Sunday 28 July 2019

Does SIA's 3.03% Bond Have Sufficient Margin of Safety?

Following up from last week's blog post on Will Temasek Bail Out SIA Bondholders In Event of Default?, here is the analysis on SIA's 5-year 3.03% bond based on Benjamin Graham's criteria as described in The Lost Art of Bond Investment. Surprisingly, the bond is not as strong as I initially thought based on a simple Debt-to-Equity ratio check. Below are the computation of the earnings coverage and stock value ratio based on SIA's latest financial statements for Financial Year 18/19 ending in Mar 2019.

Earnings Coverage
Profit before tax = $868.6M
Adjusted for:
- Deduct: Share of profits from joint ventures = $23.2M
- Add: Share of losses from associates = $97.4M
- Add: Rental on leased aircraft = $679.7M
- Add: Finance cost = $116.1M
Total earnings available for covering fixed charges = $1,738.6M

Current finance cost = $116.1M
Adjusted for:
- Add: Rental on leased aircraft = $679.7M
- Add: Interest for $600M @ 3.16% MTN 007 series = 3.16% x $600M

= $19.0M
- Add: Interest for $750M @ 3.03% MTN 001 series = 3.03% x $750M

= $22.7M
Total finance cost = $837.5M

Earning Coverage = $1,738.6M / $837.5M

= 2.08

Several adjustments were made to compute the total earnings available for covering fixed charges and total finance cost. The more unusual adjustment in SIA's case involves adding the rental of leased aircraft to both figures. This is because SIA leases aircraft in addition to buying them. The leases range from 6 to 12 years and cannot be cancelled, although there are options for early termination for up to 2 years before the original lease expiry. The leased aircraft do not appear on the balance sheet.

On the other hand, for aircraft that SIA owns by borrowing money from the banks, the aircraft appear as a asset and the loan appears as a liability on the balance sheet. On the income statement, there is no rental required, but SIA incurs depreciation and interest on the loan.

Hence, for the leased aircraft, even though SIA does not incur a finance cost, the rental is effectively a fixed charge that SIA has to cover, as the leases cannot be cancelled and SIA needs the aircraft to continue its operations. A similar adjustment needs to be made for the balance sheet, as discussed in the section later.

The current finance cost is also adjusted for interest on a $600M 3.16% Medium Term Note (MTN) issued on 26 Oct 2018 and the $750M 3.03% bond issued on 29 Mar 2019 which is the subject of this blog post. Although both bonds already appear on the balance sheet as at 31 Mar 2019, their first interest payments will only be made in FY19/20, Hence, their interest payments need to be added to compute the actual finance cost.

Based on the above adjusted figures, the earnings coverage is computed to be 2.08 times, which is below the minimum average earnings coverage of 3 times for industrial companies.

Stock Value Ratio

No. of shares = 1,199.9M
Share price = $9.62
Market value of shares = $11,542.6M

Current borrowings = $6,654.4M
Adjusted for:
- Add: Liability for rental aircraft = $2,200.0M
Total borrowings = $8,854.4M

Stock value ratio = $11,542.6M / $8,854.4M

= 1.30

As mentioned above, adjustments need to be made to the balance sheet for the rental aircraft. The rental aircraft is effectively an asset for SIA. Correspondingly, there should be a liability to account for the loan that SIA would have borrowed to purchase the aircraft outright. In fact, International Financial Reporting Standard (IFRS) 16 on Leases came into effective starting from Jan 2019 that requires companies like SIA to account for leased assets on their balance sheets. SIA has disclosed in its Annual Report that the assets will be increased by $1.7B while liabilities will be increased by $2.2B.

Considering the $2.2B increase in total borrowings, the stock value ratio is computed to be 1.30, which is higher than the minimum stock value ratio of 1.0 for industrial companies.

Quantitative Assessment

Thus, based on the above figures, SIA's 5-year 3.03% bond does not meet the earnings coverage criterion but meets the stock value ratio criterion. Based on Benjamin Graham's criteria, the bond does not have sufficient margin of safety.

Other Considerations

As mention in my blog post on Will Temasek Bail Out SIA Bondholders In Event of Default? last week, I believe Temasek will come to the rescue of SIA bondholders in the event that SIA could not pay interest and/or redeem the bond.

P.S. I am vested in SIA's 3.03% bond.

See related blog posts:

Sunday 21 July 2019

Will Temasek Bail Out SIA Bondholders In Event of Default?

