The majority of local investors opt to disregard to give the necessary importance to the indenture, or locally better known as the prospectus or offering document. Unfortunately, other investors literally ignore the document and invest blindly in a particular issue.
Looking at bonds, the indenture is a legally binding document between two parties, in this case the bond issuer and investor. This document includes very important features, which an investor should be aware of and feel comfortable with prior to investing. What investors usually look at are the popular features such as the bond’s maturity date, timing of interest payments (whether annually or semi-annual) and the use of proceeds, i.e. the main reason behind why the company is borrowing money from the public.
Unfortunately, despite these being important concepts which investors are familiar with, other very important features in the document are usually ignored, for one reason or another. It could be that the financial jargon used in the document is difficult for an investor to understand, or it is also possible that investors do not want to delve into much detail.
One of the most important features that investors should search for is whether the bond has a callable option. A callable feature gives the right to the issuer to call the bond prior maturity at pre-defined dates and price levels, usually with a so-called non-call period. For the avoidance of doubt, for instance, a bond with a 10-year maturity can be called following three years from issuance at the agreed price level, a feature that is found in the said indenture.
Other important features within the document are covenants, which restrict the company from certain activities. Covenants are dissected into affirmative and negative covenants. Affirmative covenants, are usually clauses that require the borrower to perform certain actions, for instance to provide the lender with audited financial statements. Whereas negative covenants are in place to safeguard investors against possibly any actions by management which could be detrimental towards the company’s financial sanity.
The most common negative covenants are financial ratios that a company must maintain. One of the most popular ratio is the interest coverage ratio, i.e. how many times the company can cover its interest payments from its operations. In this regard, an example would be that a company must maintain its coverage ratio at 3x as of the date of the financial statements. Such covenants should be strictly adhered to throughout the tenor of the bond and can only be ratified by bondholders’ approval, which usually get a so-called consent fee for accepting the amendments. It is important to understand that the said covenants cannot be amended by shareholders or the board of directors.
Another important negative covenant is the adherence to certain debt ratios. This is very important for investors to look for as it impedes the company from incurring further debt. Note that the incurrence of more debt can put pressure on the current bond investors, and place them in a worst position than when the bond was issued. That said, some sort of loopholes do exist to a certain limit. In fact, a particular clause better known as carve-out gives the opportunity to the issuer to incur further debt under certain circumstances. For instance, increasing a revolving credit facility in order for the company to be more comfortable to manage its day-to-day working capital needs.
Luckily enough for local investors, the above financial jargon is merely found under local issuance, whereas the said clauses are the norm for foreign bonds. Unfortunately, locally investors tend to ignore the above-mentioned points and at times when the company opts to implement any option within the prospectus, they tend to be surprised and query if this could be done. In my view, investors should indeed allocate time in reading the prospectus and be well-informed prior investing. As the said clauses might not be in line with the investor’s expectation. If the jargon used in the prospectus is difficult to understand, investors should seek professional advice.
Disclaimer: This article was issued by Jordan Portelli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt .The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Calamatta Cuschieri Investment Services Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this website.