(Bloomberg News circulated the following article by Walden Siew on June 7.)
NEW YORK — Union Pacific Corp., Burlington Northern Santa Fe Corp. and other railroad company bonds are rallying compared with government debt as fuel surcharges shield them from rising energy prices.
The extra yield, or spread, above Treasuries investors require to hold notes of Union Pacific and Burlington Northern narrowed as much as 5 basis points since April. The spread for investment-grade bonds widened as much as 6 basis points to an average of 93, according to indexes prepared by Merrill Lynch & Co. that track the performance of the U.S. bond market.
Railroads are unusual because the government allows them to raise fees to cover extra fuel costs. Their energy bill totaled $6 billion last year, double the amount from 2002. A May survey by the Philadelphia Federal Reserve showed manufacturers’ costs rose the most in 30 years while the prices they charged fell.
“You want to be in an industry that’s maintained pricing power,” said Jim Keegan, who has added railroad bonds to the $19 billion he oversees as a senior vice president at American Century Investments in Mountain View, California.
Fuel surcharges put in place by rail companies are at least $900 million more than increases in fuel costs, according to Thomas Schick, senior director of distribution for the American Chemistry Council, whose members include Dow Chemical Co.
The yield spread on Omaha, Nebraska-based Union Pacific’s $250 million of 5.375 percent notes due 2014 narrowed about 5 basis points to 71 since April. The price of the bonds issued by the biggest U.S. railroad fell to about 97 cents on the dollar from 98.2 cents, boosting the yield to 5.9 percent from 5.7 percent, according Trace, the NASD’s bond-price reporting system. The decline was smaller than the drop in Treasury notes with a similar maturity.
Profit Forecast
Burlington Northern, the second-biggest U.S. railroad, said on June 5 that it expects annual profit growth of at least 10 percent through 2010 because it’s transporting more consumer goods and coal.
The spread on Fort Worth, Texas-based Burlington Northern’s $200 million of 8.75 percent notes maturing in 2022 narrowed 3 basis points to 112 basis points since April, according to Trace. The price rose to 125 cents on the dollar from 124 cents, as the yield fell to 6.2 percent from 6.3 percent.
“Railroads are having a fair amount of success passing through fuel increases through surcharges,” said Lisa Jenkins, a New York based analyst at Standard & Poor’s. “The industry outlook in terms of fundamentals is very favorable. Railroads are enjoying a good pricing environment.”
The four biggest U.S. railroad companies reported first quarter earnings that rose at least 29 percent, almost twice the 16.7 percent earnings growth reported by companies in the S&P 500 Index.
Shares of railroad companies have also rallied, climbing 13 percent this year, according to S&P’s Rail Index, outpacing the 1.6 percent gain in the S&P 500 Index.
Canadian National Sale
Canadian National Railway Co., Canada’s largest railroad company, took advantage of narrower spreads by selling $700 million of debt in the U.S. on May 23.
The sale included $450 million of 6.2 percent bonds due 2036 at a yield 97 basis points more than Treasuries, or 8 basis points narrower its last 30-year bonds in July 2004, according to Bloomberg data. Canadian National also sold $250 million of 5.8 percent notes due 2016 at a spread of 77 basis points, or 3 basis points narrower than when it offered 10-year notes in March 2003. Chief Financial Officer Claude Mongeau didn’t return a phone call seeking comment.
The four biggest railroads spent $6 billion on fuel last year as the price paid for a gallon of diesel rose to an average of $1.65, more than double the price in 2002.
Customer Backlash
Shippers including electric utilities, automakers and grain companies said at a Surface Transportation Board hearing on May 11 in Washington that the group, which regulates railroads, should limit the surcharges.
The fees are set individually and vary by shipment and distance, according to the railroad companies.
“With the increase in fuel prices, through our surcharge program, we’re recovering about 70 percent of that increase,” Paul Weyandt, senior vice president and treasurer at Kansas City Southern, based in Kansas City, Missouri, said in a phone interview. “That helps mitigate the fuel price increase, and is helping profits.”
Burlington finance chief Thomas Hund said surcharges aren’t being used to boost profits. “Are we over-recovering? The answer is no,” Hund said at the hearing. “The objective of the BNSF program is to recover the increase in fuel expense.” He said fees collected over the past five years are $1.1 billion short of the increase in the railroad’s fuel costs.
Merrill’s index of investment-grade transportation bonds, where more than half the members are railroad companies, returned 1.1 percent since April, outpacing the 0.6 percent return for the broader investment-grade market.
Junk Bonds
Junk-rated railroad bonds are rallying as well.
The spread for speculative grade bonds sold by companies such as Kansas City Southern have narrowed 3 basis points to 220 basis points since April, according to Merrill’s index of six securities with a market value of $1.46 billion. The average junk-bond spread widened 20 basis points to 324 basis points. Junk bonds are rated below BBB- by S&P and Baa3 by Moody’s Investors Service.
Kansas City Southern’s 7.5 percent notes maturing in 2009 rose to 101.75 cents on the dollar in May from 101.5 cents at the end of April. The yield fell to 6.9 percent from about 7 percent, according to Trace. The spread narrowed to about 186 basis points from about 200 basis points.
The bonds gained even after the company’s credit rating was cut one level by Moody’s in April to B2 and two levels by S&P to B in part because of increased capital investment, which added to debt outstanding. The company, which bought Mexico’s biggest railroad a year ago, has about $2 billion in outstanding bonds and loans, according to Bloomberg data.
“The market digested the news and is more comfortable with our first quarter operating results,” Weyandt said.