Tuesday 09 December 2014 by Legacy

Investing in the resources sector: why bonds are a better option than equities right now

In our article last week “Investing for yield: When to pick the equities and when to pick the bonds”, we looked at the reasons for picking the bonds over the equity of a company, and vice versa

 To profit from equities, you either need share price growth, dividends or a combination of the two. A rising share price comes about when a company’s earnings are expected to grow faster than equities markets have priced in. 

There is no doubt we are in a period of weakening commodity prices. This has been driven in part by increases in production and supply that have outweighed the growth in demand. In a weakening commodity price environment, the prospects for earnings growth in resources companies reduces, and many resources companies start talking about ‘balance sheet management’ strategies, which is another way of saying dividends will be cut and debt levels will be reduced (both of which are actually positive actions for a bond investor). In a weak commodity price environment with no prospects for a turnaround in the short term, the chances of profiting from an investment in the equity of a resources company are slim.

On the other hand, to profit from a bond investment you simply need the company to generate sufficient cashflow to exceed its debt obligations. As long as the company can service its interest obligations out of cashflows, and repay or refinance the principal by its maturity date, a bondholder stands to earn the yield to maturity on the credit investment. The credit analysis becomes largely a question of whether the commodity price can stay high enough for the company to service its interest obligations, assuming there is sufficient demand or forward orders for the underlying resource and that the company has sufficient reserves to continue producing.

As an example, the chart below shows the comparative credit and equity performance of Fortescue, starting from when the Fortescue 2019 US dollar bond was issued in late 2011. Since the Fortescue bond was issued, the total return on the bond has been around 16%. Over the same period, an investor in Fortescue equity would have made a 56% loss. The equity performance has reflected the ebbs and flows in the iron ore price, with the weak outlook for earnings growth driving a significant fall in the share price over 2014. Meanwhile, a bond investor would have profited from the high income returns paid on the bond to date, which Fortescue has been able to pay from its strong cashflow generation. If you believe that iron ore prices are unlikely to rebound in the short term, then it makes sense to invest in the credit of Fortescue over the equity.


Source: Bloomberg. Please note bond price history is based on Bloomberg reported quotes which do not reflect the full suite of quoted prices for a bond on any given day