Aviation bonds: Where Qantas flies higher

Qantas shares have nosedived since the GFC, but its bonds are still hovering in investment grade.

Summary: The airline industry has hit turbulence since the GFC, and longer-term Qantas shareholders have had to buckle their seatbelts since 2008 as their shares have plunged from nearly $6 to their current level just over $1.40. Yet, surprisingly, Qantas is one of only two listed airlines in the world to hold an investment grade corporate credit rating, albeit that is just one notch above junk bond grade status.
Key take-out: Qantas is hoping that additions to its airline fleet, and cost cutting initiatives, will drive operational efficiencies across the business and improve its earnings profile over the medium term.
Key beneficiaries: General investors. Category: Shares.

Aviation might just be the last global industry to fully surmount GFC-era problems.  But while the battle to rule the skies enters a new phase, Qantas (QAN) is emerging as a surprise winner ... in the bond market at least.

For Qantas equity holders even this year’s price gains may pale in comparison to the lofty heights reached some years ago, but in the lesser-known aviation bond market Qantas is an unlikely champion.

The airline industry is heavily cyclical, with its performance closely tied to global industrial production and world trade.

The International Air Transport Association (IATA) was forced to cut its forecast for airline growth this year by $1 billion to $11.7 billion last month after oil prices spiked higher due to the Syrian crisis and growth disappointed from several emerging economies.

IATA has been expecting to see an upturn in the airline industry amid accelerating global economic activity after business confidence bottomed out last year, but it has so far failed to materialise.

However, the association is more confident about the industry’s prospects in 2014 as business confidence rises and is forecasting net income to be $16.4 billion. That would be around 40% growth – its biggest increase since emerging out of the GFC.

In an industry constantly buffeted by fuel prices, strong competition and high capital demands – sending many carriers not supported by governments into receivership – Qantas stands out as one of the few listed airlines able to issue wholesale bonds in the capital marketplace that aren’t rated junk.

In fact, the Australian airline comes joint first place with America’s Southwest and, moreover, credit analyst May Zhong at Standard & Poor’s says: “Compared to Southwest Airlines, the key competitive advantage from a credit perspective for Qantas is its strong position in the domestic market.”

While the US and Europe operate in more competitive markets with many rival carriers, Qantas holds 65% market share in what is ostensibly a duopoly with Virgin Australia Holdings (VAH). 

Standard & Poor’s holds a BBB- corporate credit rating on the two airlines, while Moody’s has an equivalent Baa3 rating using its own scale. Both agencies give the airlines a “stable” outlook.

However, the plain truth is that these ratings simply put Qantas and Southwest Airlines just a notch above the rest of the rated airline pack. Some might say it’s faint praise to sit just one rung above what the agencies classify as speculative grade – junk bonds – and 10 levels below the highest rating they can bestow, AAA. Indeed, Qantas’ rating was downgraded last year from BBB.

“It’s a high-risk industry they operate in,” S&P’s Zhong says. “Even if you are the best performer, the rating is going to be constrained by the industry risk.”

The arrival of 14 Boeing Dreamliner aircraft over the past weekend, painted orange with the Jetstar logo, is expected to boost Qantas’s competitiveness as older planes are retired and the fleet is simplified. This will provide multiple benefits, including increased fuel savings, more seating and a reduction in the number of spare parts required.

Chief executive Alan Joyce anticipates the new airlines to slash mainland operational costs by 10 percentage points by 2015, narrowing the cost base to 5% above arch domestic rival Virgin.

Earlier this week US aircraft manufacturer Boeing forecast the Oceanic market – where Qantas is the largest airline – will nearly double over the next two decades, with 4.8% growth a year. 

With the Dreamliners arriving at last and the relatively high ranking of Qantas in the lower reaches of the bond market, equity holders might at least be reassured the national carrier is making progress on just about every front.

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