As regular readers would know, I stopped blogging for a year. I did not just stopped blogging; I also stopped monitoring performance of my portfolio and analysing shares and bonds in detail. So when SIA launched its retail 3.03% bond in Mar this year, I did not analyse it in detail as I would typically do using Benjamin Graham's method (see The Lost Art of Bond Investment for details) and simply bought it. I took a glance at its financial statements, carried out a simple Debt-to-Equity check and concluded that its debt obligations were not too excessive. Most importantly, I relied upon the assumption that SIA's parent, Temasek, would bail out bondholders in full in event of a default. This was not the only time that I relied on similar assumptions when buying bonds. I did the same when I bought Fraser Property's 3.65% bond (see Does FCL's 3.65% Bond Have Sufficient Margin of Safety? for more info).

Now that I am back to blogging (and thinking about financial issues), it is worth diving deeper to examine whether the assumption is rock solid and could be relied upon. Do note that this is not entirely a hypothetical question, as the airlines industry is a highly competitive one. Bankruptcies are not uncommon. Past examples include American Airlines, Delta Airways, Northwest Airlines, etc. going into Chapter 11 protection.

So, will Temasek come to the rescue of bondholders in the event SIA defaults on the bond? To answer this question, we need to first understand the background of SIA and Temasek. So, the first question is: will Temasek rescue SIA? The answer must be a resounding yes. SIA is the national airline and the pride of the nation. When our political leaders go overseas for conferences, they fly with SIA. It is difficult to imagine our political leaders flying on some other countries' national airlines. Thus, yes, Temasek will come to the rescue of SIA.

However, rescuing SIA the company is not the same as rescuing SIA bondholders. While SIA the company is a strategic national asset, SIA bondholders (and shareholders) are not. Furthermore, the ultimate shareholders of Temasek are Singaporeans. Bailing out SIA and its bondholders with Temasek's money is akin to using taxpayers' money to do so. It will be politically difficult to use taxpayers' money to bail out bondholders in full. The most likely scenario is that the settlement with bondholders will be at arm's length basis on normal commercial terms, i.e. the outcome would be similar to another company that is not owned by Temasek. In other words, bondholders will suffer some capital losses. This is not unlike the case of Hyflux preference shares and perpetual capital securities. Thus, from this perspective, SIA bondholders should not expect Temasek to bail them out in full.

On the other hand, SIA is not the only company that Temasek owns. Temasek owns a lot of companies in its portfolio. Temasek has triple-A ratings from both Moody's and S&P. Not all the companies in its portfolio has similar ratings based on their own merits. When companies with lower ratings borrow money, lenders take into consideration the fact that the company is majority owned by Temasek and offer a lower interest rate compared to a company that does not have Temasek as its backing. In the event that Temasek does not step in to bail out bondholders in full, credit markets will take note and will not offer lower interest rates to Temasek-owned companies in future. Each company has to pay an interest rate that is commensurate with its own credit rating. In other words, Temasek will have to bear higher interest payments across most of its subsidiaries. This long-term economic cost might outweigh the short-term political cost and prompt Temasek to bail out bondholders in its subsidiaries in full.

Finally, we should also note that Temasek, although it does not play an active role in day-to-day management of the subsidiaries' operations, is not a sleeping partner either. Long before trouble happens and hits the headlines, Temasek would have done something to avert it. For example, Tiger Airways, SIA's budget airline, had been losing money for 4 out of 6 years since its listing on SGX in Jan 2010. It carried out 3 rights issues over the same period. It also issued a 2% perpetual capital convertible securities (PCCS) in Apr 2013. If the trend were to continue, Tiger Airways would probably have failed and defaulted on the PCCS. In Nov 2015, SIA announced that it would take over Tiger Airways. It also redeemed all outstanding PCCS upon successful takeover of the company.

In conclusion, I had been lazy in analysing the SIA 3.03% bond when I bought it. But I guess I still can rely on the assumption that Temasek would step in and bail bondholders out in the event of default by SIA. Nevertheless, I should do my homework and analyse whether the SIA bond has sufficient margin of safety according to Benjamin Graham's method.

See related blog posts:

Sunday 7 July 2019

Are Private Equity Bonds Better Than Corporate Bonds?

When Astrea V 3.85% bond was launched, some investors remarked that it is better than some of the recently issued corporate bonds, such as SIA 3.03% bonds. What are the differences between Private Equity (PE) bonds and corporate bonds, and are PE bonds really better than corporate bonds?

It is difficult to compare Astrea bonds with, say, SIA bonds, since their nature of business are different. To make the comparison between PE bonds and corporate bonds more meaningful, let us consider a hypothetical bond issued by Azalea Asset Management, which is the sponsor of the Astrea III/IV/V bonds. Fig. 1 below shows the corporate structure of Azalea.

