issued in US dollar fixed rate bonds totalling USD3.9 billion: USD1 billion maturing April 2017, USD400 million maturing February 2018, USD1.5 billion maturing November 2019 and USD1 billion maturing April 2022. All are senior debt.

The current yields to maturity on the November 2019 and the April 2022 fixed rate bonds, which are available in parcels from $50,000, are 6.81 and 5.85 per cent respectively.

Interestingly, the shorter dated bond pays a higher yield to maturity. This is for a number of reasons, but the main one is that the bond has a series of call dates, where Fortescue can repay it early. When the 2019 bond was issued in 2006, it had a fixed coupon rate of 8.25 per cent, which does not change over the life of the bond. This makes it Fortescue’s most expensive bond and an obvious target to call or repay to reduce costs.  

The first call date on the bond is 1 November 2015 and yield to first call, an important number in this instance, is 5.98 per cent if you hold the bond and it is repaid at this date. We think there’s a good chance this bond will be called, so your assessment then becomes one of the likelihood of the call and the 5.98 per cent return for a 12 month investment.

If you hold US dollars they could be used to buy the bonds, otherwise you would need to convert Australian dollars into US dollars before you transact. Over the life of the bond, income is paid in regular instalments in US dollars and assuming the company survives, the USD100 face value of the bond is returned at maturity.

Foreign currency bonds take on additional currency risk, over and above the credit quality of the company issuing the bond and are only available to wholesale investors.