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What Fortescue tells us about bond investing

Christine St Anne  |  10 Apr 2015Text size  Decrease  Increase  |  

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Christine St Anne is Morningstar's online editor. Follow her on Twitter @MstarChristine

 

Investors will no doubt be familiar with a highly influential CEO of a well-known iron ore producer who is also known for making public statements about his philanthropic achievements.

He still retains a controlling interest in the business. His previous venture was described by a major shareholder as "having too much debt, over-ambitious expansion plans, poor corporate controls and unrealistic forecasts".

The mining magnate in question is, of course, Andrew Forrest of Fortescue Metals Group (FMG). Investors can take a stake in a business like Fortescue through buying either shares or a bond.

And understanding a company like Fortescue can provide a useful guide to assessing the quality of an issuer behind a bond.

As an asset class, fixed income plays a crucial role in an investment portfolio. At the recent Morningstar SMSF Strategy Day, Morningstar head of credit John Likos scrutinised the risks of a number of fixed-income assets such as hybrids and bonds.

Using the example of Fortescue, Likos applied a framework known as the "four Cs".

"The four Cs is a well-known process in fixed income for analysing a bond issue -- it's not the most rigorous process but everyone should use it as a starting point when buying a security," he says.

(It is important to note the following illustration is aimed at highlighting the risks associated with investing in bonds and in no way suggests the company will default on its obligations.)

Let's look at the four Cs a little more closely.

1) Character

"The character of the issuer is critical. Investors need to look at the ethics, education, qualifications and track record of management," Likos says.

Morningstar's stewardship ratings help investors understand and assess the quality of management.

In Fortescue's case, construction and expansion plans have been fast-tracked and are highly aggressive. The current Morningstar stewardship rating on the company is "standard" but was recently upgraded from "poor" due to improved capital allocation.

2) Capacity

Capacity is the ability of the issuer to make its payments. Investors need to assess the cash-flow operations of the business, cash flows relative to debt, interest coverage and operating margins.

Looking at the balance sheet is also important, including debt/capital ratios.