Metals and mining: The worst appears over for these bonds, but risks remain
Since early January, metals prices have turned sharply higher, thanks in part to a weaker US dollar and improved sentiment about China. In turn, we have seen a strong reaction in the bonds of metals and mining companies — investment grade and high yield metals and mining bond yields are tighter by 300 and 500 basis points, respectively.1 Following such strong moves, the question now is whether there is still value in metals and mining bonds.
Figure 1: After falling in 2015, the Bloomberg Base Metals Commodity Index is up 15% year-to-date
(chart axis illustrates index level)
Signs point to significant uncertainty …
There are ample reasons for bearish views on the metals and mining sector as the supply-demand picture remains challenged, with uncertainty around Chinese demand being a key factor. That said, there are supportive factors as well: We have seen a modification of company behavior, weaker players exiting the market and US dollar weakness. Weighing the various factors, it is clear that significant uncertainty remains and the overall backdrop for metals is far from robust, leaving the potential for prices to give back some or all of their recent gains.
… But we believe the worst is likely over
However, it is important to note that in late December and January, when sentiment was at a nadir, investors’ worst fears failed to materialize. Prices did not fall to extreme bear case levels, the leading companies in the industry continued to demonstrate the sustainability of their operations, and demand — while far from robust — did not experience severe deterioration. We think that has bolstered investor comfort with the industry, at least as far as the top-tier operators are concerned.
This marks a key shift in sentiment as evidenced by the significant narrowing in bond spreads across the major miners in February and March, from historically wide levels to levels that we believe are more in line with fundamentals.2 In the view of Invesco Fixed Income, this is a key adjustment and leads us to believe that there is a strong probability that the worst has passed for the industry.
Figure 2: Global metals and mining yields have declined in 2016
Where we see value in metals and mining bonds
Taking into consideration our view that the worst has likely passed for the sector, we still see value in metals and mining bonds as yields remain well above historical norms, as indicated in Figure 2. However, we believe it is essential to distinguish between those companies that are well-positioned to survive if the current environment of depressed prices persists and those that are at risk of failure.
In general, we focus on companies that are cost leaders in their sectors, with strategic assets and strong balance sheets that we believe can sustain a prolonged period of commodity price weakness. Such considerations are part of Invesco Fixed Income’s investment approach, which is designed to identify companies that are well-positioned to weather a prolonged period of depressed prices and asset valuations. While companies that do not meet such criteria can offer substantially greater upside in a stronger price environment, we think the risk remains too high given the uncertainty about the direction of commodity prices over the intermediate term. As such, we think the more attractive risk-reward trade-off lies with the top-tier operators across the credit universe.
As shown in Figure 3 below, even within the higher-quality segments of the metals and mining sector, spreads remain well above the average levels of the past five years. The key risk to our view would be a macro catalyst that could cause metals prices to retest or break though recent lows, such as concerns over China, renewed US dollar strength or a global risk-off catalyst such as geopolitical turmoil.
Figure 3: Current metals and mining spreads are above five-year averages
1 Source: Barclays US Aggregate Metals and Mining Index, Barclays US High Yield Metals and Mining Index, data from Jan. 31, 2016, to March 23, 2016
2 Source: JP Morgan BBB Metals and Mining Index, Bank of America Emerging Market Investment Grade Metals and Mining Index, Barclays US High Yield BB Metals and Mining Index, data from Jan. 31, 2016, to March 23, 2016
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Spread represents the difference between the yield on a corporate bond and a similar maturity US Treasury bond.
A basis point is one hundredth of a percentage point.
The Bloomberg Base Metals Commodity Index tracks London Metal Exchange prices for aluminum (45%), copper (25%), nickel (2%), lead (12%), zinc (15%) and tin (1%).
JP Morgan BBB Metals and Mining Index comprises global metals and mining bonds rated BBB, as determined by a composite derived from Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
Bank of America Emerging Market Investment Grade Metals and Mining Index comprises investment grade metals and mining bonds, as determined by a composite derived from Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
Barclays US High Yield BB Metals and Mining Index comprises high yield metals and mining bonds (rated BB), as determined by a composite derived from Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
The Barclays US Aggregate Metals and Mining Index comprises investment grade, US dollar-denominated, fixed rate taxable bonds issues by companies in the metals and mining industry.
The Barclays Global Credit Index – Metals and Mining Sector comprises credit securities from global metals and mining companies.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Fluctuations in the price of gold and precious metals may affect the profitability of companies in the gold and precious metals sector. Changes in the political or economic conditions of countries where companies in the gold and precious metals sector are located may have a direct effect on the price of gold and precious metals.
A credit rating is an assessment provided by a nationally recognized statistical rating organization (NRSRO) of the creditworthiness of an issuer with respect to debt obligations, including specific securities, money market instruments or other debts. Ratings are subject to change without notice. Short-term credit ratings are measured on scale that generally ranges from A-1 (highest) to D (lowest) for Standard & Poor’s and from P-1 (highest) to NP (lowest) for Moody’s and F1+ (highest) and D (lowest). S&P and Fitch ratings will also denote those securities that possess extremely strong safety characteristics with a plus sign (+) designation. NR or blank fields indicated the debtor was not rated, and should not be interpreted as indicating low quality. For more information on rating methodologies, please visit the following NRSRO websites:www.standardandpoors.com and select ‘Understanding Ratings’ under Rating Resources on the homepage; www.moodys.com and select ‘Rating Methodologies’ under Research and Ratings on the homepage www.fitchratings.com and select ‘Ratings Definitions’ on the homepage.