Underlying strength of local bonds

The weekly Times Business supplement represents, in my view, the best financial journalism available locally. I particularly like the very informative periodic articles by Edward Rizzo of Rizzo, Farrugia & Co. (Stockbrokers) Ltd.

His article Investing In Bonds: It's Not All About Security is most opportune. Hopefully this will serve to make entirely clear to holders of local bonds the rather confusing term "unsubordinated" which, as he rightly points out, is a positive and not a negative factor. Unfortunately the name could easily be taken to imply the latter.

By quoting examples of local bonds on the market, Mr Rizzo also very clearly explained the distinction between a bond that is "secured" (normally by way of a hypothec) as distinct from one that is "guaranteed" (but is referred to as "unsecured"). He rightly says that in the case of secured bonds "the security hypothecated in favour of bondholders gives a certain degree of comfort" but goes on to explain that "it is not right in my view to conclude that all unsecured bonds are riskier than the secured ones".

I feel that one should go further by saying why a bond secured by a hypotec may be deemed riskier than one secured by guarantee. I say so because in the case of those local bonds falling in the former category the hypothec normally ranks after a prior hypothec in favour of the lending bank (or even special privileges in favour of the developer in the case of incomplete developments). Thus, while, on paper, the security value might look adequate based on valuations at the time of issue of the bond, in practice if things go wrong the property value is likely to have fallen to the extent that only the bank will recover its lendings in the event of a forced sale of the underlying immovable property, leaving the bondholders high and dry with no security cover at all!

On the other hand, in the latter category a guarantee of the parent company (as, for example, in the case of the Corinthia Finance plc bond issue) could well provide bond holders with more valuable security than a second charge on immovable property the value of which could prove to be worthless; more so if no buyer comes forward in a forced sale.

In the case of a bond with a guarantee much depends, of course, on the nature of the assets of the guarantor. If the published audited accounts of the guarantor company include substantial liquid assets (and there are such cases) these could provide more comfort to bondholders than a second hypothec on immovable property in the event that the bond issuing company fails to honour its obligations to bondholders.

Experience has shown that so-called "secured" bonds could well prove to be more risky than "guaranteed" bonds!