Fig. 1: Azalea Corporate Structure

The assets of Azalea are the 3 Astrea companies issuing the Astrea III/IV/V bonds and owning the underlying portfolios of PE funds. Azalea probably has some other income-generating assets, such as the investment management company shown in Fig. 1 above, plus some other unlisted PE funds. Thus, the nature of business of Azalea and Astrea III/IV/V companies are similar. What would be the differences between the hypothetical Azalea corporate bond and Astrea III/IV/V PE bonds? Note that the PE bonds are not limited to the Class A-1 bonds which are open to retail investors. There are also Class A-2, B and C bonds.

The first key difference would be the security of the bonds over the assets. Astrea PE bonds are secured against the PE funds in the respective Astrea companies, whereas Azalea corporate bond would be unsecured. In the hypothetical scenario where the Astrea PE bonds default, Astrea bondholders could force the respective Astrea companies to liquidate their PE funds and return money to the bondholders. However, in the event that the liquidation proceeds are insufficient to redeem the bonds, bondholders have no recourse to Azalea, or to the other Astrea companies. For example, if Astrea III bonds were to default, Astrea III bondholders have no rights to the assets of Azalea, Astrea IV and Astrea V companies. The assets of each company are ring-fenced and could only be used to service the bonds issued by the respective company.

Similarly, in the hypothetical scenario where the Azalea corporate bond defaults, Azalea bondholders have no claims over the PE funds held in the 3 Astrea companies. Nevertheless, they could force Azalea to sell off the Astrea companies together with their portfolio of PE funds and PE bonds. However, they could not force Azalea to break up the Astrea companies, sell off their PE funds, redeem the Astrea PE bonds, and return excess cash to Azalea to pay off the corporate bondholders (Note: it might be possible to do so for other project/ asset-level bonds, but the terms of Astrea PE bonds do not allow for early liquidation of assets and redemption of bonds). In other words, regardless of what happens to Azalea, Astrea PE bondholders will not be affected. 

So does it mean that Astrea PE bonds, which are secured against the PE funds of the respective Astrea companies, are better than Azalea corporate bonds which are unsecured? Not necessarily. The key factor is the quality of the assets that are securing the bonds. If the assets are of high quality, the PE bonds have good collaterals. Conversely, if the assets are of low quality, the collaterals would be useless. Remember, Astrea PE bondholders have no recourse to Azalea and the other Astrea companies. They can only count on the assets in their respective Astrea companies to pay interest and redeem the bonds. 

Although Azalea corporate bond is unsecured, if the Astrea companies are generating good cashflows for Azalea, it does not matter whether the bond is secured or not. In a hypothetical scenario where one of the Astrea companies have poor assets whereas the other Astrea companies have good assets, it might be better to hold the unsecured Azalea corporate bond than the secured but troubled Astrea PE bond. So, quality of assets is key in determining whether secured or unsecured bonds are better.

The second difference is that Azalea could have other income-generating assets and businesses besides the 3 Astrea companies. In Fig. 1 above, it has an investment management subsidiary to manage the investments in PE funds for the Astrea companies in return for a fee. It could also have other PE funds that are outside the Astrea companies. So, for Azalea corporate bonds, there could be other sources of operating cashflows, whereas for Astrea PE bonds, the only source of cashflows is the PE funds in the respective Astrea companies.

The third difference is that besides receiving cashflows from the Astrea companies to redeem the Azalea corporate bond, Azalea could refinance the bond through bank borrowings, new corporate bonds, shareholder loans from Temasek, or even private share placements and IPO! Being a corporate bond, there are many avenues to refinance it. Astrea PE bonds do not have such avenues. To reiterate, Astrea PE bondholders can only count on the assets in the respective Astrea companies. If the assets are good, PE bondholders will get the promised returns. If the assets are poor, they will suffer some losses.

Having said the above, being able to borrow money is a double-edged sword. While borrowings could help to refinance the Azalea corporate bond, Azalea could also run the risk of borrowing too much money and jeopardise its ability to pay interest to and/or redeem the Azalea corporate bond if banks decide that Azalea's credit risk is too high. For the Astrea PE bonds, such risks have been mitigated. The terms of Astrea PE bonds prohibit the Astrea companies to borrow money other than to issue the different classes of bonds at inception, as well as to meet capital calls and cover bond interest payment shortfalls. The last 2 conditions are actually safeguards for the PE bondholders (see Understanding the Safeguards of Astrea IV 4.35% Bonds for more info).

In conclusion, PE bonds are not necessarily better or worse than corporate bonds. The key words are: quality of assets securing the PE bonds. This is unlike preference shares and perpetual capital securities, which are inherently inferior to stocks and bonds (see Prefs and Perps are Generally Inferior to Stocks and Bonds as an Investment Form for more info).

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