The year is close to its end and Azerbaijan State Railways (ADDY) is unlikely to receive a credit rating from a top-three international rating agency before the New Year dawns, in our view. This has certain important consequences for holders of the $125mn AZRAIL 8.25% LPN due in 2016.
§ The bond documentation for AZRAIL 16 contains a covenant which obliges ADDY to receive a credit rating from S&P, Moody’s or Fitch before 31 Dec 2011, provide written evidence of this development and disclose the rating it received to the lender, trustee and agent bank of the LPN programme (Clause 18, ‘Borrower rating covenant’ of the loan agreement).
§ Any breach of this covenant calls for a coupon step-up under Clause 7.1 ‘Calculation of interest’. In this case the coupon increases by 1 ppt to 9.25% per annum starting from 1 Jan 2012. The frequency of coupon payments, calculation type and other coupon-related provisions remain unchanged.
§ We think that ADDY is unlikely to receive a credit rating from any of the three rating agencies by 31 Dec. This means that the rating covenant will be breached and the effective coupon rate will be 9.25% starting from the first day of 2012.
§ The coupon step-up will have a visible effect on the implied bond price. Currently AZRAIL 16 trades at a mid-market price of 100.5 (YTM of 8.10% based on the current 8.25% annual coupon rate and a no step-up assumption). A 100 bpts increase in the coupon to 9.25% from 1 Jan 2012 implies a ‘fair’ price for AZRAIL 16 of 104.5, i.e. four points higher.
§ Therefore, we expect the market to re-price AZRAIL 16 in the coming days.
§ The key associated risk is that ADDY could still manage to receive a credit rating in the next few days. We expect that ADDY would get a rating on par with the sovereign rating of Azerbaijan (‘BB+ / Positive’ [S&P], ‘Ba1 / Positive’ [Moody’s] and ‘BBB- / Positive’ [Fitch]). Thus, this risk would be compensated by the mere presence of a rating because a circle of investors who can buy AZRAIL 16 will widen significantly. Furthermore, at this rating level the mispricing relative to similarly-rated KTZ 16 will become more evident. The spread between AZRAIL 16 and KTZ 16 stands at around 275 bpts now while we see the maximum justified level at 150 bpts. A 125 bpts spread compression would translate into a ‘fair’ price of AZRAIL 16 of 105.0 (at the old 8.25% coupon). The respective upside is comparable with that from a coupon step-up.
That said, we remain positive on ADDY. We deem its credit quality as strong thanks to exposure to Azerbaijan, the quasi-sovereign and strategic status of the company, the stability and good growth potential of its operations and its strong market position. We believe ADDY’s financial risk profile is moderate-to-strong due to its comfortable debt profile, good cash flow generation capacity and flexible capex programme.
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