BHP versus Fortescue: What bond prices tell us

Remarkable figures from the corporate bond market reveal the real picture for the iron ore miners.

Summary: Iron ore prices have climbed nine days straight to about $US60 a tonne, with mining stocks such as Fortescue Metals rebounding. But the bond market is telling a different story: While Fortescue Metals was forced to pay close to 10 per cent on a bond issue to push its repayments into the future, BHP was able to raise fresh debt in the European market at an average interest rate of less than 1 per cent.

Key take-out: It’s stretching the point but the bond market is telling us that BHP Billiton is 10 times less risky than Fortescue, and that ought to be a warning to all investors in second-tier miners with high debt levels.

Key beneficiaries: General investors. Category: Iron ore.

A lot happened in iron ore in recent days – including a nine day upward streak in prices which finally brought the metal to about $US60 a tonne.

Share prices of miners such as Fortescue Metals rose in response to a recovery in the short-term price of iron ore but the bond market told a different long-term story.

BHP Billiton, one of the biggest and lowest-cost miners, was able to raise fresh debt in the European market at an average interest rate of less than 1 per cent.

Fortescue Metals, which is struggling to drive its costs down while also carrying a heavy debt burden, was forced to pay close to 10 per cent on a bond issue which pushes repayments further into the future.

That 10-to-1 difference between what bond investors demanded of Fortescue and what they were prepared to accept from BHP Billiton was a sobering reminder that iron ore is in a long-term cyclical downtrend that will last for years.

Anyone who believes that last week’s 25 per cent rise in the iron ore price as reported from the thinly-traded Shanghai market was the start of a long-term recovery will be disappointed because the critical factor in iron ore, Chinese steel demand, has not improved.

When all the evidence from the different markets is considered the iron ore industry remains a place that is safe only for the biggest and lowest-cost producers able to survive in surplus conditions.

What we are facing is a wall of iron ore hitting world markets which is forcing dramatic cost cutting across the sector. BHP Billiton and Rio Tinto have slashed their cash costs to less than $US20/t with a break-even cost probably around $US35/t.

Fortescue is not far behind with its cash costs which are down to $US25.90/t – though Fortescue’s other challenge is that its poorer-quality ore attracts a hefty price discount.

In the March quarter Fortescue was paid an average of $US48/t at a time when the widely-report price based on high-grade ore was $US55/t.

Standard & Poor’s, a rating agency, reckons Fortescue’s break-even cost is currently around $US44/t, with a fall to $US40/t tipped for next year.

Last week’s events on different markets reflected a disconnection between equities and bonds, a process best explained by time with share prices being driven by short-term factors and bonds by long-term factors.

On the stock market a classic relief rally was underway, perhaps aided by short-sellers covering their positions after the Shanghai iron ore price bounce could have been aided by a BHP Billiton decision to slow (but not stop) its iron ore expansion program.

The higher iron ore price was responsible for Fortescue shares rising by 47 per cent over just nine trading days but, even as the share price was going up so was the cost of the company’s debt as measured by the interest rate payable on its bonds.

Fortescue’s $US2.3 billion bond issue, designed to push repayment commitments further into the future (kicking the can down the road), was sold to junk-bond investors desperate for high-yield assets – which they got thanks to Fortescue being forced to offer a sky-high rate of 9.75 per cent with the full price reported to be 10.25 per cent after incentives.

It was a very different story 24 hours earlier when BHP Billiton quietly raised €2 billion ($US2.2 billion) via a bond issue in Europe with the average interest rate on three tranches less than 1 per cent.

The new BHP Billiton bonds included €750 million due in 2030 at 1.5 per cent. €650 million due in 2022 at 0.75 per cent, and €600 million due in 2020 at a floating rate based on the three-month Euribor (Euro Interbank Offered Rate) plus 0.35 per cent -- with the Euribor rate going negative last week at minus 0.001 per cent for the first time.

BHP Billiton’s appeal to investors does of course extend well beyond its status as a big iron ore miner with its diversified portfolio of assets benefiting from a higher oil price as well as the higher iron ore price. In contrast, ‘pure play’ Fortescue is totally exposed to iron ore.

So is the worst over as iron ore players so desperately want to believe? It seems to me the recent iron ore price recovery is a short-term event triggered by Chinese steel mills re-stocking to take advantage of low prices, and further boosted by BHP Billiton’s move to slow expansion work at iron ore operations in WA.

A longer and deeper view of the iron ore market remains less appealing because Chinese demand for steel has not suddenly recovered, and might even be in decline, while supplies of iron ore continue to rise. In other words the iron ore market remains flooded and the level is rising, not falling.

The core problem for everyone exposed to iron ore is that recent production expansion programs have been based on the original “stronger for longer” proposition about commodity demand and prices which surfaced during China’s boom years.

Management at BHP Billiton, Rio Tinto, Fortescue and other iron ore miners believed forecasts that China’s demand for steel would continue rising until 2025 and beyond, eventually hitting one billion tonnes a year.

Chinese forecasters have been busily talking down those forecasts with the latest tipping a drop to 560 million tonnes by 2025 – roughly half the forecasts used by the iron ore miners to justify their expansion programs.

To really test out which miners are winning in this deadly game of race to the bottom you are better to look at the bond market not the stock market.

It’s stretching the point but the bond market is telling us that BHP Billiton is 10 times less risky than Fortescue, and that ought to be a warning to all investors in second-tier miners with high debt levels.