Investing in bonds: It’s not all about security!

During the first nine months of 2009, new corporate bond issues in Malta (excluding those of the government) totalled €265 million, by far the largest amount ever raised by companies through the primary market of the Malta Stock Exchange. This is a very positive development, although it is disappointing that it has taken so many years for the corporate bond market to register meaningful growth providing companies with an alternative source of funding to customary bank borrowing.

The increased investor interest in bonds is also spilling over into the secondary market with an increasing number of bonds trading on a daily basis. Again this is a very positive outcome making it easier for investors to trade their bonds on the secondary market although a truly liquid bond market can only happen when market makers commence operating in the market with an obligation to quote continuous bid and offer prices.

In recent weeks there has been increased awareness of the bond market as a result of three new issues coming to the market simultaneously during September. While all three issues amounted to an aggregate total of €65 million, the amount of new money raised was lower as a result of two of the bonds having an element of an ‘offer of exchange’ for existing bonds.

The new 6.25 per cent Corinthia bonds were issued ahead of the redemption of the 6.7 per cent Corinthia bonds due tomorrow while CareMalta bondholders were offered an exchange into the new bonds of Island Hotel Group Holdings. Corinthia raised €21 million in “new money”, Island Hotels raised €17.9 million “new money” in their bond issue and another €6.1 million in equity while Melita Capital raised a further €25.8 million.

This demand in a space of a few weeks confirmed the strong appetite for fixed interest investments by the public. During the offering period of these bond issues, a number of investors and press contributors aired their views on the attractiveness or otherwise of each of the new offerings, which is normal at such times. However, the misinformation in a particular newspaper article published recently on some technical terms used within a prospectus needs to be clarified. While questioning the MFSA’s role in the listing process, the writer’s opinion on the unsuitability of most of the bond issues listed on the Malta Stock Exchange since they are unsecured and unsubordinated (incidentally, this latter condition is positive not negative) requires commenting upon.

In two of my articles over the past year (November 13, 2008 and February 12), I had tried to address the most important features which an investor should look into before deciding on whether to invest in a particular bond issue.

When a bond is secured, the “security” usually takes the form of a hypothec on some property of the issuer in favour of bondholders. While this is beneficial since it provides some comfort to investors in case of the issuer defaulting on its obligations to bondholders, this should not be the most important attribute one must look into when analysing the attractiveness of a bond. In my view, the financial robustness of the company when issuing the bonds and its indicative ability to meet regular interest payments and final capital redemption is more important.

In Malta there are only four secured bonds which had offered some form of security to investors, namely Dolmen Properties plc, Big Bon Finance plc, Pavi Shopping Complex plc and Gap Developments plc. All other bonds are unsecured. While the “security” hypothecated in favour of bondholders gives a certain degree of comfort to some investors, it certainly is not right in my view to conclude that all unsecured bonds are riskier than the secured ones.

While some of the secured bonds such as Dolmen and Big Bon have very robust financials together with the added comfort of the security feature, many would probably agree that an unsecured bond issued by a number of Malta’s leading companies with a gearing ratio of less than 50 per cent and high interest covers (over seven times in the case of Gasan Group), should be more comforting to investors.

The weak financial situation of the property development company GAP Developments plc which at the launch of its public bond issue had a gearing ratio of 93.7 per cent (capital of €4.6 million and borrowings of €64.3 million) should have severely tested an investor’s suitability check-list although bondholders had been offered a second hypothec on some of the property which still had to be built. In my view, the starting point when looking to invest in a bond should be the financial indicators of the issuer.

The recent newspaper article also confused the concept of subordination. Unsubordinated bonds rank higher than subordinated ones and should therefore be preferred. In fact, in case of default or winding up of an issuer, creditors with unsubordinated debt would get priority over others holding subordinated debt and therefore unsubordinated debt is less risky than subordinated debt. This is important especially in many overseas markets since various multinational companies have both types of bonds in issue (unsubordinated as well as subordinated). Due to the lower ranking of subordinated bonds, these usually carry a higher coupon rate.

The newspaper article highlighted that “bonds in Malta are nearly always unsecured and unsubordinated so that the investor is not guaranteed his money back”. This is misleading. “Secured” bonds in no way “guarantee” that an investor will get his money back on maturity let alone holders of subordinated debt. Once again it is the financial robustness of the bond issuer at the time of the launch and more importantly during the lifetime of the bond that can provide comfort to bondholders that they can expect to get their capital back at maturity.

Another term which is also used in some bond issues and which was again misinterpreted in the article was the “guarantee” that is sometimes attached to a bond issue. Since many bond issuers do not have any major assets, as their only purpose is to act as the financing arm of a group of companies, as is the case with Tumas Investments, Corinthia Finance and others, a guarantee is provided by the parent company to assume the issuer’s obligations in case of default thus providing additional comfort to bondholders.

In the case of the recent bond issue by the Tumas Group, it was incorrectly argued that the bonds were “secured only by Spinola Development Co Ltd”. While Tumas Investments plc is the financing arm of the company owning the Portomaso development, SDC’s balance sheet shows total reserves of €40 million compared to €51.6 million in net borrowings, which is considered to be a sufficiently healthy balance between debt and equity.

Likewise last month’s Corinthia Finance plc bond issue was guaranteed by their parent company CPHCL which has a total amount of capital and accumulated profits of €378.8 million compared to total net debt of €293 million. These companies are considered to have robust financial positions providing a good level of comfort to bondholders and can be regarded as safer investment propositions than some others which are in the “secured” category of bonds.

While investing in local corporate bonds is a fairly recent development, in past years local investors sought to channel their savings to overseas corporate companies and governments since the local Borza was not offering sufficient investment opportunities. Although some of these foreign corporate bonds and government issues had credit ratings issued by well-known international credit rating agencies, many investors who had acquired some bonds overseas unfortunately lost most of their capital as a result of defaults by some issuers.

The recent nasty experiences encountered by numerous Maltese investors with Argentinian bonds and other bonds including those of Lehman Brothers has helped to entice a number of local investors to invest in local companies since these companies fortunes can be better monitored.

Mr Rizzo is director of Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, RFC, is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the issuer/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.
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