Soaring High with Air Canada Bonds

Investing in Air Canada Bonds

Don’t expect to eat anything fancy when you’re flying because you’ll just be getting plane food. In last week’s blog post it showed that I had over $7,000 of cash saved up. I usually don’t like to have idle money doing nothing. But it’s hard to decide what to buy when everything appears to be overbought lately. However as I was browsing the fixed income tables on my discount broker site I noticed that Air Canada had issued high yield bonds with a 7.625% coupon, maturing in 2019. This looked like a great opportunity to park some money for the next few years and earn some interest. 🙂 My decision to buy Air Canada bonds at this point was still up in the air. I had to do some research to determine if this was the right investment for me or not.

The first thing I did was calculate my potential return on this bond by looking at the bond description as of early March.

Coupon: 7.625%
Maturity: 10/1/2019
Worst Call Date: 10/1/2016
Ask Price: 105
Yield to Worst: 3.3%
Yield to Maturity: 5.5%

If someone were to buy these bonds then their expected annual return would be 3.3% to 5.5% depending on when the bonds expire. This range of return is better than leaving money in a savings account. So the next thing I did was research the company’s credit risk, which involves analyzing its financials and common shares in the stock market. 🙂

Air Canada’s Credit Analysis

Standard & Poor’s rates the bond a BB, which makes it slightly below investment grade BBB. From a valuation perspective, Air Canada’s stock (AC) is trading rather cheaply. At around $8 per share today, its P/E ratio is just 8.4 times compared to the broad TSX index which is more than 18 times. Out of 14 analysts covering the stock, the majority agrees that AC will become quite a lot higher one year from now.

In terms of historical profitability Air Canada has been somewhat of a mixed bag. The credit crisis of 2008 and high oil prices (fuel cost) made it difficult for AC to operate its way out of the recession. It suffered 4 consecutive years of losses from 2008 to 2011. But when the airline became profitable again in 2012 things were looking up. 😉

It appears that in 2013 Air Canada’s stock really took off.

It’s hard to predict how profitable Air Canada will be almost 4 years later when the bond matures, but TD Securities has conducted some estimates of Air Canada’s financials up to 2018. When dissecting tables like this one the most telling figures for me are net income – which describes profitability, and ROIC – which stands for Return on Investment Capital and gives a sense of how well a company is using its money to generate returns. Both metrics are outlined in red below.

Many factors come into play when making these predictions and there are a lot of assumptions made. But if TD ends up being even remotely right then Air Canada could be soaring to new highs in the future. Indeed, the chance for AC to file for bankruptcy protection before the bond’s maturity date seems very small given the low cost of energy.

Air Canada is going through a deleveraging phase and it issued these 7.625% bonds to refinance existing bonds that were at higher yields. These bonds are also first lien secured which means the bond owners are basically at the top of the priority list to be made whole in a worst case scenario where Air Canada has to liquid all its assets. The collateral that these bonds are associated with include real estate, spare engines, and other goods that are tangible and real. These are very senior bonds. They represent a small position in TD’s High Yield Bond fund.

Bond Purchase

Given the returns that this fix income provides and it’s relative low risk of capital loss, I decided to invest $5,000 face value in these Air Canada bonds. 😀 So earlier this week I called a broker at TD and put in the order to buy 5,000 of AC bonds in my RRSP.

There was a $30 commission to place the trade but TD just wrapped the cost into the final price. I also paid $168 in accrued interest. I plan to hold this bond until maturity. So this is what should happen now. Every year I will be paid $381.25 into my RRSP account. Then in October of 2019 Air Canada will return $5,000 back to me. Buying the bond at par ($5,000) would generate a 7.625% annual return. But because I paid $5,305, or roughly 6% above par, my yearly return for this investment is only 5.5%. It’s not very high, but it’s something. 🙂 If Air Canada decides to call back the bond before 2019 then my return would decrease a bit. But that would also give me the opportunity to roll the proceeds into another investment sooner.

Potential Risks for Air Canada

Some investors believe one of the cardinal rules to smart investing is to maintain a safe distance from airlines, lol. This sector is very unpredictable and goes against energy prices, and most Canadian investors are long energy. According to Warren Buffett, airlines are the worst sector of the stock market for long-term investors.  In an interview with the Telegraph, he explains that the industry “has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions and you’ve got commodity pricing. That is not a great recipe for success.”

But that interview took place in 2002. A lot has changed in the industry since then. Back in 2002 the airlines were so cash-strapped that they were about to charge their customers for emotional baggage. But in today’s world Air Canada is cash flow positive and making large profits. 🙂 Much of the old legacy costs and labor disputes have been dealt with too. In 2014 Air Canada worked out a 10-year contract with its pilots. And in 2015, flight attendants also approved a 10-year agreement which includes wage increases, better job security, and improvements to working conditions. So there shouldn’t be any major headwind surprises.

I think there are only two main risks associated with holding these Air Canada bonds to maturity.

• Global air travel crashes – This could be caused by increased hijacking events, some kind of biological outbreak/pandemic, or the entire economy collapses.
• Oil prices soar – Oil fell from $100/barrel to below $30/barrel in less than 2 years. It’s possible oil could recover back up to $100/barrel or even higher over the next couple of years if there’s a shock in the energy market. A short-term oil price spike wouldn’t be a big concern but a sustained high cost would be problematic.

Overall I’m happy with my new investment in Air Canada bonds. I think the potential reward of making 5%+ annual return far outweighs the risks. That being said, my previous 2 bond purchases have both fallen in value since I bought them. But you know what they say – third time’s the charm, right?

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