Heavy machinery is seen at Frontier copper mine in Fungurume, in southern Democratic Republic of Congo May 25, 2010.Katrina Manson
Equity analysts see lots of potential in beaten-up base-metal miners. The bond market begs to differ.
Many producers of basic industrial materials – including Freeport McMoRan Inc. of the United States, and First Quantum Minerals Ltd., HudBay Minerals Inc., Sherritt International Corp. and Teck Resources Ltd. of Canada – have seen their bonds hit by a stampede of selling in recent months as prices for copper, nickel, iron ore and other key raw materials have ground relentlessly lower.
The yield of a bond moves in the opposite direction to its price, so the outburst of selling has driven the expected payoff on the sector's bonds into the stratosphere. Nearly all of Teck's bonds now offer yields-to-maturity north of 10 per cent, while the corresponding payouts for issues from First Quantum, Freeport, HudBay and Sherritt have shot even higher – above 20 per cent in some cases.
Such eye-popping yields typically go hand in hand with a high risk of default. The generous payout serves as compensation for the possibility that bondholders won't get all of their money back.
But despite the nail-biting levels of anxiety indicated by soaring yields, most equity analysts say there is little to worry about. Their "buy" and "hold" recommendations on the sector's shares far outweigh a few scattered "sells."
Rarely have bond yields and equity recommendations delivered such starkly contrasting messages. The tension between the viewpoints is helping to create an unusually volatile market.
One example: HudBay and First Quantum shares lost about half their value in January, but both surged in recent days. Other base-metal miners have also rebounded and posted big gains in their share prices in response to mild improvements in commodity prices.
If equity analysts are right, the current bond market is making a major blunder and there is tremendous profit potential in miners' debt.
At Freeport, for instance, yields on a few of the company's bonds have soared above 22 per cent, according to Bloomberg data. Anyone who is confident of Freeport's continued solvency could bypass the company's volatile stock and lock in the big returns available on its bonds.
The problem is that the rich payday is far from a sure thing. A gloomy outlook for base-metal prices hangs over the entire industry, according to major credit-rating agencies.
For many reasons, "we came to the conclusion in January … that this was not a normal cyclical downturn [for base metals] but a downturn we think will be much deeper and with a much longer time frame to recover," Carol Cowan, senior vice-president at Moody's Investors Service, said in an interview.
Moody's, which is reassessing ratings across the sector, says booming supply is the prime culprit. An outburst of mine construction in recent years was intended to serve a fast-growing Chinese economy, but the newly abundant supply of base metals has swamped demand as China's economy has slowed.
"There is little light on the horizon and we expect the physical supply/demand imbalance to widen further, leaving industry conditions extremely weak and making a return to normality unlikely for several years," the Moody's reported in January.
Equity analysts retort that the bond market is underestimating companies' ability to whittle down costs and sell non-core assets to make ends meet. Teck, for instance, could auction off part of a port terminal and hydro-electric facilities if pressed.
In addition, many miners do not have to repay bond principal for several years. "Most of HudBay's debt is due in late 2020 and was taken on to fund mines that are low cost and long life," a spokesperson wrote in an e-mail response. "In that context, by managing costs and being able to adapt, HudBay is positioned to manage through the present environment."
The constant selling pressure on the sector's bonds indicates that not everyone is quite so confident. But it's difficult to isolate the factors that have driven yields to such lofty levels.
Some observers say it's because of general revulsion toward the resource sector; others point to technical factors, such as market liquidity. And then, of course, there's the unimpressive outlook for raw materials.
In a report issued in late January, Standard & Poor's chopped its price assumptions for all metals in 2016 and 2017.
Earlier this week, the credit rater followed up by downgrading BHP Billiton Ltd., the world's largest miner, to single-A from single-A-plus as a result of low commodity prices. "We forecast a material drop in BHP Billiton's results in the coming 18 months," it said.
As might be anticipated, equity analysts remain much more positive. Twelve of 30 analysts following the giant producer continue to label it a "buy." The stock has advanced since the credit downgrade.
Ian McGugan