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It’s not only about the security and a guarantee

Last Friday, I came across an article published online titled ‘Only 25 per cent of bonds listed on Stock Exchange are secured’, which stated that “only a quarter of the outstanding bonds listed on the Malta Stock Exchange are secured, with just under half of them guaranteed, either by other companies or by guarantors, the Central Bank of Malta warned on Friday”.

The article made reference to the 2017 Financial Stability Report published by the Central Bank of Malta which also contained a review of the corporate bond market in Malta.

The wording used in the online article may have alarmed some investors as was evident from a comment from one of the readers. In fact, there was no such ‘warning’ by the Central Bank and the feature within the lengthy report provided a useful analysis of the growth in the bond market in recent years.

When reading the article online highlighting the ‘security’ and ‘guarantee’, I immediately recalled that I had published an article some time ago in which I had explained some of these technical terms found in a bond issue prospectus. A google search quickly brought up the article which I had published in October 2009.

Given the amount of time that passed since then as well as the growing number of investors resorting to utilising the bond market in Malta, I thought it would be worth highlighting again some important observations when contemplating an investment in bonds.

The Financial Stability Report also made reference to the Prospects Multilateral Trading Facility launched by the MSE in 2016. As such, I thought it would be useful to start by emphasising the different features of the regulated Main Market as well as Prospects.

Prospects is not a regulated market. It is a trading facility operated by the MSE serving as a trading platform for debt and equity securities issued mainly by start-up companies and SMEs. The size of an equity or bond issue via Prospects was originally envisaged not to exceed €5 million (although the most recent issue was of €8 million) and the offer cannot be made to more than 150 natural or legal persons in any one member state of the EU. Due to the restricted offering and the smaller size when compared to the regulated main market, issues on Prospects tend to be much more illiquid than those on the regulated main market. In fact, very few trades have taken place on Prospects as opposed to the marked increase in trading activity in many bonds listed on the regulated main market.

One of the main characteristics which is highlighted in any bond issue is the security feature. Some bonds are secured while others are unsecured. When a bond is secured (such as the most recent issue by Exalco Finance plc), the ‘security’ usually takes the form of a hypothec on property in favour of bondholders. In the case of Exalco, two business centres will be hypothecated in favour of bondholders. While this is beneficial since it provides some comfort to investors in the eventuality that the issuer defaults on its obligations to bondholders, this should not be the most important attribute one must look into when analysing the attractiveness of a bond.

As I explained on various occasions in the past, in my view, the financial robustness of the company should be assessed. This should portray a company’s ability to meet the regular interest payments and the repayment of the capital amount upon redemption which is more important than the security feature which would only be used as a last resort in times of financial difficulties. In fact, some weeks ago I published an analysis of two of the most important ratios to gauge the financial strength of bond issuers.

Investors must evaluate the financial strength of a company by measuring the extent of leverage as well as the ability to honour annual interest payment obligations. In the latter case, the interest coverage ratio is a common metric used across local and international financial markets. With respect to the leverage or gearing of a company, there are various methods for determining this. The net debt to equity is one such measure and another is the net debt to Ebitda multiple showing the length of time that would be required by a company to repay its net borrowings, assuming it maintains a stable level of operating profit.

Another term which is also used in many bond issues and which was again mentioned in last Friday’s online article was the ‘guarantee’ that is sometimes attached to a bond issue. Many companies issue bonds via a special purpose vehicle (a finance company) which borrows money from the investing public and then lends the funds to the parent company or other companies forming part of the wider group structure. In such cases, the bonds are guaranteed by the ultimate company borrowing the funds and it is important to analyse the credit metrics of the guarantor rather than the finance company. However, this ‘guarantee’ should not be misinterpreted. This does not imply that the bonds will be repaid under all circumstances and that an issuer may not default when the bonds are guaranteed.

By way of example, the bonds of Exalco Finance plc are secured as well as guaranteed by Exalco Properties Ltd. Had the recent offer been issued directly by Exalco Properties directly rather than via Exalco Finance plc and guaranteed by Exalco Properties, investors ought to have been indifferent since the ultimate credit risk remains unchanged.

On the other hand, the bonds of say Simonds Farsons Cisk plc or Premier Capital plc are not guaranteed. This should not in any way suggest that the bonds of Exalco are safer than those issued by Farsons or Premier Capital. In fact, although the credit metrics of Exalco Properties as the guarantor are comforting with a projected interest cover of 4.6 times in 2018 and a net debt to Ebitda multiple of six times, the ratios of Farsons and Premier Capital are far superior and rank among the strongest in Malta. This would suggest that there is a much lower chance of default by these two companies despite the fact that both these bonds are not guaranteed.

Another point which may be worth highlighting once again is the classification of complexity among various issuers. ‘Complex’ financial instruments are instruments which include a feature or characteristic that make it more difficult for potential investors to understand and assess. Complex financial instruments include bonds having an early redemption option (callable bonds), instruments embedding a derivative or presenting a structure which makes it difficult for the client to understand the risk, subordinated bonds as well as bonds issued by financial institutions subject to the BRRD. In terms of MiFID II, complex financial instruments are ineligible for retail investors unless they are capable of demonstrating that they have sufficient knowledge and experience to understand these features and characteristics.

On the other hand, ‘non-complex’ financial instruments include ordinary shares and plain vanilla fixed interest bonds having a single fixed maturity date.

Most bonds in Malta are now non-complex since they do not have an early repayment option. As such, they may be subscribed to by all types of investors without the need for the investor to demonstrate their knowledge and experience.

On the other hand, bonds issued by the local banks would be classified as complex financial instruments which makes their marketability very restricted due to the regulation currently in place.

This point was discussed in a recent interview with HSBC Malta’s CEO Andrew Beane who was quoted as having stated that regulation around the bond market is “very much based on the complexity of an instrument, not the risk profile – so you can have something which is high in complexity and low in risk, or vice versa”.

Mr Beane urged regulators to ascertain that the focus is on making sure that the supervisory intervention is centred mainly on the risk profile and not simply on the complexity of an instrument. Currently, this is resulting in a situation where retail investors have the possibility of investing even in bonds issued effectively by start-ups or relatively small unknown issuers not having an adequate track record while they may find it rather cumbersome to invest in bonds issued by large, regulated, dominant and strong banks simply because these institutions are issuing subordinated and therefore ‘complex’ bonds.

As the bond market continues to grow, more companies from various economic sectors and with different characteristics are likely to tap the market with a bond issue. It is essential for investors to understand the different characteristics but, more importantly, the financial strength of the issuer. In essence, while the ‘security’ hypothecated in favour of bondholders gives a certain degree of comfort to some investors, in my view it is certainly not right to conclude that all secured bonds are less risky than unsecured ones.

Rizzo, Farrugia & Co. (Stockbrokers) Ltd, “Rizzo Farrugia”, 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 company/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. Rizzo Farrugia, its directors, the author of this report, other employees or Rizzo Farrugia 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, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither Rizzo Farrugia, 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.

© 2018 Rizzo, Farrugia & Co. (Stockbrokers) Ltd. All rights reserved.

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