Deposits in banks are guaranteed for up to €100,000 by a Special Compensation Scheme should any bank fail. Corporate bonds do not have such a guarantee but, to compensate, the bondholder has the comfort of a promise in the prospectus that the issuing company will put aside stipulated sums of money annually into a sinking fund so that sufficient funds will be available to redeem the bond on maturity.
There are cases where the custodian is a related or associate company of the sponsoring stockbroker- Joe Pace Ross
To prop up this promise, the issuer prepares financial projections in the prospectus to show that the company would indeed be able to generate sufficient cash to enable it create and feed the sinking fund. These financials are prepared by professional accountants and the bondholder relies on them when taking the decision to buy the bond.
Notwithstanding this, some local companies, on maturity, issue a second bond so that cash can be raised to redeem the first issue. This rollover exercise often triggers some legitimate questions.
If the reason for the rollover is shortage of funds, what circumstances occurred during the currency of the bond that prevented the company from accumulating sufficient cash or profits to meet this commitment? How realistic were the projections in the prospectus? Were these based more on the premise of what is possible rather than what is probable? Were these projections analysed to verify their feasibility, taking also into consideration the issuer’s past performance?
There is a common assumption in some sectors of the market that the rolling over of a bond to address unachieved results is the accepted norm. However, rollovers are not the anodyne for all that could go wrong in the life of a bond. Rollovers have worked well so far, but the market cannot be taken for granted. The economy and the sentiment of investors may change five or 10 years down the line, and the bondholders or new investors may be lukewarm to a rollover offer.
From a bondholder’s perspective, this is why it is important to have a feasible and water-tight sinking fund included as a mandatory condition in the prospectus. The requirement for the sinking fund is usually only for 50 per cent of the bond amount. The MFSA has tightened its requirements in this regard.
However, some prospectuses indicate that although the issuing company promises to create a sinking fund over which it may not allow to subsist security, it retains the right to create a privilege in favour of a credit institution when the company is facing temporary liquidity problems. In such cases, the company would normally have to seek the consent of the fund’s custodian. Similar wording can be somewhat equivocal to the ordinary investor.
The bottom line is that the company can pledge the sinking fund assets (those accumulated over the years) to its bank as security for a temporary loan – this pledge will impair the protection that the fund provides to the bondholder,
Admittedly, this is only allowed when the financial problem is temporary. But who decides what is temporary and what is not?
Apparently, the arbiter in such matters would be the custodian of the sinking fund who must give consent and who would presumably do so after examining the company’s financial situation to ascertain that the problem is truly temporary and that the relative loan can be repaid within a short time.
There are cases where the custodian is a related or associate company of the sponsoring stockbroker. Would it not be more prudent if the custodian were unconnected to the sponsoring stockbroker in view of the latter’s close relationship to the company? Sponsoring stockbrokers and custodians both have an excellent reputation of integrity and would no doubt take a detached and independent stand if the occasion arises, but this would be better seen to be the case if their functions are completely segregated.
When matters have reached the stage where the company approaches the custodian to seek consent to pledge the assets of the sinking fund, would the bondholders have any say in the matter? Apparently, not.
It is precisely when the company is facing financial problems, however temporary these may be, that the bondholders should look more critically at the issuer’s financial situation to ensure that their interests are protected and that fund assets remain unencumbered by a pledge to a bank.
“Temporary” and “feasibility of repayment” are subjective issues. Conflicting views will probably be held by the company and other third parties. It is therefore advisable if the opinion of an independent qualified accountant is obtained before consent is given.
The lobby of the financial sector is a strong one and the open wording of the conditions of some sinking funds seem to confirm this. One must admit that this lobby has a strong argument. Without them, economic activity would grind to a halt. This is true.
But the hundreds of investors who, as stakeholders, have about €800 million invested in current corporate bond issues also have a point. Without them, there would be no market at all. So, if there must be a sinking fund, let it be effective without loopholes. More so, if a bond is unsecured.
Joe Pace Ross is a retired banker.