When faced with a selection of fixed income securities, investors generally make their buy or sell decisions based on readily available information, such as the price and yield of the bond, the coupon, maturity date and the credit rating of the issue assigned by international rating agencies. In this article I hope to explain various other equally important terms found in a bond prospectus, which could affect the pricing of the bond including private placements, senior versus junior debt, subordinated and unsubordinated, secured or unsecured, covered bonds and the sinking fund.
The Izola Bank bond issued in 2010 took the form of a private placement. In this kind of offering, the issue is sold to a select group of sophisticated investors, such as insurance companies and collective investment schemes, rather than to the general public. This works to the advantage of the issuer by reducing the time and cost of raising capital – but given the smaller size of the issue and hence lower liquidity, investors would require a somewhat higher interest rate.
Liquidity is the ease with which one could buy or sell a security once the bond is issued. One major factor in the liquidity of a bond is the issue’s size or the nominal amount of debt when the bond is issued. You would expect that the larger the issue, the higher the liquidity, and hence this could explain why Maltese corporate bonds trade infrequently once issued. On the Eurobond market, the benchmark size is €500million – anything smaller than €250million would not offer great liquidity. Maltese corporate bonds, quite expectedly, average approximately €20 - €30 million in size.
Other terms describe the priority of payments to creditors when a bond fails to pay its dues, after entities such as the company liquidator, company employees and the tax collector receive theirs. Should an issuer default or run into difficulties paying off the debt, senior bondholders have a prior claim for interest payments and the principal amount in receiving whatever monies are available. Junior bonds have a lower ranking vis-à-vis other bonds.
Given this ranking, senior bonds offer lower yields than junior bonds because they are considered less risky. This ranking will also be reflected in the pricing of the bond should the bond default. This was evident with the collapse of Lehman Brothers in 2008, where a senior 4.75 per cent January 2014 bond lost 75-80 per cent of its face value, whilst the 5.125 per cent issue – a non-cumulative preferred security – lost more than 99 per cent of its face value (non-cumulative preferred security is a preference share for which the issuer does not need to pay all dividends.
Should for any reason, the issuer miss a dividend payment, it no longer owes the dividend. This type of debt would rank amongst the lowest on the issuer’s balance sheet). Within the senior and junior ranks, bonds are also classified as unsubordinated or subordinated. In such cases, senior unsubordinated debt ranks above senior subordinated debt, and both rank higher than junior unsubordinated debt.
Another term is secured debt – debt to which some specific property belonging to the issuer is charged. In this case the borrower pledges an asset, such as a building as collateral for the loan. In the event of default the creditor takes possession of the secured asset and may sell it to recover all or part of the amount lent in the same way that a bank repossesses a mortgaged property should the property owner fall back on repayments. When the issue is unsecured, the debt is not connected to any particular asset, but would normally be covered by the general assets of the firm.
A stronger variant of security is the covered bond issue. This is a senior debt instrument having priority to a pool of assets ring-fenced from the other assets on the balance sheet of the issuer. The pool of assets in the main covers residential and commercial mortgages; such issues have been increasing in the international market over the last few months.
The credit rating given to the bond reflects the credit strength of the pool of assets covered, thus bonds issued by Royal Bank of Scotland are generally rated A+ by Standard & Poor’s, however the same bank’s covered bonds are rated AAA. Given the strength of the pool, covered bonds are often regarded as a substitute government bonds.
A further term one comes across in a prospectus is the sinking fund. In essence, this fund is made up of regular, mandatory payments to the “sinking fund” by the bond issuer during the life of a bond. Each payment is calculated as a percentage of total debt issued or according to a pre-determined formula, thus reducing the principal amount due at maturity. A number of securities trading on the Maltese bond market operate a reserve account, which differs slightly from the sinking fund in that the issuer is obliged to start building reserves several years prior to the maturity of the bond such that a significant proportion of the bond can be redeemed by using this account.
These funds should be segregated from the issuer’s assets, and transferred to a custodian to repurchase or cancel part of the bond issue, or to purchase liquid securities described in the prospectus. The sinking fund or reserve account provides some peace of mind to the bondholder given that the issuer will not be impacted by a one-off cash outflow (the size of the bond issue) at maturity hence reducing the possibility of bond default.
The decision to buy a bond must not only be a function of the coupon / rate of interest, but also the many factors mentioned above, as these factors also contribute to the value, or otherwise, of each bond.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
www.curmiandpartners.com
Mr Micallef works with Curmi and Partners Ltd.